As a sole trader, there is no legal distinction between you as an individual and your business (unlimited liability). This contrasts with a limited company structure, which has limited liability, and which will also pay corporation tax (rather than income tax) on its profits.
Savvy sole traders should not treat all income from their business as if it belongs to them, but will need to keep back at least 20–40% of what they earn each month to cover their tax bill and NI contributions at the end of the tax year (6 April–5 April).
While the rules are simplified somewhat for self-employed/sole traders in terms of who owns the company profits, this does not mean that all the profits from the business are yours to keep. Only once income tax and National Insurance (NI) contributions have been deducted is what is left yours to keep as “wages”.
Our sole trader accountants have put together this blog with you in mind. Read on to learn how to calculate your profits as a sole trader in order run your business compliantly and how our CloudCo accountants can help.
Does a sole trader get to keep all the profits?
A minority of sole traders do seem to be under the misconception that what they earn as profit from their business is all theirs.
Some people who are “self-employed” are not even registered with HMRC. This is a serious error, because everything a sole proprietor of a business earns is not theirs to keep.
Like every other working person who is not taxed at source via PAYE, everyone earning income over the personal tax allowance (£12,570) must pay 20% basic rate income tax (or 40% at the higher rate tax). Sole traders must also pay two types of NI contributions.
But to be able to pay tax on your profits, if you are intending on becoming self-employed, you must first register with HMRC.
Records a sole trader must keep
Once you have registered with HRMC as self-employed, you are then legally obliged to account for what you earn from your business. Your accounts must be up to scrutiny by the tax authorities.
If you earn anything at all, you must account for it, even if you do not make a profit over and above the tax-free personal allowance of £12,570.
So, this is why a sole trader cannot keep all their profits. Anything earned that has not been taxed at source (e.g. via pay-as-you-earn, PAYE) must be declared on a self-assessment tax return.
This goes for anyone earning money from property or shares; or above the thresholds for online sales or letting out a room.
To be compliant with HMRC’s rules and company law, you must keep all the paperwork that relates to your business for five years.
This goes for any business structure: limited company, a sole trader business or a partnership, a charity even.
The books and accounts that relate to the organisation must be available for inspection if requested.
The documents you need to keep in good order are:
- Bank statements
- Sales and income (purchase orders, accounts received (invoices), etc)
- Business expenses (receipts, accounts payable; money owed by the sole trader)
- VAT records (if VAT registered)
- PAYE records (if employing people)
- Records relating to personal income (e.g. interest on shares, income liable for capital gains tax, rental income from a property, that is, any money earned that is not taxed at source)
- Any state benefits you have received
A record should also be kept up to the end of the tax year (5 April) of:
- Money owed but not yet received/work in progress
- Money committed but not yet spent (e.g. unpaid invoices)
- Year-end bank balances
- Money awarded to yourself “wages”
- Charitable donations
- Share value
What do sole traders pay on their profits?
Income Tax for sole traders (as of 2022–23 tax year):
- Personal allowance: £12,500 tax-free
- Tax, basic rate: 20% (after deduction of personal allowance)
- Tax, higher rate: 40% tax over £50,001–£150,000
- Tax additional rate: 45% tax over £150,000
Sole traders also pay two types of national insurance contributions
NI contributions go towards the National Health Service and entitle you to certain benefits, e.g. Universal Credit, support allowance when statutory sick pay runs out, and the State Pension.
The value of your NI contributions can affect how much State Pension you will receive and effect the value of benefits should you need to claim them.
It is important to keep up to date with your NI contributions.
Class 2 NI contributions:
- charged at a fixed rate of £3.15 p.w./£163.80 p.a. unless below the small income threshold of £6,725 p.a.
Class 4 NIC contributions (Sole traders calculate the Class 4 NI they owe on their self-assessment tax return, based on their profit):
- First £9,880 @ 0%
- £9,880–£50,270 @ 9%
- All profit above £50,270 @ a further 2%
NOTE: Class 4 self-employed NI rates rose in April 2022, but this will be reversed on 6 November 2022. This is a cut of 1.25% for self-employed workers, putting the rate back to 9% for the tax year 2022–23, but the NI reduction will not be backdated.
How is it calculated?
You will have been keeping accounts, and from these you will be able to work out what your gross income is.
To work out your gross income you will add together all your invoices and any other income that has not been taxed at source.
You will then apportion your allowable expenses and capital costs to come to the figure of your gross income.
For example if you gross income is £55,000:
|Applied Tax Rate||Taxable Income Breakdown|
|Tax free||First £12,500|
Class 2: @ fixed rate of £3.15 p.w./£163.80 p.a.
Class 4: @ 9% after £9,880 and up to £50,270 and + 2% on anything over this threshold.
How to pay yourself as a sole trader
While there is no legal obligation to open a business account – you can pay all the income from your business into your personal account – this can be a messy way to go about things and it cannot be said to meet the legal obligations of a business in terms of HMRC’s rules about transparency.
Same with using PayPal, payments through this platform are still taxable income, which means that you must declare the income you receive through the platform. This is the same with cash payments.
Any income not taxed at source must be declared. HMRC benchmark employment sectors and trades and suspicions will be aroused if your income seems to fall way below what they would expect a business like yours to earn.
This could kickstart an HMRC investigation, which is definitely something to avoid. Although some accountants offer HMRC investigation cover as part of their services offerings.
Transparency is important, as there is nothing to say that your business won’t be selected at random by HMRC for a “spot check” investigation.
