Understanding your business taxes as a small business
The ultimate guide to paying tax when you’re a freelancer
You’re probably reading this because you’ve recently become a self-employed freelancer or it’s something that you’re considering. Self-employment can provide greater flexibility, more control over your work, a higher income and greater satisfaction. But a key consideration is what taxes you must pay.
In this guide, GoSimpleTax explains:
- What taxes freelancers pay.
- What expenses you can claim to reduce your tax bill.
- What taxes are payable if you set up a limited company.
- Whether you must register for VAT.
- When Capital Gains Tax is payable.
Self-employment: a popular choice
Self-employment remains hugely popular. Sole proprietorships (ie sole trader businesses) are the UK’s most common legal business structure. According to government figures, at the start of 2022, out of the UK’s 5.5m total business population, 3.1m were sole proprietorships (56%), 2.1m were limited companies (37%) and 353,000 were ordinary partnerships (6%).
Did you know? Whether freelance or working for a limited company that they set up, there are 4.1m “solo self-employed workers” in the UK and they contribute £278bn a year to the UK economy.
Sole trader v limited company
When people decide to become self-employed, usually they either register as a sole trader (most people’s choice) or register a private limited company, for which they work. There are pros and cons to both, but personal financial liability is a key consideration.
- When you’re a sole trader, you and your business are the same thing in law, so, you’re liable for your business’s debts.
- With a limited company, you’re not normally liable for the company’s debts, as it’s a separate legal entity. If it fails, all you stand to lose is the value of your shares and any money you’ve invested, because you have “limited liability”.
If you’ve just gone self-employed or you’re considering it, you’ll want to know how much tax you’ll pay. Before we move to working for a limited company that you set up, let’s look at sole trader taxes.
- Need to know! The UK tax year runs from 6 April until 5 April in the following year.
What taxes do freelancers pay?
Freelancers pay Income Tax on their taxable business profits – which is turnover (ie total sales or income) less “allowable expenses” (explained further on). Your Income Tax liability is determined by how much you earn above the Personal Allowance and what Income Tax band your taxable income falls into.
- The standard Personal Allowance is £12,570 a year (2022-23 tax year), and you don’t pay any tax until your taxable income is higher.
- The Personal Allowance decreases by £1 for every £2 of net income over income of £100,000. If your net income is £125,140 or more – you don’t get the Personal Allowance.
Now, let’s look at Income Tax bands for 2022-23:
- If your taxable income for the year is between £12,571 and £50,270, it’s taxed at the basic rate of 20%.
- If your taxable income for the year is between £50,271 and £150,000, it’s taxed at the higher rate of 40%.
- If your taxable income for the year is more than £150,000 a year, it’s taxed at the additional rate of 45%.
Need to know! The additional rate Income Tax threshold will decrease from £150,000 to £125,140 from 6 April 2023, affecting some 250,000 UK taxpayers.
Freelance National Insurance contributions
- Paying National Insurance contributions (NICs) entitles you to certain benefits and the State Pension.
- You need a National Insurance number before you can start paying your NICs. You’ll find it on old pay slips and your P60.
- As a sole trader, you can pay two types of NIC – Class 2 and Class 4.
- For the 2022/23 tax year, the Class 2 NIC rate is £3.15 a week, payable if your annual profits are more than £6,725.
- For the 2022/23 tax year, Class 4 NICs are payable if your annual profits are more than £11,908. You’ll pay Class 4 NICs of 9.73% until your profits reach £50,270, then you pay a reduced rate of 2.73% on profits above this threshold.
Need to know! If your sole trader profits are less than £6,725 a year, you can pay voluntary Class 2 NICs so that there aren’t any gaps in your National Insurance record and your benefits entitlement isn’t affected.
Income Tax allowances
The first £1,000 of income you earn from self-employment can be claimed as your tax-free ‘trading allowance’, in addition to your personal allowance, to reduce your tax bill.
