Choose Which Taxes You Pay
27 Sep 2021
The choice of business classification (whether you are a sole trader, partnership, LLP etc) will determine which taxes are paid by your business. Sole traders and partnerships pay income tax on their profits and Class 2 and Class 4 National Insurance contributions, whereas a limited company pays corporation tax. However, there may also be income tax to pay on profits extracted from a limited company and where those profits are extracted in the form of a salary or bonus, Class 1 NICs.
The profits from a sole trader's business and a partner's share of partnership profits are taken into account in working out his or her overall income tax liability, together with income from other sources, such as any employment income, taxable interest, and dividend income. Personal allowances are available to reduce the amount on which tax is charged. To the extent that business profits exceed the proprietor's personal allowance, they are taxed at 20%, 40% or 45%for taxpayers in the UK excluding Scotland (the Scottish rates of income tax apply to Scottish taxpayers). By contrast, the taxable profits of a company are taxed at the corporation tax rate of 19% (financial years2020-21and2021-22). Profits extracted from the company as salary or bonus are liable to income tax and also Class 1National Insurance contributions. However, salary and bonus payments and the associated employer's National Insurance are deductible in computing profits chargeable to corporation tax. There is no corporation tax deduction for dividends, which must be paid out of retained profits, but in the hands of the shareholder, they are tax-free to the extent that the dividend allowance is available and otherwise at the relevant dividend rate of tax.
Gains realised by individuals are liable to capital gains tax, whereas a company pays corporation tax on chargeable gains.
All businesses with turnover of VAT able goods and services above the VAT registration threshold, currently £85,000,must register for VAT. All businesses with turnover below this level can choose to register if they wish, but this is not compulsory. VAT-registered businesses with turnover above the VAT registration threshold of £85,000 must comply with the requirements of Making Tax Digital (MTD). Where the business is VAT registered but turnover is below this level, compliance with MTD for VAT is optional.
A sole trader and an individual partner in a partnership are self-employed and pay both Class 2 flat rate National Insurance contributions and Class 4contributions on their profits if their profits exceed the relevant profit thresholds. It is the payment of Class 2 National Insurance contributions that builds up entitlement to the state pension and certain contributory benefits.
Companies do not pay National Insurance on their profits but must pay employer contributions on payments of earnings made to employees.
By choosing the structure for your business, it is also possible to choose which taxes you pay–the taxes that are paid vary depending on the structure of the business.
It is important when choosing a structure to consider not only the current rates of tax, but also any future changes where these are known. The personal allowance is to be frozen at £12,570 until April 2026,and the basic rate band is to remain at £37,700 for the same time period. Also, the rate of corporation tax for companies with taxable profits in excess of £50,000will increase to 25% from 1 April 2023, with marginal relief reducing the effective rate where profits are between £50,000 and £250,000. Companies with profits of £50,000 or less will pay the small profits rates of 19%. These limits are proportionately reduced where a company has one or more associated companies.
Example:
Tim wants to set up a business. Having considered the options, he decides that being a sole trader is the right decision for him.
Tim will pay income tax on any profits from his business. His income tax liability will depend on his total income from all sources.
He will pay capital gains tax on any capital gains made from the sale of business assets, etc. where his net chargeable gains for the tax year exceed the annual exempt amount.
He will also pay flat rate Class 2 National Insurance contributions and Class 4 contributions on his profits where his profits exceed the relevant thresholds.
If his turnover exceeds the VAT registration threshold, he must also register for VAT. If his turnover is below this level, he can register voluntarily as this will allow him to recover any VAT suffered, although he must also charge VAT on any VAT able supplies that he m