A UK sole trader's overview to paying yourself as a self-employed freelancer
Working as a sole trader consists of a simple operational structure and a limited number of responsibilities, giving you the flexibility to juggle self-employed life and your commitments to HMRC with ease.
This low maintenance form of generating business is an ideal starting point for those new to flexible working, or for successful traders with low tax liabilities due to the size of the business and income. Exclusively for FreelanceUK, let’s run through how to pay yourself as a sole trader, how tax affects your earnings and where expenses tend to come in, writes David Tattersall of Handpicked Accountants.
Operating as a sole trader
As a sole trader, you are not classed as a separate legal entity (as you are with a limited company), and therefore the oft-talked about payment structure of extracting dividends and/or an optimum salary does not apply to you. There is no legal distinction between your business and personal finances, therefore you are not legally obliged to open a separate bank account.
That said, you may prefer to differentiate between private and business-related income, so as to keep a clear track of your financial performance as a self-employed business. A sole trader is not protected by limited liability as a limited company would be, which means that you will be held personally liable for any debts incurred from your business.
Paying yourself as a sole trader
As a sole trader, you can opt to take ‘drawings’, which simply refers to drawing money to pay yourself. As the income is generated by yourself (and not through separate legal entity, as with a limited company), you have the freedom and flexibility to take drawings as you wish. It is worth noting that you must retain sufficient funds to cover the tax on profits which is payable by January 31stand July 31st of each year through HMRC’s ‘Self-Assessment’ tax system.
As a sole trader, you will be taxed on the profit generated. And ‘profit’ is defined as the surplus of the income generated and allowable expenses incurred. Pensions are not an allowable expense, as they are a personal contribution. However, if you’re a basic rate taxpayer, the tax relief is added automatically by the provider to your contributions.
Tax liabilities as a sole trader
Earnings below personal allowance (£12,500)
No income tax payable
Basic rate (£12,501- £50,000)
Higher rate (£50,001- £150,000)
Additional rate (Over £150,000)
Class 2 NICs
For the 2020/21 tax year, you will need to pay Class 2 National Insurance if the profit made by your sole trader business is more than £6,475 (up from £6,365 in 2019/20). This amount is known as the ‘Small Profits Threshold.’
The Class 2 rate per week is £3.05, which you need to pay annually to HMRC through the Self-Assessment process. So, your Self-Assessment liability to HMRC includes the Class 2 NIC of £158.60 for the tax year (up from £156.00 in 2019/20).
No National Insurance is payable on any profit up to the Small Profits Threshold.
Class 4 NICs
For the 2020/21 tax year, you’ll need to pay Class 4 National Insurance if the profit made by your sole trade business is more than £9,500. This amount is known as the ‘Lower Profits Limit’ (up from £8,632 in 2019/20).
If your profits are £9,500 or more a year, you’ll pay Class 4 NICs of:
- 9% on profits between £9,500 and £50,000
- 2% on profits over £50,000.
The £50,000 amount is known as the ‘Upper Profits limit’.
Class 4 NICs are calculated annually by HMRC as part of your Self-Assessment. Your Self-Assessment liability will include a calculation based on the amount of profit made by your sole trader business.
As drawings are non-allowable for tax, your profit will not be affected by the level of drawings that you take and the tax/NI liability due.
Responsibilities as a sole trader
Now we need to delve into your responsibilities as a sole trader because HMRC’s guidance states that if your earnings amounted to over £1,000 between April 6th 2019 and April 5th 2020, you must register with HMRC as a sole trader.
If your turnover is over £85,000, you must also register for VAT. You may voluntarily decide to register for VAT for many reasons such as:
- You want to strengthen your business reputation and appear as a professional entity
- VAT-registered business can only trade with other VAT-registered businesses
- You want to reclaim VAT from other VAT-registered business
As a sole trader, you will need to record your business sales, expenses and submit an annual Self-Assessment Tax Return to HMRC, through which you will be able to claim your business expenses.
Allowable business expenses for sole traders
As a sole trader, you will be able to take advantage of allowable business expenses which are tax-deductible and therefore can be excluded from your taxable profit, subject to expenses claimed. This means that you will pay less tax, increasing your income after tax. The expenses must be ‘wholly and exclusively’ incurred for business purposes.
Stock, goods & materials – The cost of some items may be classed as a claimable expense.
Business premises – Rent, maintenance, utility bills and security. If you work from home, you may be able to claim for a fraction of these costs using the so-called ‘flat rate’ method.
Travel – Vehicle insurance, fuel, hire transport charges, maintenance, public travel costs, hotel rooms and meals on overnight stays.
Legal & Financial Costs – Business insurance and accounting costs for business purposes.
Marketing – Ongoing marketing and PR costs to advertise business services.
Office expenses – Stationary, printing, postage, phone/mobile bills
Clothing – This must be strictly work-related uniform if you plan on claiming as an allowable expense and so cannot be for personal use.
A fuller list of self-employed expenses can be found here. To claim for the expenses correctly, you must keep individual records and you are legally bound to retain these for six years. If you have access to intelligent financial accounting software, you can store these records on the cloud and can dispose of physical receipts. Helpful – if you’re not the shoebox-type!
Navigating your finances as a sole trader can be a simple exercise. However, if you are unsure – it is vital to seek expert advice from a qualified accountant as each situation is unique, including the VAT status and the expenses in question. When in doubt, reach out!