If you claim the trading allowance, you can’t claim “allowable expenses” (see below). So, don’t claim the trading allowance if your sole trader business tax expenses are more than £1,000 a year. If you’re a sole trader and rent out land or property, you can also claim the £1,000 tax-free property allowance (as can others with whom you own land or property).
If you’re blind, you can claim the Blind Person’s Allowance (BPA), which is an additional tax-free allowance worth £2,600 a year (2022/23 tax year). If you and your spouse/civil partner are both blind, you can both claim BPA. The Blind Person’s Allowance can be transferred between spouses and civil partners if either does not pay tax or earn enough to use all of their allowance.
- Top tip! If you’re married or in a civil partnership and your spouse or partner earns less than the Personal Allowance a year (ie £12,570), via the Marriage Allowance, they can transfer £1,260 of their Personal Allowance to you, which could reduce your tax bill by up to £252 in the tax year (6 April to 5 April). Visit the government website GOV.UK for more information.
What freelance allowable expenses can you claim?
“Allowable expenses” are costs that HMRC allows sole traders to claim as tax expenses to reduce their tax bill. Allowable expenses must be generated “wholly and exclusively” for business reasons – personal expenses are not allowable and trying to claim for them can have serious consequences.
- Need to know! If you use something for business and personal reasons, your mobile phone, for example, you must reliably work out the business-cost proportion and claim only for that amount.
The cost of buying stock or materials are allowable expenses, as are payments to subcontractors, agencies, freelancers, etc, if you employ others (sole traders can employ others).
If you run your freelancer business from home, allowable expenses can include a proportion of your rent or mortgage interest if you’re buying, as well as some of your council tax, water rates, electricity, gas and insurance. You can also claim for business telephone, mobile and broadband costs, as well as postage, stationery, printing, small office equipment and computer software/ink cartridges.
- Need to know! If you use cash basis accounting, where you only record income or expenses when you receive money or pay a bill, the cost of equipment and tools can be claimed as an allowable expense. If you use traditional accounting, where you record income and expenses by the date you invoiced or billed, you should claim capital allowances for such costs.
If you work from commercial premises you can claim for all business costs, including insurance and security, as well as equipment repairs and maintenance. Advertising and marketing costs can also be claimed as an allowable expense, as well as trade or professional journals, trade body or professional organisation membership. Accountancy fees and other professional fees can be claimed as long as they relate to the business. Allowable business expenses can also be claimed for staff uniforms and protective clothing.
What about vehicles, travel and accommodation?
If you buy a vehicle for business, you claim it as a capital allowance, but allowable expenses can include vehicle insurance, repairs and servicing, fuel (business use only), vehicle-hire charges, vehicle licence fees and breakdown cover. You can also claim for parking, train, bus, air and taxi fares, hotel room costs and meals for overnight business trips.
- Need to know! Any parking or speeding fines must come out of your own pocket, as they’re not allowable. And you cannot claim allowable expenses for fuel or mileage for travel between your home and your normal place of work. You’ll also need to buy your own lunch each day, as this isn’t allowable.
How freelancers pay Income Tax and NICs
- Need to know! Sole traders must maintain accurate financial records, detailing all sums entering and leaving their business. HMRC can ask to see your financial records and proof of your business expenses (ie receipts and invoices). You must keep both for at least five years after the 31 January online-submission deadline of the relevant tax year.
You pay your Income Tax and NICs via Self Assessment, the system UK tax authority HMRC uses to collect both taxes. Each year you’ll need to submit a Self Assessment tax return (SA100 form) and the SA103 supplementary pages, summarising your income and business costs, so that HMRC can work out how much Income Tax and National Insurance you owe (HMRC will write to you to let you know). Every year, the annual online-filing deadline for Self Assessment tax returns is midnight on the 31 January. There are financial penalties for filing your tax return late and not paying your tax bill when due (see GOV.UK for more).
