Becoming your own boss opens up a world of possibilities – but perhaps the greatest downside to self-employment is the burden of having to calculate and pay your own tax bill.
Whereas HM Revenue and Customs collects income tax from employees directly through the PAYE system, the self-employed must work out what they owe and report this via self-assessment every year.
If you operate as a sole trader, then you will pay income tax on your business profits, minus expenses. You will also need to pay class 2 and class 4 National Insurance contributions (NICs) if your profits are above £12,570.
If you work through a limited company, then as a director you will pay income tax and NICs on the income you take. However, you can choose to take some of your income as dividends, which are not subject to NICs.
Every penny counts when you run your own business, so it is important to cut tax where you can. This is especially important given the UK’s tax burden is on track to reach its highest level since the Second World War, according to the Office for Budget Responsibility, because of the Government’s freeze on tax thresholds.
Under Chancellor Jeremy Hunt, the self-employed also face a number of tax rises.
For example, working through a limited company means you may have to pay corporation tax. The Government increased the rate of corporation tax this year so owners of limited companies with profits of over £250,000 now pay tax at 25pc, up from 19pc.
Meanwhile, the dividend tax allowance has dropped from £2,000 to £1,000 and will fall again to £500 next year, meaning company directors who pay themselves in dividends face higher tax bills.
If you are one of the 4.4 million self-employed people in the UK, then Telegraph Money has five tips to help you avoid the Chancellor’s tax raid and keep more of what you earn.
Maximise all your expenses
The more business expenses you can claim, the less tax you will pay. This is because you can deduct these expenses from your profits; and as you get taxed on your profits, your tax bill will therefore be reduced.
Seb Maley, of Qdos, a tax insurance provider for the self-employed, said: “This is one of the smartest ways to reduce your tax bill, with the self-employed able to claim a range of business-related expenses – from travel costs to internet and phone bills, to marketing spend and mileage.”
Generally, expenses must be incurred “wholly and exclusively for business purposes”, to be deductible from taxable profits.
Examples of business expenses:
- Travel costs
- Training courses
- Office supplies
- Legal costs
- Business premises
- Advertising and marketing
- Business insurance.
Matthew Todd, of tax firm RSM, said: “Timing of expenses can be key. If a taxpayer is having a bumper year, they may wish to advance anticipated expenses into that tax year in order to obtain tax relief.”
Some of the simplest expenses you can claim are those for working from home. If you work from home for more than 25 hours a month, then you claim via the flat-rate method, based on hours worked from home, which saves you having to work out what proportion of your heating and electricity is spent on business use.
“Self-employed workers can shave over £300 a year from their tax bill this way,” Mr Maley said.
If your business has a small income, or if you run a “side hustle”, then instead of claiming all your expenses, it might make more sense to claim the £1,000 trading allowance.
Pay into your pension
One of the biggest advantages of paying into your pension is the tax relief you receive on your contributions.
For every £100 you put in, the Government will automatically add £25. For higher-rate and additional-rate taxpayers, the bonus is even higher. They can claim an additional 20pc or 25pc in tax relief through their tax return – just make sure to include the gross value of your pension contributions, that is, the total amount paid in by you plus the 20pc tax relief.
The extra tax relief will either be paid to you directly, or used to reduce your tax bill.
So this is well worth considering if you have spare cash. The annual allowance for tax relief on pension contributions has been increased this year, so the maximum you can add in one year is £60,000. With carry forward, you can also use any unused annual allowance from the three previous tax years.
Claim loss relief
Turning a profit when you work for yourself isn’t a given, but the good news is that you can use any losses you make to reduce your tax bill wherever you have made a profit. This is also known as “sideways loss relief”.
“If a sole trader makes a loss, they may be able to offset that loss against other taxable income in the same or previous tax year, or against capital gains in the same or previous tax year,” said Mr Todd. You usually make a claim for loss relief on your self-assessment tax return.
Consider incorporating your business
Incorporating your business means setting up as a limited company, with yourself as director. This allows you to pay yourself in a combination of salary and dividends.
Dividend income earned above the annual tax-free allowance of £1,000 is taxed at 8.75pc for basic rate taxpayers, 33.75pc at the higher rate and 39.35pc at the additional rate.
However, because of the rise in corporation tax and the cut to the dividend allowance, incorporating is not as tax-efficient as it once was.
“People working through their own limited company have had a hard time of it in recent years, with the government increasing the tax burden on these workers significantly,” Mr Maley said. “However, the tax planning opportunities – and the ability to withdraw money from your business in a tax-efficient manner – mean incorporating your business remains a more tax-efficient way to operate.”
However, it may not be such a good idea if you need the net income generated by the business, Mr Todd said.
“Generally, if an individual spends their profits personally as they arise, it may not make sense to incorporate as two layers of tax will be incurred to spend the profits – firstly corporation tax in the company, then income tax in extracting the profits from the company. This can make incorporation a more expensive alternative.”
Ultimately, the commercial considerations will probably be more important than the tax savings when it comes to deciding whether or not to incorporate.
Get rewarded for charitable donations
Ticking the “gift aid” box when you make a charitable donation means charities can claim back 25pc from the tax man for every £1 you donate.
But if you’re a higher or additional-rate taxpayer, you can claim the difference between the rate of tax you pay, and the basic-rate of tax relief paid on your donation.
For example, if you made a £1,000 donation to a charity, they would claim £250 in tax relief, bumping up your donation to £1,250. However, if you pay higher-rate tax, you’d have paid 40pc on this money, meaning you can claim a further £250 (20pc of £1,250).
You can detail your donations in your self-assessment tax return. Note that you will not qualify for Gift Aid if donations exceed four times your tax bill.
