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 in the form of Income Tax. As well as this, they must pay Class 2 and 4 National Insurance contributions.
Limited companies pay Corporation Tax on all of its 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:
|Income Tax and NI paid by you and employers NI will need to be paid by the business|
|Income Tax – lower rate than Income Tax arising on salary and no NICs arise on dividends|
A limited company is its own legal entity, so as a shareholder your liability is limited. Sole traders have unlimited liability, which means if the business gets into debt, the business owner is personally liable and any personal assets (such as your house) are not protected.
A limited company must prepare annual accounts from the company records at the end of each financial year, which are to be filed with HMRC along with the Corporation Tax return. Sole traders must keep a record of business expenses and income to fill in their tax returns (Self Assessment).
A sole trader can withdraw cash from the business without a tax effect. Where cash is withdrawn from a limited company, this is treated as a dividend and will be taxed as such.
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
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 tax year 2018/19 this is £11,850).
If your business has been incorporated, you will pay Income Tax on any salary or dividends that you take from the company. If you are paid a salary from the company, as your employer, the business will deduct the Income Tax from your salary under the PAYE scheme.
|Band||Taxable Income||Tax Rate|
|Personal Allowance||Up to £11,850||0%|
|Basic Rate||£11,851 to £46,350||20%|
|Higher Rate||£46,351 to £150,000||40%|
|Additional Rate||Over £150,000||45%|
The Income Tax rates for dividend income are different:
|Band||Taxable Income||Tax Rate|
|Personal Allowance||Up to £11,850||0%|
|Basic Rate||£11,851 to £46,350||7.5%|
|Higher Rate||£46,351 to £150,000||32.5%|
|Additional Rate||Over £150,000||38.1%|
In addition to the personal allowance, there is also a dividend allowance of £2,000 per year. This means that during the tax year you will only pay tax if your dividend income goes above 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
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).|
If you are a sole trader, you'll pay:
|Class 2 NICs|
|If your profits are £6,205 or more (a year)|
|On all profits £8,424 and over (a year)|
Most sole traders pay their class 2 and 4 NICs through Self Assessment.
If you have a limited company, you must pay Corporation Tax on the profits. Registering for Corporation Tax is simple and can be completed online.
You must keep accounting records and prepare a company tax return to work out how much Corporation Tax you need to pay. The deadline to pay your Corporation Tax (or report if you have nothing to pay) is 9 months and 1 day after the end of your ‘accounting period’. However, the deadline to file the company tax return is 12 months after the end of your ‘accounting period’.
Your ‘accounting period’ for Corporation Tax is the time covered by your tax return. It is usually the same as your financial year covered by your annual accounts.
The Corporation Tax rate for company profits is currently 19%. You may be able to get deductions or claim tax credits on your Corporation Tax. Examples of these types of relief are:
- You can deduct some or all of the value of an item from your profits before you pay tax. Applies to items such as equipment, machinery and business vehicles.
- In most cases you can deduct the full cost of these items using your ‘annual investment allowance’ (AIA) which is £200,000 per year (you cannot claim this allowance on cars).
- If you buy an asset that qualifies for ‘first year allowances’ (FYA) you can deduct the full cost from your profits before tax. Items that qualify; some low CO2 emission cars, energy saving equipment etc.
- For items that don’t qualify for AIA or FYA, you can claim ‘writing down allowances’ which allows you to deduct part of the value from your profits before you pay tax.
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 filing
There are penalties if you don’t file your return by the deadline:
|Time after deadline||Penalty|
|3 months||Another £100|
|6 months||HMRC will estimate your Corporation Tax bill and add a penalty of 10% of the unpaid tax|
|12 months||Another 10% of any unpaid tax|
If your tax return is late 3 times in a row, the £100 penalties are increased to £500 each.
If you don’t pay your Corporation Tax by the deadline, HMRC will charge your company interest. Interest is charged daily and the rate is currently 3%.
If you make a Corporation Tax loss, there are a number of ways that you can use these to claim relief. There is guidance on the options and how to claim relief on the .Gov website.
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 £85k (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;
Standard VAT AccountingYou 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 SchemeThe 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 SchemeYou 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 SchemeWith 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.
A VAT-registered business must;
- Keep records of sales and purchases (invoices, credit notes, import/export records etc)
- 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)
- Issue correct VAT invoices
You must keep VAT records for at least six years and you can keep paper or electronic records.
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 record a ‘default’. A fixed surcharge of up to 15% (of the VAT outstanding on the due date) will be charged, based on how many times you default within a 12-month period and how much your annual turnover is.
|Defaults within 12 months||Surcharge if annual turnover is less than £150k||Surcharge if annual turnover is £150k or more|
|2nd||No surcharge||2% (no surcharge if less than £400)|
|3rd||2% (no surcharge if less than £400)||5% (no surcharge if less than £400)|
|4th||5% (no surcharge if less than £400)||The higher of 10% or £30|
|5th||The higher of 10% or £30||The higher of 15% or £30|
|6th or more||The higher of 15% or £30||The higher of 15% or £30|
HMRC can charge penalties:
- Of 100% of any tax under-stated or over-claimed if you send a VAT return with a deliberate or even careless inaccuracy.
- Of 30% of an assessment of VAT due if HMRC send you a VAT assessment that is too low and you don’t advise that is incorrect within 30 days
- Of £400 if you submit a paper VAT Return, unless HMRC have told you that you’re exempt from submitting your return online, in which case paper VAT returns are OK.
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 are unable to pay the VAT over to HMRC when it is due. You may benefit from sourcing VAT finance from lenders such as Fleximize who offer VAT funding. Click below to find out more.
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