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Balancing the books
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you have taken the leap and gone into business for yourself, or are considering doing so. But in order to stay legal and profitable,you need to know about the different types and levels of tax you will be subject to —whether you are a sole trader, a partnership or a limited company.
You will be investing in vehicles and equipment, so it pays to be aware of the capital allowances available.And in the future you may decide to sell up — it is imperative you know about the tax penalties should you do so,
Income tax
1 ndividuals operating as a partnership or sole trader are subject to income tax on their profits, regardless of whether the money is actually withdrawn from the business. Such individuals make income tax payments on account halfyearly on 31 January in the tax year and 31July following the tax year.
Shareholders of a limited company pay income tax only on the money withdrawn from the company, regardless of the level of profits. This money may be paid out as a salary (or bonus) or a dividend. Income tax is payable on salaries and bonuses at 40% (assuming the individual pays at the higher rate) whereas the rate of tax payable on dividends works out as 25% of the cash received.
To avoid an income tax charge in a specific tax year, shareholders could retain the profits in the company. Partnerships' and sole traders' profits are taxable regardless of whether they are paid out. The company itself is subject to corporation tax on its profit.
Making your NI contributions
Class 2 and Class 4 National Insurance contributions (NICs) are payable by self-employed individuals. Individuals in a partnership are treated as self-employed for NIC purposes. Class 2 NICs are payable at a weekly rate of £2.20 whereas Class 4 NICs are earningsrelated. A rate of 8% is payable on profits between £5,225 and £34,840 per year, and a rate of 1%, is payable on profits over £34,840 per year. These contributions are not tax-deductible.
Employees and directors of limited companies are subject to Class 1 primary NICs, which are levied at 11% on earnings between £5,200 and .04.840 per year. A rate of 1% applies on earnings over the £34,840 threshold. Class 1 secondary NICs are payable by employers on employees' salaries over £5,200 at a rate of 12.8%. There is no maximum ceiling for these contributions.Class 1 secondary NICs are deductible by a company in calculating taxable profits.
Although the level of Nits payable is higher on salaries for employees and directors than on the profits of a partnership or sole trader, using dividends will save on these payments.
Dealing with corporation tax
Unlike a sole trader or partnership, a limited company is treated as a separate entity for tax purposes so individuals are taxed only on the income they withdraw from the company. If the income is taken in the form of a salary, it is an allowable deduction. This is not available for dividends. The current rate of corporation tax for companies with profits of less than £300,000 is 19%. For companies with profits of more than £1.5m,corporation tax is payable at 30 % . Profits between £300,000 and £1.5in are chargeable at the full 30% rate subject to marginal relief.
Use your capital allowances
Capital expenditure cannot be deducted in calculating taxable profits, so relief for certain types of such expenditure is given in the form of capital allowances. Generally, the writing down of allowances is at a rate of 25% per year on a reducing balance basis. Effectively if you buy a truck for £10,000, by year two its book value may be £9,000 and that reduced figure will be the basis for your 25% tax allowance. The allowance available in the first year of purchase is higher on most types of plant, machinery and vehicle. A higher first-year allowance is available in some instances. Capital allowances are available to both incorporated and unincorporated businesses
Capital gains tax When an individual or partner sells their business or share in the business, they will be subject to capital gains tax al their normal tax rate. Tax on any gains made will he reduced by taper relief, which is tax relief based on how long the asset was held. Buy a business and sell it tomorrow and you will pay a lot of tax: hang on toil for several years and you will pay less tax at the time of sate. Its rate depends on the type of asset sold and the length of ownership. More favourable rates are available for business assets — and the longer the asset is held, the higher the relief available. If an asset has been used in a business for two years or more, the capital gain will be reduced by 75%.
When an individual sells theirshares in a limited company. any capital gain made will be subject to capital gains tax in the same way. Provided the company is an unquoted tradingcompany,the full 75% taper relief rate is available. When the company itself sells any assets, there is no taper relief available. Instead there is an indexation allowance linked to the Retail Prices [ndex.The company will pay corporation tax on the resulting capital gain.
Where the assets are shares, a special relief is available to companies. If a company disposes of shares in a trading company in which it holds 10% or more of the shares, any gain made will be exempt from tax provided certain conditions are met. There is no similar exemption for sole traders and partners.
investing in the business
Where the business has been established as a limited company, external investors can invest using reliefs under the Enterprise Investment Scheme.
Enhance your losses
Losses incurred by a company can be carried forward to use against profits of future years or carried back against profits for the previous year. Losses incurred by a sole trader or partnership can be set against income in the current or previous tax year. This claim could be extended to offset the losses against capital gains but they must be used against income first. Alternatively, the losses can be carried forward and set against future profits.
Losses incurred by a sole trader or partnership in the first four years of the business can be carried back and set against the income of the three tax years preceding the year of the loss, starting with the earliest year first. Where a business is likely to be loss-making and the owner has significant taxable income in the previous three tax years, it is worth considering starting out as a sole trader or partnership and transferring to a limited company when the business becomes profitable. • • Paula Talton is a director and head of direct tax at Chiltern plc
CONTACTS www.hmrc.gov.uk www.chilternplc.com