The best way for the self-employed/sole trader business to manage finances transparently is to set up a business account.
Keeping personal money separate from business finances goes immediately further towards meeting your obligations as a UK taxpayer to be compliant and transparent.
Once you’ve set up a business bank account, it is then straightforward to transfer a sum each month to pay yourself a “wage”.
The transaction will then show up on your business bank account statement and on your personal account statement and this will mean that you can easily keep a track of your “salary”.
If you draw out cash for personal use from your business bank account, then it is a good idea to note it down; same goes for if you pay cash for a business expense, you should keep the receipt.
So long as it’s within the “wholly and exclusively” rules you can claim it as a business expense.
Filling in a tax return
Sole traders pay their tax by filing a tax return with HMRC and paying whatever they owe by the deadline of 31 January each year.
Depending on your earnings, “payments on account” may also be due in January followed by a further payment at the end of July in the same tax year.
Remember, it is highly advisable, essential even, to keep back between 20–40% of what you have earned to cover your income tax and NI.
So, keep in mind that the tax year runs from 6 April to 5 April and that you must file a self-assessment tax return to report your self-employed income each year by 31 January, and pay any tax you owe on your profits and two types of NI.
What expenses can sole traders claim?
All businesses – self-employed sole traders included – must keep accounts, and calculate their profits after having deducted expenses. But, these expenses must have been “wholly and exclusively” incurred for business purposes.
Allowable expenses incurred under the “wholly and exclusively” rule can be direct business costs, or may be apportioned between personal and business expenses as appropriate.
Consumable sorts of allowable business expenses differ from business items that are “fixed assets” of the business, such as a work vehicle, tools, or a new computer, as these are taxed under capital allowances rules.
Expenses businesses can claim include:
- Office costs, e.g. stationery, letterhead, phone bills
- Travel costs, e.g. fuel (mileage), parking, train or bus fares
- Subsistence (work-related trips for the day or on overnight business trips)
- Clothing expenses, e.g. uniforms
- Staff costs, e.g. salaries or subcontractor costs
- Things bought to sell on, e.g. stock or raw materials
- Financial costs, e.g. insurance, bank charges, an accountant
- Business premises costs, e.g. rent, heating, lighting, business rates
- Advertising/marketing, e.g. website hosting, design or redesign, print or online leaflet or brochure
- Training courses, but only if specifically related to your business, e.g. a refresher course
- Books and magazine subscriptions (only in relation to your business)
Costs you can claim as capital allowances
Capital allowances can be claimed for something bought for the business and used over time, for example:
- Business vehicles, e.g. a car, van, lorry
But capital allowances cannot be claimed if you are using the £1,000 tax-free “trading allowance”.
What is the rule about something bought for business and personal use?
Remember the “wholly and exclusively” rule for expenses. Allowable expenses relate to business costs, so if, for example, you use your mobile phone for business and personal use then you must apportion the cost.
Same goes for if you are working from home, you can apportion the cost of using the premises, such as use of broadband and landline etc. And it’s the same with a vehicle you use for personal and business use.
As an example, take your broadband bill; this adds up to £350, p.a. You work from home, so let’s say that £150 relates to personal use and £200 to business use. A business expense of £200 can be claimed for business use.
What if you work from home?
A proportion of costs for the following can be claimed if working from home:
- Council tax
- Mortgage interest or rent
- Telephone use
A reasonable method of dividing costs between personal and business use would be to work out the portion used for business and/or the amount of time spent working from home.
The percentage of time you have spent at work is a good way to work out what portion of broadband, energy, water use belongs to the business.
What are simplified expenses?
You can avoid the complexity of working out sole trader business expenses by using simplified expenses.
Simplified expenses are flat rates that can be used for:
- Vehicle use
- Working from home
- Living on your business premises
While the process of claiming allowable expenses appears simple, beware! Applying expenses correctly and advantageously can be tricky.
Should you still be unsure, you can check on the HMRC website or contact a qualified bookkeeper or accountant such as CloudCo.
Can sole traders register for VAT?
Some sole traders are VAT registered – either because they are earning over £85,000, in which case registration is mandatory – or because they are selling products or services to other businesses that are VAT registered.
If this is the case, sole traders will need to manage their VAT compliantly too. You must register for VAT with HMRC, calculate what you owe accurately, and file a VAT return every three months and pay what you owe.
The profits earned by sole trader businesses are theirs to keep, but only after income tax and NI have been paid. A sole proprietor business has statutory legal responsibilities just as any other business operating in the UK.
If applicable or desirable, you will need to register for VAT and file the return on time every three months and pay whatever you owe.
Running any business as if all the money the business generates is yours is not advisable, it’s a sure way to burn your fingers with the tax authorities and even land yourself in court or prison.
To safeguard your business and your personal assets, to grow your business and run it to the letter of the law, seeking help with the bookkeeping and accounting side is probably a good idea (unless you have plenty of time on your hands and know about UK tax law).
Hiring an accountant can save you a lot of effort as well as prevent you from making unintentional errors in your books and accounts.
At CloudCo we offer online accounting services with online bookkeeping systems and accounting software, which makes the recording of expenses and keeping track of invoices a lot more straightforward.
And remember, accountancy fees are a legitimate business expense – an expense that, frequently, pays for itself in terms of the amount of time an accountant can save you, not to mention the money accountants tend to save their clients in taxes as well.
To find out more about our Sole Trader accounting services, contact us today!