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In 2020, there were an estimated 6 million private sector businesses in the UK. Of these, 4.6 million had no employees at all.
Sole proprietorships represent more than 50% of the total UK private business sector and, as the modern business world evolves, this number is predicted to rise.
Many people enjoy the freedom and autonomy that running their own business or being self-employed can offer.
Setting up as a sole trader is a relatively simple process and, for many, a way to turn their passion into a legitimate career; however, there are certain rules and regulations that you need to follow in order to be compliant with business and taxation laws.
What is a sole trader?
If you decide you would like to run your own business, or become self-employed, you will need to decide if you wish to become a sole trader or form a limited company.
Sole traders run their businesses as individuals and are self-employed. If things go wrong, sole traders are personally responsible for losses or debts that their business incurs.
There are many businesses or forms of self-employment where it would be suitable to register as a sole trader, for example:
- Self-employed cleaners.
- Freelance creatives (writers, designers, tattooists).
- Children’s entertainers.
- Tradespeople (plumbers, plasterers, carpet fitters etc).
Sometimes, business owners choose to structure their business as a limited company instead of a sole trader. Limited companies operate as legal entities in themselves, meaning that the directors and shareholders have little personal responsibility for debts, losses and liabilities.
Limited companies usually have a more complex business structure than sole traders (although it is still possible for sole traders to sub-contract work out to others).
When you are considering how best to structure your business, or how to contract work out, it is also advisable to take IR35 requirements into consideration. This applies when work is being carried out on a self-employed basis through a limited company, but the worker is really acting more like an employee. IR35 does not apply to sole traders.
- A sole trader is a self-employed individual who works for themselves and has full responsibility for the company. They must be registered with HMRC, either under a company name or with their own name.
- A limited company is a legal entity in itself. They must have at least one appointed director who is responsible for running the company, ensuring compliance, record keeping and filing a corporate tax return. Limited companies must be registered with Companies House and Corporation Tax with HMRC.
Do sole traders pay corporation tax?
Every limited company in the UK will be subject to corporation tax. Businesses that operate as sole traders (or partnerships) are not required to pay corporation tax.
What tax does a sole trader pay?
Sole traders are required to pay income tax based on their profits for each tax year, which runs from 6th April to 5th April the following year.
Sole traders also need to pay Class 2 and 4 National Insurance contributions.
When you are working out how much tax you need to pay, you are allowed to account for reasonable expenses that you have in your business and offset this against your earnings.
These expenses might include:
- Marketing and advertising.
- Materials or stock.
- Phone or internet (for business use only).
- Rent for premises.
- Utility bills.
- Travel expenses, business vehicle and fuel.
You will pay tax as a sole trader based on your annual profits. You calculate your profits by deducting your business expenses from your self-employed income.
How is a sole trader taxed?
For sole traders, tax is paid on their profits through the annual self-assessment scheme run by HMRC.
Sole traders are given a personal allowance (tax-free amount) that they can earn each year that is not taxable. For the current tax year (2021/22) it is £12,570. This allowance is the same for those employed through P.A.Y.E. and self-employed sole traders.
Usually, employees in the UK pay tax on their salary (if their earnings exceed their personal allowance). They will receive a payslip either weekly or monthly which breaks down the amount they have been paid and the amount that has been deducted by their employer in National Insurance and income tax.
Because sole traders work for themselves, they are responsible for organising their own tax. This is done each year, usually online (although paper copies are available).
Once you are registered with HMRC as a sole trader, you will be sent all of the information you need to access your self-assessment account online, via the Government Gateway. You will need your Unique Tax Reference (UTR), password and an activation code.
The activation code is required if this is your first time filling in the self-assessment. It arrives by post to the address you provided when you registered as self-employed and takes up to ten days, so ensure that you have adequate time to successfully log in and complete your tax return before the deadline (31st January).
HMRC will write to you throughout the year to remind you that your self-assessment for that year is due.
When does a sole trader pay tax?
You will have to pay tax on your profits every year that you are in business. You have to notify HMRC of your earnings using their self-assessment system.
The deadline for completing the self-assessment is 31st January and you must pay any tax that you owe.
You do not legally have to register your business until the October after the first tax year in which you started trading; however, it is advisable to register as soon as possible.
Sole traders are only required to pay tax if their profits exceed their personal tax allowance, however, even if you have made a loss or only a small profit you MUST fill in your self-assessment form each year. You will then receive notification that you have no tax amount due (you will have the opportunity to pay Class 2 NI contributions to ensure that you qualify for certain benefits, although this is optional).
Once you have completed your self-assessment with HMRC, you will be notified exactly how much you are required to pay and when. There are various ways to pay and in some instances you may also set up a payment plan.
