The Small Business Guide to Tax, NICs & VAT

Understanding Corporation Tax, Income Tax, National Insurance, and VAT and how it will affect your small business can be tricky. Added to this is the fact that your business structure (sole trader, limited company, partnership) can vastly change how much you pay, when, and how you pay. With HMRC fines applicable on late or inaccurate payments, simple miscalculations and mistakes, it’s important that as an entrepreneur, you have a solid understanding of your business’s tax situation, even if you have an accountant that does the majority of the legwork. Here’s our guide to understanding small business Tax, National Insurance, and VAT.

Sole trader or limited company?

A sole trader is a self-employed person who is the sole owner of a business. Sole traders must pay tax on their business profits through Income Tax. In addition to this, they must pay Class 4 National Insurance contributions.

On the other hand, limited companies pay corporation tax on all of their taxable profits. In addition to this, tax will be due on any money you take out of the business, dependent on how you take it out:

Salary

Both income tax and national insurance contributions (NI) for employees, as well as employer's NI contributions, will need to be covered by the limited business.

Dividend

The income tax rate of dividends is typically lower than the tax rate applied to your salary. Also, no national insurance contributions arise on dividends.

Main differences

Liability is a crucial distinction. A limited company, being a separate legal entity, limits your liability as a shareholder. On the other hand, as a sole trader, you bear unlimited liability, meaning you're personally responsible for any debts and any personal assets (such as your house) are not protected.

Financial obligations differ too. A limited company must prepare annual accounts and file them with HMRC, along with the Corporation Tax return. Sole traders, however, need to maintain a record of business expenses and income for their self-assessment tax returns.

Withdrawal of cash has different tax implications. A sole trader can withdraw cash from the business without any tax effect. In contrast, cash withdrawal from a limited company is considered a dividend and is taxed accordingly.

Advantages of being a sole trader:

• Easy to set up
• Greater privacy than incorporated business as details are not publicly available on companies house.

Disadvantages of being a sole trader:

• Unlimited liability, as they are not viewed as a separate legal entity.
• Raising finance can be difficult as banks and investors prefer limited companies.
• When you reach a certain level of earnings, it might not be tax efficient to stay a sole trader.

Advantages of being a limited company:

• Limited liability – you only stand to lose what you put into the company
• Stand to be more tax efficient than sole traders as a limited company pays Corporation Tax on its profits rather than Income Tax. There are also a wider range of allowances and tax-deductible costs that a limited company can claim against its profits.

Disadvantages of being a limited company

• Added responsibility of being a director
• Additional filings to Companies House; confirmation statement and annual accounts
• Information on your business is publicly available on Companies House

Income Tax

Sole trader tax is paid on business profits. If, as a sole trader, you don’t have any other sources of income, such as a salary from a job, then you will start paying Income Tax on your business’s profits once it goes over the personal allowance (for the tax year 2024/25, this is £12,570).

If you're a limited company, you will pay income tax on any salary or dividends you take from the company. If you pay yourself a salary, the business will deduct the income tax from your salary under the PAYE scheme.

Band	Taxable Income	Tax Rate
Personal Allowance	Up to £12,570	0%
Basic Rate	£12,570 to £50,270	20%
Higher Rate	£50,270 to £125,140	40%
Additional Rate	Over £125,140	45%

The above table shows income tax rate bands for employment.

The income tax rates for dividends are different and only available to limited companies. Here are the rates below:

Band	Taxable Income	Tax Rate
Personal Allowance	Up to £12,570	0%
Basic Rate	£12,570 to £50,270	8.75%
Higher Rate	£50,270 to £125,140	33.75%
Additional Rate	Over £125,140	39.35%

In addition to the personal allowance, there is a tax-free dividend allowance of £500 per year. This means that you will only pay tax during the tax year if your dividend income exceeds this amount.

If you have a limited company and you are deciding how to take money from the business, even though the dividend rates are lower than for self-employed/employment income, you should consider paying yourself a small salary for the following reasons:

• A salary is an allowable expense for the company, a dividend is not. This means that the company will not pay Corporation Tax on the earnings used to pay the salary, whereas it would if the profits were used to pay a dividend.
• If you receive a salary of over the lower earnings limit for National Insurance, you are generating NI credits for certain state benefits such as state pension and maternity allowance.

National insurance contributions (NIC)

There are different types of National Insurance, known as classes. The type you pay depends on your employment status and how much you earn.

If you have a limited company and are paid a salary:

You will pay:

Class 1 NICs

(12% of your earnings above £162 per week up to £892 per week, and 2% on your earnings above £892 per week).

Your business will pay:

Class 1 (secondary) NICs

(13.8% on your earnings that are above £162 per week).

As a sole trader, you'll pay your class 4 NICs through self-assessment. The rate is below:

Class 4

Up to £12,570 - 0%

£12,570 to £50,270 - 6%

Above £50,270 - 2%

Corporation Tax

You must pay Corporation Tax on the profits if you have a limited company. Registering for Corporation Tax is simple and can be completed online.

You must keep accounting records and prepare a company tax return to determine how much Corporation Tax you must pay. The deadline to pay your Corporation Tax (or report if you have nothing to pay) is nine months and one day after your ‘accounting period’ ends. However, the deadline to file the company tax return is 12 months after your ‘accounting period’ ends.

Your ‘accounting period’ for Corporation Tax is the time your tax return covers. It is usually the same as your financial year covered by your annual accounts.