To file your tax return, you’ll need to register for Self Assessment. It’s quick and easy and you can do it online via GOV.UK. You’ll need to register again if you did not send a tax return last tax year, even if you’ve sent one previously.
- Need to know! Although it’s better to do it sooner rather than later, you must register for Self Assessment by 5 October in your sole trader business’s second tax year. You may be fined if you don’t.
What taxes do limited companies pay?
- Limited companies must maintain detailed accounting records and each year they must file company accounts, summarising all sums received and paid out.
- After their running costs are deducted and any tax allowances and tax reliefs accounted for, they must pay Corporation Tax on their profits.
- From April 2023, the main rate of Corporation Tax will rise from 19% to 25%. The current 19% rate will still apply where company profits are less than £50,000. The full 25% rate applies to limited companies with annual profits of £250,000 or more. Between these two rates, marginal tax relief will apply; the higher the profit, the greater the Corporation Tax payable.
How would your income be taxed?
If you set up a limited company, you become an employee of that company, which means you’re liable for Income Tax on your salary (as per the bands stated previously) via the company’s Pay As You Earn Scheme (you must register as an employer, even if you’re the only employee, and set up your payroll).
You could pay yourself all of your income that way, but it’s not the most tax-efficient option. What many self-employed people who work for a limited company they’ve registered do is:
- Pay themselves a salary of at least £6,396 (the Lower Earnings Limit for the 2022/23 tax year), so that they pay NICs that entitle them to the state pension and other benefits.
- You can pay yourself a salary of up to £12,570 a year, which means you don’t go over your Personal Allowance, which means no Income Tax is payable, although you will need to pay NICs.
- The rest of their take-home comes from regular company share dividend payments, which are subject to tax, once you earn more than your Personal Allowance, while you also get a dividend allowance, but from 6 April 2023, this will decrease from £2,000 to £1,000 a year.
- The amount of tax you pay on dividends above the dividend allowance depends on your Income Tax band. If you’re in the basic rate band you pay 8.75%. If you’re in the higher rate band, you pay 33.75%. If you’re in the additional rate band, you’ll pay 39.35%.
Need to know! Being self-employed by working for a limited company that you register is far less tax-efficient than it used to be, which is something to consider when starting your business. If your company profit is, say, £25,000 a year, running a limited company rather than sole trader business may offer a tax saving of £360 a year. But you might pay out more to have an accountant take care of your Limited Company tax admin and payroll. Crunch the numbers before deciding your legal business structure.
What about VAT?
Whether you’re a sole trader or run a limited company, you must register for VAT (Value Added Tax) if your VAT-taxable turnover is more than £85,000 a year (2022-23 tax year). Then you can charge VAT to your customers and reclaim any VAT you pay for things your business buys. The VAT you pay to HMRC is the difference between any VAT you’ve paid and the VAT you’ve charged. If you’ve paid more VAT than you’ve charged, HMRC repays you the difference.
Top Tip! You can register for VAT if your turnover is less than £85,000 a year. This can be a tax-efficient option if many of the things your business or company buys is subject to VAT. That said, it involves additional tax admin, especially now it’s subject to Making Tax Digital for VAT requirements.
What about Capital Gains Tax?
Sole traders may need to pay Capital Gains Tax (CGT) if their business make a gain (ie profit) when they “dispose of” (ie sell) all or some of a business asset, which can include land, buildings, fixtures and fittings, plant and machinery, shares, registered trademarks and even goodwill (ie your business’s reputation).
You pay tax on the gain, not the sale price. As well as the CGT tax-free allowance (currently £12,300 for 2022/23 tax year, reducing to £6,000 for 2023/24), Capital Gains Tax reliefs can be claimed to reduce your tax liability. More CGT is payable on gains from residential property when compared to other assets. Your Income Tax band will also determine the amount of CGT that you pay (it ranges from 10%-28%). Visit GOV.UK for more information about CGT.