Some businesses will also be required to make payments towards their following year’s bill, depending on the profits they have declared. These payments are due at the end of July and the end of January.
How much tax does a sole trader pay?
The payments that you have to make each year will reflect the profits you have made. As with employed workers, the higher your earnings, the more tax you will have to pay.
Currently £12,570 – You are able to earn up to this amount tax-free.
Currently (Tax year 2021/22) if your earnings exceed the personal allowance threshold you can expect to pay the following tax:
- Earnings over £12,571 and under £50,270 Basic Income Tax rate at 20%.
- Earnings over £50,271 and under £150,000 Higher Income Tax rate at 40%.
- Earnings over £150,000 Additional Income Tax rate at 45%.
Your National Insurance Contributions are usually calculated and paid through self-assessment.
There are two types of National Insurance that apply to self-employed sole traders:
- Class 2 – For annual profits over £6,515.
- Class 4 – For annual profits over £9,569.
Class 2 National Insurance provides eligibility to certain benefits. If your earnings are under the threshold you may want to make voluntary contributions instead.
Rates for tax year 2021/22:
- Class 2 – £3.05 per week.
- Class 4 – 9% on profits between £9,569 and £50,270.
2% on profits exceeding £50,270.
- VAT is not payable until your business has an annual turnover of £85,000.
If your annual income exceeds this limit as a sole trader, you are required to register for Value Added Tax (VAT) which is payable on most goods and services. You will have to charge VAT on your sales; however, you can also reclaim it on purchases.
The tax you owe will be a final amount for the previous tax year. This means if you file on 31st January 2022, it will be for the last full tax year (2020/21). The amount you owe is called a ‘balancing payment’.
If your tax bill exceeds £1,000, you will receive an additional payment on your bill that goes towards next year’s bill. This is referred to as ‘payment on account’.
Payments on account are due twice yearly. They are advance payments towards your next bill. They are calculated to be half of your previous year’s bill, payable by midnight on 31st July and 31st January. You can read more about balancing payments and view examples at gov.uk.
How does a sole trader pay tax?
You are legally responsible to pay any tax and National Insurance that you owe to the government. This is paid through the annual self-assessment scheme. Once you have entered all of your details for the tax year into the system it will tell you exactly what you owe.
You can pay your tax bill in several ways as a sole trader:
Same or next day services
- By using your online bank account.
- Telephone banking (via Faster Payments).
- In branch at your bank or building society (this requires a paying-in slip from HMRC).
- Debit card or corporate credit card (payment by personal credit card is not allowed).
Services within 3 working days
- Direct debit (this needs to have been previously set up with HMRC).
- Via a cheque in the post.
(It is no longer possible to make payments at the post office).
You need to make sure that the payments you make will reach HMRC on time. HMRC issues fines for those who fill in their annual self-assessment tax return late, or do not pay the tax that they owe on time.
It is important to allow enough time for your payments to reach them, as well as to consider whether the deadline falls on a weekend or public holiday, in which case they must be received on the last working day before (this does not apply to Faster Payments or debit/credit card payments).
It is possible to be both employed and self-employed at the same time. This could be because you have more than one job or you do some freelance work on the side. In this instance, any tax that you owe might be taken from you at source using your tax code.
If you are registered as a sole trader as well as being employed and think your tax code is wrong, you should contact HMRC immediately to avoid underpaying, or overpaying, tax.
How to do a tax return as a sole trader?
Each year, you will need to file a tax return through the government’s annual self-assessment scheme. This is usually done online and is relatively simple. You will need to log in using your Unique Tax Reference and password and provide the information that the assessment form requires.
Once you have completed all pages, you will receive confirmation of how much tax and National Insurance you have to pay (if any).
If you complete your assessment online you have the opportunity to see this once you have finished filling in all the relevant fields but before you submit it. To do this select ‘View Your Calculation’.
Once you have sent your final self-assessment you will also be able to view what you owe in your account by signing in (it can take up to 72 hours for this to show).
If you send in a paper copy of your assessment you should receive your tax bill in the post.
The annual self-assessment is mostly straightforward and when working as a sole trader is usually a fairly simple business set-up – you should not run into too many problems. It will be significantly easier if you have kept clear records of your sales and transactions during the year.
Having a dedicated business bank account will also make it significantly easier to assess your incomings throughout the year.
If you feel overwhelmed or confused about how to pay income tax as a sole trader and cannot find the answers you need on the official government website or online forums, you may wish to employ the professional services of an accountant. Accountants are skilled when it comes to finance and may be able to offer advice on ways that you, as a sole trader, can maximise your profits whilst staying compliant with current income tax laws.