Business Start-Up

Taxation of Profits

Introduction

Self-assessment will affect every person running a business, be it as a sole trader, a partner, or as a director of a limited company. It places added costs and pressure on the self-employed. However, if the accounting records of the business are well kept, and accurate personal tax information is kept, it should not pose too many problems, although, for all but the very straightforward business, it will almost inevitably mean having to employ an accountant.

National InsuranceClass 2 National Insurance is payable by the self-employed unless they can demonstrate that their earnings will be below the figure laid down by law. Class 2 contributions are either paid monthly by direct debit or quarterly by assessment. The contributions count towards your state pension and sickness benefit, but very few other benefits are provided.

Class 4 National Insurance is payable on self-employed earnings between certain levels, based upon the profit for the relevant year. It is payable at the same time as income tax and is effectively a tax. It does not entitle you to any benefits.

For employees, including directors, Class 1 National Insurance is payable on their earnings. The contributions are split between the employee's contributions and the employer's contributions. If their earnings are below a certain figure, no National Insurance is due. However, above that figure, National Insurance is due at varying rates on the whole earnings for the employer's contributions and up to a prescribed limited for the employee's contributions. Payment is made at the same time as PAYE.

National Insurance contributions are a lot lower for the self-employed, but so are the benefits that accrue from them.

Registration

If you are setting up as a sole trader or a partnership, you will need to register with the Inland Revenue and the Contributions Agency, who administer National Insurance. This is done on the same form, which is available from both departments.

If you are setting up a limited company, you will need to set up a PAYE scheme for paying yourself and any other people that the company may employ. In addition, you will need to complete a Corporation Tax form that will give details of the directors and of the company.

Income Tax

For sole traders and partnerships, the taxation rules in the opening years are often not straight forward, especially with the timing of the tax payments. Under self-assessment, self-employed people are taxed on a current-year basis.

The tax is payable in two halves, on 31 January and 31 July, with the balance payable on the following 31 January when the Tax Return is also due. The relationship between accounting periods and tax payments will depend upon the year-end chosen. Having a 31 March year end is simplest but has a cash-flow disadvantage as the first instalment of tax is due before the year end to which it relates.

As has been stated earlier, monies taken out of the business are not subject to income tax. The calculation of income tax is based upon the profit for the business year, excluding drawings, taking into account allowances for capital expenditure, private use of assets, pension contributions and personal tax allowances.

Corporation Tax

As we have mentioned before, directors are treated in the same way as employees and so receive their income net of tax and National Insurance. If the company has a successful year, it may pay the directors a bonus. This would still be taxed under the PAYE system. The company could also pay a dividend to the shareholders, but for maximum cash-flow advantage this would need to be done before the year-end. Dividends do not attract National Insurance, so are often a cheaper way of extracting money from a company.

Any profits made by the company, after deduction of directors' remuneration, will be subject to Corporation Tax. Corporation Tax is payable nine months after the year-end, and, unless profits are over a certain limit, are taxed at the smaller companies rate.

It is normally more expensive from a tax point of view to use a limited company to run a business. If the business is sold, there can also be a double tax charge in respect of capital gains.