Tax tips for small business owners

Pressures are mounting on small business owners and those who aspire to work for themselves. With annual inflation approaching double digits and energy prices up significantly more, households have been cutting back on spending. Retail sales fell at an annual rate of 1.1 per cent in May and borrowing costs are going up – the Bank of England recently raised interest rates to 1.25 per cent and indicated that there will be more rate rises. So now more than ever, it is important to run your business as efficiently as possible.

Sole trader or limited company? 

If you want to set up a business and work for yourself, you need to decide whether to operate as a sole trader or set up a limited company. Partnerships are less common but, in broad terms, their tax treatment is similar to a that of a sole trader, though the filing requirements are more substantial. Incorporated partnerships have the benefit of limited liability, but their accounts have to be filed on public record at Companies House.

"In practice, a sole trader or limited liability company seem to be the obvious choices for most businesses," says Adela Cebotari, associate director at RSM UK. 

The advantage of being a sole trader is that it’s quick and easy to set up, there’s no requirement to register with Companies House and the reporting requirements are fairly light. Government statistics show there were 3.2 million registered sole proprietors in the UK last year.

However, depending on the amount of money you are turning over, it might be less tax-efficient than setting up a company. Sole traders pay income tax at their marginal rate of 20 per cent, 40 per cent or 45 per cent on revenue generated after costs. Limited companies, by contrast, pay corporation tax at 19 per cent within the business and dividend tax is payable on any money distributed. Corporation tax is set to rise to 25 per cent in April 2023 for companies with profits of £250,000 and above, but will stay at 19 per cent for companies with profits of less than £50,000 per year and  taper up to 25 per cent for those with profits between £50,000 and £250,000. Setting up a company also means that you don’t have personal liability for its debts.

“Look at what you’re expecting to get in terms of income, because a lot of people tend to jump in without initial planning,” says Michelle Denny-West, partner at accountancy firm Moore Kingston Smith. “A lot of people start as a sole trader, which can be absolutely fine, but the downside is that you are taxed as and when you earn the income. The positive with a company is that you pay corporation tax initially on the income as it rises, which is at a much lower rate. And then you pay further tax when you extract the money."  

The right structure for your business depends on its nature. But Denny-West says that, generally, a business with profits over £50,000 per year might be more tax-efficient with a company structure and one with profits below this level might be better as a sole trader.

“Quite often, we see that the tax efficiency is completely eroded by the administrative costs of filing company accounts and a corporate tax return along with a personal one,” she says.

As a sole trader, you just file your own tax return and prepare an informal set of accounts. 

Government statistics show that last year 46 per cent of the 2.05mn corporate businesses were single-employee limited companies and 90 per cent had 10 employees or fewer. There were also around 384,000 ordinary partnerships and 150,000 limited liability partnerships.  

Limited companies

If you set up a limited company, you can combine dividend payments with a salary to keep your overall tax bill down. Anthony Whatling, private client tax partner at Evelyn Partners, says that, for example, a company owner might pay themselves a salary of £12,500 which they can offset against the personal allowance for income tax. Supplementary income could be paid via dividends, the first £2,000 of which could be offset against the annual dividend tax allowance. And the tax rates for dividends above that value are lower than income tax at 8.75 per cent for basic, 33.75 per cent for higher and 39.35 per cent for additional rate tax payers. 

Whatling also says that when setting up a company to get the structure right from the beginning. It is perfectly possible to involve family members as shareholders, and even employees or directors of the company. Salaries are tax deductible for the company, however, the amounts paid to family members need to be commensurate with the work they do for the company, otherwise HM Revenue & Customs can disallow the tax deduction.

If you give shares to children under age 18, any dividends they are paid are charged at your marginal tax rate. And when the business is up and running, if the company is thriving and you give shares to other people this is likely to incur a capital gains charge.

The partnership structure is an easier way for other people to buy into the business but tends to be less popular because the partners are taxed like a sole trader but still have to file with Companies House. 

Tax deductible expenses

Because tax is paid on business profits, it’s important to keep a close eye on what your business expenses are so that you can log them in your tax return and lower your overall tax bill. “People can get nervous of making claims for genuine business expenses as the rules can be complex,” Whatling says.

For example, if your business owns rental property and you go to check on it, the expenses incurred for the trip, such as petrol, should be tax deductible. However, regular commuting to and from work is not. 

Cebotari says that, generally, expenditure is tax deductible if it meets the “wholly and exclusively for business purposes” test. This might include office equipment, renting premises, utility bills, uniforms or protective gear, staff salaries, and legal and accounting costs. 

Companies can claim 130 per cent capital allowances on qualifying plant and machinery investments for expenditure incurred between 1 April 2021 and the end of March 2023. Businesses can deduct capital allowances when calculating taxable profits. Assets which qualify as ‘plant and machinery’ include computer equipment and servers, office chairs and desks, solar panels, and electric vehicle charging points. You can see the full list on the government fact sheet at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/967202/Super_deduction_factsheet.pdf.

Staff entertainment worth up to £150 per employee is tax deductible. And a £300 trivial benefits allowance per year can be applied to benefits for employees which cost £50 or less, and aren’t a reward for their work, cash or a cash voucher. Also, you carry another employee in your own car or van on a business journey, you can pay yourself passenger payments of up to 5p per mile tax-free – a measure to encourage car pooling. 

Electric cars

If your business provides company cars, electric vehicles have very attractive tax benefits. Since April 2020, businesses have been able to claim 100 per cent of the cost of an electric vehicle against profits in the year of purchase. If you are a sole trader and use the car for both business and personal use, you would have to work out how much of the cost is tax deductible. If half of the car’s mileage is for business purposes, for example, only 50 per cent of the cost would be tax deductible. 

If you buy a fully electric car through a company, you can do it via salary sacrifice which lowers your National Insurance bill and gives the company a 100 per cent deduction for the cost of the car. If you use it for personal use, you pay a benefit in kind charge of just 2 per cent. This means that 2 per cent of the market value of the car is added to your income tax liability and charged at your marginal rate.   

“You can get your company to fund an electric car for you and other individuals working for you very tax effectively,” says Denny-West. So if you're going to get an electric car it quite often makes sense to do it through a company. Drivers of highly polluting vehicles, by contrast, have to pay a benefit in kind charge of 37 per cent.   

National Insurance

A sole trader pays National Insurance (NI) on income of between £9,881 and £50,270, but at a lower rate than that paid by an employee, and the business does not pay employer NI. If you own a company and pay yourself a salary you are likely to have to pay both employer and employee NI. 

“The NI saving is often a reason why individuals operate as a sole trader rather than a limited company,” says Denny-West. However, NI does not apply to dividends. 

The threshold at which most employed and self-employed people start paying NI is earnings or profits above £9,880, known as the main rate. But this is increasing to £12,570 from 6 July to align it with income tax and compensate low earners for the 1.25 percentage point headline rate rise this spring. The higher rate threshold remains at £50,270. 

 Source: IFS