Which Business Entity? Sole Traders

In the second of his series of articles on the taxation of different business entities, Lee Sharpe this month looks at sole traders.

 

This article, which is the second of the series, looks at the taxation of sole traders. Sole traders are often referred to as being ‘self-employed’. Note, however, that partners trading in a partnership are also referred to as self-employed – that term is not exclusive to people trading on their own. Whether or not someone is trading is determined on a case-by-case basis, reviewing the so-called ‘badges of trade’.

 

Sole traders are primarily liable to:

• income tax on business profits;
• class 2 National Insurance contributions (NICs) – the ‘stamp’ which entitles the payer to state pension – although this may soon be abolished/absorbed; and
• class 4 NICs – effectively an additional income tax.

Tax and NICs are calculated by reference to ‘tax-adjusted profits’, which disallow private or otherwise non-business expenditure, and capital expenditure including depreciation (as an alternative to depreciation, capital allowances may be claimed instead for eligible assets). 

 

A sole trader may be liable to capital gains tax (CGT) if he or she makes a gain on the sale, etc., of a fixed asset used in the trade. Most often, this would be the trading premises – or the sale of the business itself.

 

A sole trader is also potentially liable to register and then account for VAT, if VATable turnover looking back over (up to) the last 12 months exceeds the registration threshold. There is also a requirement to register as soon as one expects a month’s worth of turnover to exceed the threshold.

 

Basically, individuals are legally required to notify HM Revenue and Customs (HMRC) if they are chargeable to income tax – such as by reason of having commenced in self-employment – no later than six months after the end of the tax year in which the trade commenced. Form CWF1 is currently the form to use, although HMRC is trying to encourage new business notification via an online facility. 

 

A sole trader is obliged to file a self-assessment tax return annually, no later than 31 January following the relevant tax year if filing online. Tax (and NIC) bills are payable on account, (based on the previous year’s liability), half at the end of January in the tax year in question, and half at the end of July, with a balancing payment covering any outstanding amounts due (e.g. if more tax is due than the payments based on the previous year, because profits are rising), payable the following January. 

 

Most sole traders are eligible to use the ‘cash basis’ of accounting, provided their turnover does not exceed the VAT registration threshold (currently £82,000 a year), which allows the trader to ignore debts becoming due and calculate his profits based solely on cash in, and cash out.

 

If someone starts a trade on his or her own account, then he or she will automatically become a sole trader. It is the simplest and most flexible way of conducting a business. 

 

Once profits are made and taxed, the net amount belongs absolutely to that individual, to do with as he or she likes. 

 

One can choose practically any accounts ‘year-end’ in the year, to suit (although it is not always possible to keep changing the year-end).

 

The trader may claim CGT entrepreneurs’ relief on the sale of his business and related property, to reduce the tax on his or her corresponding capital gain to just 10%. Where a trader makes a capital gain on selling individual assets without ‘selling out’, then it may be possible to postpone the CGT by re-investing the proceeds into another eligible asset. 

 

1. Drawings are not the same as profits! Many sole traders – particularly those who are new to self-employment – assume that they are taxed only when they withdraw the funds for private purposes (‘drawings’). This is not the case. For example, if Bill’s trade makes £30,000 in profits, then he will be liable for tax, etc., on £30,000, even if he withdrew only £12,000 for his personal use during that accounts year.
2. Accounting dates - While you may be able to choose any year-end you please, there are potential disadvantages for some dates. Early years’ profits can end up being taxed twice, which results in ‘overlap relief’ to compensate. Unfortunately, overlap relief is fixed on commencement, and may be worth significantly less when it is eventually used years (or even decades) later.
3. Business borrowings - In the introduction to this series of articles, sole traders were noted as being legally indistinguishable from their businesses – they are personally liable for any debts incurred through trading. A set of financial accounts creates a notional dividing line between the business and its owner: if it makes profits, the business ‘owes’ those profits to its owner. Likewise, if the trader introduces capital into the business – say to help it get going in its early years. On the other hand, if the business makes losses, or the trader simply withdraws more than the accumulated funds to date, then the trader ‘owes’ money to the business. This is important from a tax perspective because, if a sole trader borrows money to finance his or her business, then it will generally be allowable – except if the accounts are ‘overdrawn’ and the trader owes money to his business. Note that the actual calculation is more complex than this – the case Silk v Fletcher [2000] SpC 201 may prove useful.
4. More than one trade - Tax law ‘tracks’ trades separately. For example, if Bill the self-employed plumber also has a DJ trade in the evenings, the profits and losses of each trade are calculated separately. By default, the losses in one trade are carried forwards against future profits of that trade only, although the sole trader can in most cases claim ‘sideways’ against other income, (including profits from another trade), or even potentially claim against profits, etc., in earlier years. But once a trade ceases, any unutilised profits are forfeit. If Bill’s DJ trade makes losses and he decides to cease it and concentrate full-time on his plumbing trade, then he cannot carry the DJ losses forwards against future plumbing profits (although he may be able to set them sideways/backwards in the year of cessation).
5. VAT ‘aggregation’ - On the other hand, VAT aggregates all of a VATable person’s taxable supplies, in order to see if he or she should register for VAT. Let’s say Bill’s plumbing business is doing well, turning over £75,000 a year. He is comfortably below the VAT registration threshold. However, if his DJ business is turning over £10,000 a year, then his overall taxable activity will breach the threshold and he will have to register, even though each trade on its own is below the threshold. It is, of course, the business’ turnover (sales) which is relevant for VAT, rather than net profits.
6. Tax payments - Generally, the first income tax payment a sole trader makes is 31 January after the tax year of commencement. For example, if Bill commenced on 1 May 2015, towards the beginning of the tax year 2015/16, he might not have to pay tax under self-assessment until 31 January 2017 – roughly 20 months later. But he will have to pay all of the tax due for his first year, and his first payment on account for 2016/17 – effectively a year and a half’s worth of tax at once.

It is possible, with proper planning, to arrange commencement and year-ends so as to maximise cashflow benefits:

• taking on family members, etc., as salaried employees can increase net incomes to the family, while reducing taxable self-employed profits. This is permissible as long as the family member’s work justifies the salary paid. This can be useful where other members of the family are not using all of their tax-free allowances, lower tax bands, etc;
• private pension contributions can reduce exposure to higher rates of tax; and
• a sole trader has some discretion as to when he or she wants to invest in items eligible for capital allowances. Investing earlier may secure those allowances against earlier profits.

Sole traders are the most straightforward business entities. They are relatively easy to run, but there are numerous pitfalls in the detail to catch out the unwary trader.

 

This article was first published in February 2016.