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Starting up a business of your own is a big step and not one to take lightly. The taxation of your business is only one of many commercial and legal aspects of starting a business that you will need to consider.
Preparation is the key and a proper business plan should be one of the first things you should do. However, tax matters are our concern here.
Choosing a business structure
The alternative business structures are:
Sole Trader
This is the simplest form of business since it can be established without legal formality. However, the business of a sole trader is not distinguished from the proprietor’s personal affairs. If the business incurs debts which are unpaid, the creditor can seek repayment from the sole trader personally.
Partnership
A partnership is similar in nature to a sole trader but involves two or more people working together. A written agreement is essential so that all partners are aware of the terms of the partnership. Again the business and personal affairs of the partners are not legally separate.
Sole traders and partnerships are often referred to as unincorporated businesses.
Limited Company
A company is a legal entity in its own right, separate from the personal affairs of the owners and the directors. A company provides specific liability which means that the creditors of the company cannot make a claim against the owners or the directors except in very limited circumstances. Often this advantage is somewhat eroded because a bank, for example, may seek personal guarantees from the directors.
These potential advantages carry the downside of greater legal requirements and regulations that must be complied with.
Limited Liability Partnerships (LLPs)
LLPs are a halfway house between partnerships and companies. They are taxed in the same way as a partnership but are legally a corporate body. This again gives some protection to the owners from the partnership’s creditors.
In this section we consider the differing tax treatments of the alternatives but you should choose which structure is right for you based on more than just the tax issues alone.
Tax Planning
If you operate as a limited company, there is a legal separation between you as the owner and the company itself. This means you cannot use the company cheque book as if it were your own! This requires a certain discipline without which all kinds of difficulties can occur.
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Many will start off as a sole trader, taking advantage of the lack of any formal procedures to establish the business. Some, however, will need the protection of limited liability because they are in a high risk business or they may need the additional stature that is seen as attaching to a limited company. Alternatively, they may need to establish and protect a particular name which only the formation of a limited company will allow them to do.
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The tax regime
Unincorporated businesses
A new business must register with HMRC within three months of commencing to trade. Income tax is paid on the profits of the business. The amount that the proprietor, or a partner in a partnership, draws out of the business (referred to as ‘drawings’) is irrelevant.
Profits are taxed on a current year basis as shown by the example.
Example
If the accounting period (or ‘year’) end is 31 March then, in the tax year 2006/07, the profits for the year ended 31 March 2007 will be taxed.
If, however, the year end was 31 August then, in the tax year 2006/07, the profits for the year ended 31 August 2006 will be taxed.
Many businesses choose 31 March (or even 5 April) as their accounting period end but this is not compulsory.
If losses arise at the beginning of a new business or if the profits grow appreciably month on month, then the choice of the accounting date can be important. Otherwise, the accounting date chosen will not be significant.
Working out profits
Profits are calculated using accepted accounting practices and crucially this means that profit is not necessarily simply receipts less payments. Instead it is income earned less expenses incurred.
Tax Planning
Try to incur expenditure just before rather than just after the year end, as this will accelerate your tax relief. Examples of the type of expenditure to consider bringing forward include building repairs and redecorating, advertising and marketing campaigns and expenditure on plant and machinery. |
Not all of the expenses that a business incurs are allowed to be deducted from income for tax purposes but most are. However, it is important that you keep proper and comprehensive business records so that relief may be claimed.
Capital allowances
When assets are purchased for the business, such as machines, office equipment or motor vehicles, capital allowances are available. As with expenses, they are deducted from income to calculate taxable profit.
| Capital allowances |
| Plant and Machinery* |
Writing Down Allowance |
| 25%# (reducing balance) |
| Motor Cars** |
25% (reducing balance) - £3,000 max. |
| Industrial and Agricultural Buildings and Hotels |
4% (straight line) |
*For small businesses: first year allowances (FYAs) of 50% for 12 months from 6.4.06 (1.4.06 for companies). 40% otherwise.
