The Tax System for the Self Employed

Registering with HM Revenue & Customs

If you start working for yourself, you must register with HM Revenue & Customs within the first three full months of self employment. Otherwise you may be liable to a penalty of £100. You may register by telephone or by using the form incorporated in leaflet P/SE/1 (Thinking of working for yourself?).

Once you become self-employed, the tax rules are quite different from those that may have applied when you were an employee. Instead of tax (and national insurance) being deducted from your earnings at source, you must be prepared to receive a bill at some time in the future. This can be a nasty shock if you haven't put enough money aside.

We aim to give you as much warning as possible of the likely timing and amount of tax payments, but it is not easy to do this during the first year of your new business, or if you do not keep your records up-to-date.

What profits do HM Revenue & Customs tax?

The starting point for the calculation of taxable profits is your profit and loss account. In calculating taxable profits you are entitled to claim deductions from your business income in respect of any expenses incurred for the purposes of trade (with a few minor exceptions).

When you buy equipment or motor vehicles, you will be entitled to deduct a proportion of the cost each year you own them and use them in your business.

If you take stock for your own use, the disposal should be shown in the accounts at market value, and not at original cost. It may be possible to avoid this by arguing that such items never actually formed part of your stock and showing the original purchase as private expenditure (drawings).

Tax is payable on the whole of the profits of a trade, and so payments for your own 'wages' (drawings) are not deductible. However, if your spouse works in the business, the wages are an allowable deduction, provided they are actually paid and are a reasonable reward for what is done.

How does HM Revenue & Customs allocate profit to tax years?

The aim of the system is that over the lifetime of your business the profits will be taxed in full, once, and once only. But to make the system fair, there are certain complications you will have to cope with.

The general rule is that the tax for a particular tax year is based on the profits of the twelve months to your accounting date in that tax year. For example, the tax for 2005/06 could be based on accounts for a year ending on various dates ranging from 6 April 2005 to 5 April 2006. This demonstrates that you get more time for the tax to be worked out if your accounts end early in the tax year, which is why 30 April is such a popular year-end for self-employed people.

How is the tax collected?

Tax returns

Tax returns covering income for the year ending 5 April 2006 have to be submitted to HM Revenue & Customs by 31 January 2007 (the 'filing date'). The return will include a self assessment of your liability to income tax and capital gains tax.

If you don't want to work out your own liability, you must send the tax return back by 30 September 2006.There are automatic penalties for late filing of tax returns.

Payment of tax

Payments on account of income tax and Class 4 NIC will be due on 31 January 2006 and 31 July 2006. These interim payments will be based on one half of the total liability (less any tax deducted at source) for 2004/05. You will have the right to reduce payments on account if you believe the income tax for 2005/06 will be lower.

The balance of income tax for 2005/06 is due on 31 January 2007 (along with the first interim payment for 2005/06 and any capital gains tax for 2005/06).

Interest and surcharges will be levied for late payment.

What about the complications?

Opening years

In the first tax year of your business, the tax payable is based on the profit arising between the starting date and the following 5 April. This is taken as the appropriate fraction of the profit shown in your first set of accounts. Say you start on 1 June 2005 and your first accounts run to 30 June 2006 with a profit of £13,000, then tax will be worked out (to the nearest month) on the profits of the following periods:

2005/06 1 June 2005 to 5 April 2006 - 10/13 x £13,000 i.e. £10,000
2006/07 1 July 2005 to 30 June 2006 - 12/13 x £13,000 i.e. £12,000

You can see that the profit from 1 July 2005 to 5 April 2006 (9 months) has been taxed twice. The 'overlap' profit of £9,000 will be available for deduction when the business comes to an end, or (at least in part) if you change your accounting date to one nearer 5 April.

Change of accounting date

If you decide to change your accounting date from 30 June 2007 to 31 December 2007 and the accounts for the 18 months ending 31 December 2006 show a profit of £27,000, the taxable profit for 2007/08 will be worked out as follows:

* Profit based on accounts (18 months) £27,000
* Less overlap relief £6,000
* Profit for 2007/08 £21,000
Cessation

If you then cease trading on 31 August 2009, and your final accounts for the eight months ending on that date show a profit of £11,000, the taxable profit for 2009/10 will be:

* Profit since accounting date in previous tax year £11,000
* Less balance of overlap relief not already used £3,000
* Profit for 2009/10 £8,000
What about national insurance?

The self-employed are subject to a two-tier system of national insurance contributions. Class 2 contributions are at a flat rate of £2.10 per week, payable against a quarterly bill or by direct debit from your bank account, if earnings exceed £4,345 per annum.

Profits between £4,895 and £32,760 are subject to Class 4 contributions at a rate of 8%. Profits in excess of £32,760 are liable to Class 4 contributions at the rate of 1% without any upper limit. Class 4 contributions are collected by HM Revenue & Customs and are payable at the same time as the instalments of income tax.

Save for your tax

It is essential that you make proper provision to ensure the availability of funds to pay income tax and Class 4 national insurance. Interest on unpaid tax is chargeable by HM Revenue & Customs, and is not deductible from business profits.