Simple Business Guide #4 - Introduction to Tax
One area new business owners are always worried about is Tax. There are a number of different taxes that you need to learn about when you have your own business, so this guide provides a starting point by giving you the basics for each of them.
Income Tax
Income Tax is the tax that all employees pay on the income they receive from the company they work for. As a business owner this is also true, as you will of course want to pay yourself a salary for all your hard work. How you are taxed on this income depends on which business structure you use (see our business structure guide for an explanation of the different options), and how you pay yourself. There are two basic methods for collection of Income Taxes:
PAYE
PAYE or Pay-As-You-Earn is where the company you work for deducts Income Tax from your salary every month, paying you the net amount. They then pay this tax to Her Majesty's Revenue and Customs (HMRC) on your behalf every month. This is by far the easiest way for employees to pay their tax bills as all the work is done for them by the company. However as a business owner this might not be possible, or it might not be the most tax efficient way of paying yourself. If you choose to pay yourself a salary from your company through the PAYE scheme, then it is advisable to invest in some good payroll software, or to use either a payroll bureau or your accountant, as calculating PAYE can be quite complicated.
Self-assessment
If you run your business as a sole trader, a partnership, or if you are a director of a limited company then you will pay your Income Tax through the self-assessment system. This is where you have to submit an annual tax return to HMRC detailing all the income you received from your business, and any other income you may have received. This is then used to calculate how much Income Tax you have to pay.
The deadline for submitting tax returns is 31st October for a paper return or 31st January for online returns. Rather than paying your Income Tax monthly as with PAYE, you normally pay this either in a lump sum, which is due by 31st January after the end of the tax year, or by two payments on account on 31st January and 31st July, followed by a balancing payment the following 31st January.
National Insurance
National Insurance (NI) is basically another form of Income Tax. It is paid by the employee, but the employer also has to pay NI, when the level of income goes above a certain weekly amount. This weekly amount changes regularly, as do the percentages charged, as NI is often used as a means of raising tax without changing the headline Income Tax rates. There are different types of NI which are paid depending on whether you are sole trader, in a partnership, or a director or employee of a Limited Company.
- Class 1 Primary - Paid by all Employees who earn more than the weekly earnings limit
- Class 1 Secondary - Paid by all Employers who have Employees earning above the weekly earnings limit
- Class 2 - Paid by the self-employed, on a flat rate either monthly or quarterly
- Class 3 - Voluntary contributions which are paid by those who havent paid enough to qualify for certain state benefits
- Class 4 - Paid by the self-employed where their proftis are above a certain level, paid annually after completion of self-assessment tax return
Corporation Tax
If you run a Limited Company then the tax the company pays on its' profits is called Corporation Tax. This covers profits from normal trading activities, but also profits from any other sources, such as a capital gain on selling a property. As the director of the business it is your responsibility to submit an annual Corporation Tax return to HMRC. In reality most companies get their accountant to prepare this return for them, as it can be quite complicated as there are many different allowances available and many rules on what can and cannot be included as expenses.
Your Corporation Tax has to be paid nine months after the end of your tax accounting period, although strangely your tax return is not actually due until twelve months after your tax accounting period has ended. This seems very much like a case of chicken and egg!
VAT
Value Added Tax (VAT) is a direct tax which businesses charge on their sales. Not all products and services are subject to VAT so not every business needs to register for VAT. There are also some products and services which charge a different rate from the standard rate (currently 17.5% although from January 2011 this rises to 20%). It isn't possible to list all the products/services and their VAT rates, so for more information on whether or not your business may be subject to VAT it is best to check on the VAT Section of the HMRC website or ask your accountant.
You only HAVE to register for and charge VAT when your turnover, or sales, of taxable products or services exceeds £70,000 in the last twelve months, or if you expect it to go over that level in the next 30 days. However you may choose to register for VAT before that level is reached. This can be beneficial as this will then allow you to reclaim VAT on your purchases straight away, but should only really be done if your business supplies mainly to VAT registered businesses.
Once you have registered for VAT you have to submit a VAT return quarterly, and then pay any VAT due. There are however a number of special VAT schemes available for smaller businesses, designed to make accounting for VAT simpler, thereby saving you time and costs.
- Annual Accounting Scheme - here you pay VAT once a quarter based on last year's sales and then submit just one VAT return at the end of the year which calculates the final payment, or repayment, due. Whilst this scheme is easier to administer and can save costs, it is not good for businesses who regularly reclaim VAT, as they would have to wait a whole year for the repayment, or for businesses who have lower sales this year than last year, as they would be paying a higher amount than is actually due.
- Cash Accounting Scheme - under this scheme the VAT is only due once the customer has actually paid you, not when the invoice is raised. This is good for businesses where customers are slow to pay, or for businesses that have a higher risk of bad debts.
- Flat Rate Scheme - this makes accounting for VAT much simpler as you don't have to account for VAT on each and every transaction you make. Instead a flat rate is applied as a percentage of your turnover, with the rate being lower than the standard rate of VAT to take into account the purchases you make where you would normally reclaim VAT. There can be downsides to this though where you could end up paying more VAT than you normally would, usually if you are making zero rated or VAT exempt sales as well as standard rated sales.
- Other schemes - there are other schemes available for certain industries, such as retailers and tour operators.
More information on these schemes is available on the HMRC website or your accountant should be able to advise you on these.
Conclusion
This guide only acts as a brief introduction to these taxes but should give you a good starting point. The HMRC website is a great source of much more detailed information on these, and all the other taxes, if you have the time or desire to read up on it. In reality though most businesses rely on their accountant to advise them on all of these matters, so if you haven't done so yet, then I would recommend you find yourself a good accountant to help you.
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