Understanding the personal tax implications of starting a small business

Our accounting partner highlightes the difference in Financial & Managment accounts..

 

If you have an amazing idea for a business, then all you will want to do is get the ball rolling and bring it to life. But before you dive headfirst into the world of business ownership, let's talk about something that might not be as exciting but is equally important; taxes.

 

Understanding the personal tax implications of starting a small business can save you a lot of headaches (and money) further down the line. In this blog post, we'll break down everything you need to know so you can do the same. Let’s take a look..

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Choosing the Right Business Structure

One of the first decisions you'll make as a budding business owner is choosing your business structure. This decision is an important one because it affects how you report income, your level of personal liability, and how you can raise capital. Plus, different structures have different tax implications. Let's break it down:

 

Sole Trader

Planning on flying solo?

Being a sole trader is the simplest way to get started. You and your business are essentially the same entity for tax purposes. You'll report all your business income and expenses through a self-assessment tax return. It's straightforward, but remember, you're personally responsible for any business debts.

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Partnership

If you're joining forces with someone else, a partnership could be the way to go. In this setup, each partner shares in the profits and losses and reports their share on their individual self-assessment tax returns. Just like with a sole trader, personal liability is still a factor, so keep that in mind.

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Limited Liability Partnership (LLP)

Want to share the responsibilities but limit personal liability?

An LLP might be your answer. Each partner pays tax on their share of the profits, but their personal assets are generally protected from business debts, which can make this structure a bit of a win-win.

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Limited Company

Thinking big?

A limited company could be the right fit. This structure separates you from your business, offering protection from personal liability. However, it's a bit more complicated tax-wise. The company pays Corporation Tax on its profits, and if you take money out as dividends, you'll need to pay tax on that too.

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Navigating Income Taxes

Once you’ve picked your business structure the hard work doesn’t stop there. The next step of understanding how your business earnings will be taxed needs to be worked out, and here’s a quick guide on how to do that.

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How Business Earnings are Taxed

Depending on your business structure, the way you're taxed can vary. We’ve touched on this above, but let’s have a quick recap:

 

• ‍Sole Trader: You'll report your business income and expenses via a self-assessment tax return. Your profits will be subject to Income Tax and National Insurance contributions.

• Partnership: Similar to a sole trader, you and your partners will each need to fill out a self-assessment tax return. Your share of the profits will be subject to Income Tax and National Insurance.

• LLP: Each partner pays tax on their share of the profits, just like in a regular partnership. However, LLPs must also file an annual partnership tax return.

• Limited Company: The company itself pays Corporation Tax on its profits. If you take money out as dividends, you'll pay tax on those as well.

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The Importance of Record-Keeping

The importance of accurate and efficient record-keeping cannot be stressed enough. It is absolutely vital for any business owner to keep meticulous records of all your income and expenses.

 

Whether you're jotting it down in a notebook, using accounting software, or hiring an accountant, good record-keeping is crucial. It not only makes your life easier when filling out your tax return but also helps if HMRC decides to take a closer look at your accounts.

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National Insurance Contributions

It’s time to tackle another crucial topic: National Insurance contributions.

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What are National Insurance Contributions?

National Insurance contributions are payments made by both employees and employers to fund various types of state benefits, including the NHS, unemployment benefits, and the State Pension. If you're self-employed (a sole trader, partner, or LLP member), you'll need to make these contributions yourself.‍

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Types of National Insurance Contributions for the Self-Employed </H3>

Class 2

If your profits are £6,725 or more a year, you'll pay Class2 contributions at a flat weekly rate.

Class 4

If your profits are between £12,570 and £50,270 a year you'll also pay Class 4 contributions, which are a percentage of your profits. More information on this can be found on the government website.

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How to Make Payments

You'll typically pay your National Insurance contributions through your Self-assessment tax return. These are usually due by January 31st following the end of the tax year. If you owe a lot, HMRC might ask you to make "payments on account," which are advance payments for the next tax year.

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Deductions and Tax Reliefs

Now, let's talk about something that'll put a smile on your face: deductions and tax reliefs. While it may seem we’ve only spoken about the tax system taking money from you, now is the time we talk about giving back (if you know how to do it right). Here's how you can reduce your tax bill legally and smartly.

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Common Deductible Expenses

First things first, let's talk about expenses you can deduct from your income. These are costs that are directly related to your business, and they can significantly lower your final payment. Here are some common ones:

• Office Costs: Think stationery, phone bills, and even rent if you have a dedicated office space.

• Travel Costs: Fuel, parking, train tickets—basically anything you spend on business travel.

• Stock and Materials: The cost of raw materials or stock you need to run your business.

• Legal and Financial Costs: Fees for professionals like accountants, solicitors, or even bank charges.

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Tax Reliefs

Apart from deductible expenses, there are also various tax reliefs you might be eligible for:

• Annual Investment Allowance (AIA):This allows you to deduct the full value of qualifying items from your profits before tax. It's a way to encourage investment in things like machinery or equipment.

• Research and Development (R&D) Relief: If you're doing something innovative, you might be able to claim R&D relief, which can be a significant amount.

• Entrepreneurs' Relief: If you're selling or giving away your business, you might be eligible for Entrepreneurs' Relief, which reduces the Capital Gains Tax on the sale.

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