Legislation for sole traders is designed to make it easy for entrepreneurs to start the ball rolling. You have to register with HMRC – for no fee – and you really should make sure you understand your tax obligations and deadlines; however, tax regulations for sole traders are relatively straightforward – though this doesn’t necessarily mean simple, or that your tax bill will be lighter than in other models!
Setting aside for a moment the various tax-free allowances and income tax reliefs which some sole traders may qualify for, the rules work like this:
You begin with a personal allowance. Usually this stands at £12,570, but if you earn over £100,000 your allowance is reduced by £1 for every £2 over the threshold; if you earned £100,002 in a tax year, your personal allowance is £12,569. If your income was £125,140 or higher, you have a personal allowance of zero.
Income within that personal allowance is not taxed. You’ll pay 20% on all income above your personal allowance up to £50,270 – this is known as the basic rate. From £50,271 to £125,140 (the point at which your personal allowance becomes zero), you pay income tax at the higher rate, which is 40%. Income above this level is taxed at the additional rate o 45%.
So if you’re earning £22,570, you pay no tax on the first £12,570 and 20% tax on the remaining £10,000. That works out at £2,000.
You’ll also be expected to pay your National Insurance Contributions (NICs) as Class 4. These are calculated on profit rather than income, and if your profits are below £6,845 any NICs are voluntary (and would instead be Class 2).
Because they’re based on profits, estimating your NICs mentally may not be as simple as your income tax. We recommend sole traders still follow good business practice and keep their books in detail so they can better plan for tax.
Sole Trader to Limited Company
For many sole traders, the biggest attraction of a limited company is the way it changes financial liability. Whether you have a separate business account or not as a sole trader (and we would certainly recommend that you do!) ultimately if events lead to significant financial loss and debts for your business, you are personally liable for them and your own savings and assets may be used to settle the debts. As a limited company, this liability vests in the company itself.
However, it’s also true that the change from a sole trader, whose personal income is any profit after tax that isn’t reinvested into the business, to a limited company director with a salary and the option of dividends can also significantly change your tax implications.
Limited companies pay Corporation Tax on taxable profit, with income tax levied on salary and dividends. However, there are more allowable expenses for limited companies. Between these two factors, a high-income sole trader can see significantly lower taxes both for the company and their personal income by making the switch.
It can also be significantly easier for limited companies to find investment and to grow.
The price of all this is an increased administrative burden and the need to disclose certain information to Companies House. Happily, there are ways to offset this. As part of our business accounting service, we can both help you assemble the right information to decide when to make the switch and ease the burden of paperwork when you do. That leaves you free to focus on what’s important.
If you’d like to discuss anything raised in this blog, please get in touch today.