The Corporation Tax rate for small profits is currently 19%, and businesses with profits exceeding £250,000 have a tax rate of 25%. You may be able to get deductions or claim tax credits on your Corporation Tax. Examples of these types of relief are:

Capital Allowances

• Capital allowances offer significant financial relief by allowing you to deduct some or all of the value of an item from your profits before you pay tax. This applies to items such as equipment, machinery, and business vehicles, helping you to manage your tax liability more effectively.
• The annual investment allowance (AIA) provides you with a flexible tool to manage your tax planning. In most cases, you can deduct 100% of the total cost of these items using your AIA, which is up to £1 million per year, giving you the freedom to invest in your business without worrying about excessive tax burdens.
• First-year allowances allow you to deduct 100% of the full amount for certain plant and machinery in the year that it was bought. This means you can immediately benefit from tax relief, which enhances your cash flow and encourages business growth.
• You can claim writing down allowances if your plant and machinery does not qualify for AIA or you've already claimed the maximum amount.

Research and development relief

• Companies that research or develop an advance in their field may be able to claim Corporation Tax relief if the project meets the HMRC definition of R&D. Here's some more information about claiming R&D Tax Relief.

Penalties for late filings

By being a limited company, there are penalties if you don’t file your return by the deadline:

Time after deadline	Penalty
No more than one month	£150
More than one month but no more than three months	£375
More than three months but no more than six months	£750
More than six months	£1500

If you're self-employed, there are still penalties. If you file your tax return late. You'll pay a penalty of £100 if it's up to three months late. You'll have to pay more if it exceeds that.

Then, if you miss a payment or are late paying, you'll be charged interest on those payments.

VAT

Regardless of whether you are a sole trader or a limited company, if your VAT taxable turnover (total sales that aren’t VAT-exempt) for the previous 12 months exceeds £90k (or you expect them to exceed that amount in the following 12 months), you need to register for VAT.

You must register within 30 days of your business turnover exceeding the threshold. If you register late, you must pay what you owe from when you should have registered (you may also get a penalty depending on how much you owe and how late your registration is).

You can register voluntarily if your turnover is less than the threshold.

Registering for VAT

Most businesses can register online. You will be able to create a VAT online account which you will be able to use to submit your VAT returns. Once your business is registered for VAT you'll need to choose which scheme you'll use to tell the government how much VAT you've charged and how much you've paid;

VAT records

A VAT-registered business must;

1. Keep records of sales and purchases (invoices, credit notes, import/export records etc)
   
2. Keep a VAT account (this is a separate record of the VAT you charge and pay – these figures will be used to complete your VAT return)
3. Issue correct VAT invoices

You must keep VAT records for at least six years and you can keep paper or electronic records.

Standard VAT Accounting You will need to keep detailed VAT records of all purchases and sales. The information is then used to complete a quarterly VAT return.

Annual Accounting Scheme The same as the standard VAT scheme, but instead you only file one return per year. You will make advance VAT payments towards your VAT bill based on your last return and when you submit your annual return, you will pay the difference between the advance payments and the actual bill. (This scheme wouldn’t benefit a business who regularly reclaims VAT as you will only be able to get one refund per year). Requirements: estimated VAT taxable turnover is £1.35m or less.

Flat Rate Scheme You pay a fixed rate of VAT to HMRC and then you keep the difference between what you charge your customers and pay over to HMRC. However, you can’t reclaim VAT on your purchases. Requirements: VAT turnover must be less than £150k

Cash Accounting Scheme With this scheme, you will pay VAT sales once your customer has paid you, and you will reclaim VAT on purchases once you have paid the supplier. This is a good scheme for people who have slow paying customers. VAT returns are required to be submitted quarterly. Requirements: estimated VAT taxable turnover is £1.35m or less.

Advantages of VAT registration

• You can reclaim VAT paid on purchases - things you have purchased during the course of business are likely to have VAT applied to them. You will have had to pay the VAT at the time of purchase, but you can reclaim it from HMRC when you file your VAT return.
• Reclaim VAT from past purchases – voluntary registration allows you to reclaim VAT from the last four years (as long as you have kept the relevant VAT records and invoices).
• It looks professional – most people are aware of the VAT registration threshold – registering voluntarily gives the impression that your business is bigger and more successful than it might actually be.
• Better relationships with suppliers – some suppliers are unwilling to do business with companies that aren’t VAT-registered.

Disadvantages of VAT registration

• You will need to charge more – being VAT-registered means that you will have to add VAT to your sales prices. However, it won’t make a difference to customers who are VAT-registered as they will be able to reclaim the VAT back themselves.
• More admin – you will need to submit quarterly VAT returns to HMRC, raise VAT invoices whenever you make a sale and maintain VAT paperwork/records.

VAT penalties and surcharges

If you fail to submit or pay a VAT return by the deadline, then HMRC will record a default. This default, if it occurs, can have serious implications. You may either receive a Surcharge Liability Notice or a Surcharge Liability Notice Extension.

For small businesses, special arrangements are in place. If your taxable turnover is £150,000 or less and it's your first time, you'll be offered support rather than a Surcharge Liability Notice.

The surcharge is calculated as a percentage of the VAT that's unpaid at the due date. 2% will be the first late payment, and the rate will increase to 5%, 10%, and 15% for further defaults.

£30 is the minimum surcharge using the 10% or 15% rates. There is no surcharge at 2% and 5% rates if less than £400.

VAT payment problems

Problems with VAT payments can arise if you have used the output VAT (VAT that you have charged on sales) as a source of finance and then cannot pay the VAT over to HMRC when it is due. You may benefit from sourcing VAT finance from lenders such as Fleximize, which offers VAT funding. Click below to find out more.

VAT funding from Fleximize