For medium-sized businesses: FYAs of 40%.
For all businesses: 100% FYAs on expenditure on energy saving plant and machinery.
**100% FYAs on new cars with CO2 emissions not exceeding 120 gm/km until 31.3.08.
#6% on certain long life assets. |
Payment of tax
A person who is self employed, either as a sole trader or a partner in a partnership, will usually pay tax twice a year, on 31 January and 31 July. At first this may seem confusing and is best explained by an example.
Example
A business starts on 6 April 2006. Profit for the period to 31 March 2007 is £10,000. Tax due in 2006/07 is £1,231.
On 31 January 2008 tax payable is £1,846 being £1,231 balancing payment for 2006/07 and £615 (50% of £1,231) payment on account for 2007/08.
On 31 July 2008 £615 will be payable being the second payment on account for 2007/08.
Profit in the year to 31 March 2008 is £30,000 and the tax on this is £7,200.
On 31 January 2009 the payment is £9,570 made up of £5,970 balancing payment for 2007/08 (£7,200 - (£615 +£615)) plus £3,600 payment on account for 2008/09.
On 31 July 2009 a second payment on account for 2008/09 of £3,600 is due. And so on...
Tax Planning
The payments on account system can make tax payments very volatile if profits fluctuate widely from year to year. You must plan ahead carefully to avoid nasty shocks. |
Companies
Unlike sole traders and partnerships who pay tax on profits only (and drawings are ignored), companies have two layers of tax. The first is tax payable by directors and shareholders on money they take out of the company and the second is corporation tax which is due on the company’s profits.
| Corporation tax |
| Starting rate |
Year to 31.3.07 |
Year to 31.3.06 |
| N/A |
0% |
| Lower marginal rate |
N/A |
23.75% |
| Small companies’ rate |
19% |
19% |
| Upper marginal rate |
32.75% |
32.75% |
| Full rate |
30% |
30% |
The starting rate (abolished from 1 April 2006) was normally applied where profits did not exceed £10,000. Where profits were between £10,000 and £50,000 tax was payable on this slice of profit at 23.75%.
The small companies rate normally applies where profits do not exceed £300,000. Profits between £300,000 and £1,500,000 are taxed at 32.75%.
The full rate applies to all profits where those profits are greater than £1,500,000.
Before 1 April 2006 companies with profits of less than £50,000 paid a minimum rate of 19% on profits distributed to non-corporate shareholders. |
Tax on ‘drawings’
The directors of the company will normally be paid a salary and this is taxed under PAYE as for all employees. The cost of this, including the employer’s NIC, is generally an allowable expense of the company.
The shareholders of the company may be rewarded by the payment of dividends on their shares. In most small companies the directors and shareholders are one and the same and so they can choose the most tax efficient way to pay themselves. Using dividends can result in savings in NIC. This requires planning. Please talk to us to decide the best options for you.
Tax on profits
The profits of a limited company are calculated in a similar way as for unincorporated businesses and the same rules about expenses and capital allowances apply. Remember though that the salaries paid to directors, but not the dividends paid to shareholders, are deductible from the profits before they are taxed.
Payment of tax
PAYE and NIC on salaries is payable monthly (or quarterly where the amount due is less than £1,500 per month).
Corporation tax is usually payable nine months and one day after the year end, so the choice of year end has no tax consequence.
In recent years companies have become more popular as they can result in less tax being paid overall.
Tax Planning
The tax saved can be a potent argument for incorporation but it should not be the only factor in deciding the best business option for you.
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Example
Terry and June own equally the shares in Scott Ltd. They have profits of £100,000 before allowing for their salaries.
They can arrange their salaries and dividends in the most tax efficient way and, assuming they draw all of the profits, the company will pay corporation tax of £17,087 and they will have income tax to pay of £1,613 each. This makes a total of £20,313.
Tom and Barbara are equal partners in Goodlife Associates and they have profits of £100,000. Irrespective of how much they draw and in what proportions, they will each pay income tax on £50,000. The amount due will be £14,179 each, making a total of £28,358.
Terry and June have saved £8,000 by operating as a limited company.
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Value added tax (VAT) and your business
VAT is a tax ultimately paid by the final consumer and businesses act as the collectors of the tax. There are heavy fines for failing to operate the system properly.
What does VAT apply to?
Tax Planning
When you first register for VAT you can reclaim input tax on goods purchased up to three years prior to registration provided they are still held when registration takes place. VAT on services supplied in the six months prior to registration may also be reclaimed. |
VAT is chargeable on the supply of goods and services in the UK when made by a business that is required to register for VAT.
A registered business must charge VAT on its sales. This is known as output tax. However, that business will also pay VAT on the goods and services it buys. This is known as input tax.
If the output tax exceeds the input tax, then a payment of the difference has to be made to HMRC. This calculation is normally done quarterly. If input tax exceeds output tax, a repayment of VAT will be made. This calculation is also done quarterly except that if repayments occur regularly this can be done monthly.
Supplies
Certain supplies of goods and services are not subject to VAT at all and are known as exempt supplies. A business that makes only exempt supplies cannot register for VAT and will be unable to reclaim any input tax.
Other supplies are called taxable supplies but there are different rates - zero rate (0%), reduced rate (5%) and standard rate (17.5%).
There are two examples of input tax that a business may incur that are not usually reclaimable. These are VAT incurred on entertaining business customers and VAT on the purchase of a car.
Do I need to register?
A business must register if its taxable supplies exceed an annual figure, currently £61,000. If taxable supplies are less than this a business may still register voluntarily. So, for example, if the business makes only zero rated sales, it can still register and reclaim the input tax suffered.
Tax Planning
You should consider carefully whether to register voluntarily. If the VAT at stake is relatively small the responsibilities of registering may outweigh the benefit. |
VAT can affect competition. A plumber, for example, who sells only to the general public will be at a disadvantage if they have to register for VAT. They may have to charge up to 17.5% more than a plumber who is not registered to earn the same profit. On the other hand, if the same plumber only works for other VAT registered businesses, such as building companies for example, then it will not matter if they are registered because the customer will be able to recover the VAT that is charged.
Indeed, in general, a business that always sells to other VAT registered businesses will normally register, even if below the annual limit, because then it can reclaim VAT on purchases and expenses. This will improve profit. This can be especially relevant for new businesses because there are often high start up costs that carry VAT.
On the other hand registration comes at the cost of having to meet onerous record-keeping requirements, a need to submit VAT returns on time and a fundamental need to get it right! Failure on any of these points exposes the business to penalties which, in some cases, can be substantial.
Schemes for small businesses
The Flat Rate Scheme
This scheme, designed to make the VAT system simpler, is open to businesses whose annual taxable supplies are less than £150,000. It allows businesses to pay VAT at a fixed percentage of their total turnover and no specific claims to recover input tax need to be made. The fixed percentage depends on the type of business.
The Cash Accounting Scheme
If annual taxable supplies are less than £660,000, a business may calculate its VAT payable by considering only the output tax and input tax on invoices which have been paid, rather than by reference to the invoice date alone. This is advantageous where a business has to wait a long time before it is paid by its customers.
The Annual Accounting Scheme
If taxable supplies are below £1,350,000 a business may choose to make only one annual return instead of quarterly returns. However, interim payments of VAT must be made monthly or quarterly by direct debit based on an estimate of the amount due.
By reputation VAT is a tax full of pitfalls for the unwary but most problems arise from poor record keeping or a lack of understanding of the rules. We can help with both and make your life a lot simpler.
Checklist for starting up in business
- Make a business plan.
- Choose the most appropriate structure.
- Set up a bank account.
- Register for VAT if necessary or if voluntary registration would be advantageous.
- Notify HMRC of the new business or company.
- Set up a PAYE scheme if there are employees (always if using a limited company).
Please talk to us for advice on these essential steps. |
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