The Tax pitfalls of being self-employed

Starting up on your own can be fraught with problems to overcome – that’s half the fun, right?

One that could really give you a headache is the tax transition from being an employee to becoming self-employed.

Not only will you be taxed in a different way, but the emphasis is on you to work out your own tax! With your own business you will also be exposed to new taxes such as VAT.

Here are the main tax differences to be aware of, and what your liabilities are.

Income tax

As an employee working for someone else, all you have to do is turn up every day and get a wage slip once a month. Your employer works out how much tax and National Insurance you have to pay and deducts it from your salary before you even see it. They even pay it to Her Majesty’s Revenue and Customs (HMRC) for you.

As a self-employed person this is all your responsibility.

The main difference as a sole trader is that you aren’t taxed on your salary, as you don’t really have one. Instead you must work out how much profit your business makes, by deducting the costs of running your business from your revenue. This profit is what you must declare to HMRC and pay tax on.

Costs that you can claim include supplies to produce goods, rent on business premises, travel expenses, the costs of admin and of course any employees. Note that capital purchases such as equipment are typically offset against your tax over several years. This is the kind of thing your accountant will work out for you. Speaking generally thought, the more legitimate business expenses you have, the lower income tax you will pay.

Paying income tax

The current tax rates will determine how much of your profit you will pay as tax. Get used to putting a proportion of your revenue aside for tax from day one, and you could ultimately be in the pleasant situation of having more saved than your tax bill. Use a separate account to do this and avoid the temptation to raid the account unless it’s a dire emergency.

Every year HMRC will send you a self assessment tax return, where you work out your own tax bill. And you will have to make payments twice a year in instalments, known as payment on account.

National Insurance

NI is fairly simple when you are self-employed. You will pay Class 2 contributions at a fixed rate of £2.30 a week (2008/9) If your profit is more than £5,435 a year, you will pay additional Class 4 contributions.

Are you self employed?

There are all sorts of rules that dictate whether or not you are self-employed or in fact someone’s employee. These are typically based around the kind of control you have over the work you do and where you do it.

It is possible to be employed by someone and run your business as a self-employed person, even if it’s only on a part-time basis.

VAT

One tax that will be new to you as a self-employed person is Value Added Tax, which you already pay when you buy goods. VAT is a tax that is collected by businesses on behalf of the government. Once registered, you must charge it from your clients, and pass it onto HMRC with a quarterly VAT return (deducting the VAT you have paid).

It is compulsory to register for this and start collecting VAT any time after your revenue for the last 12 months is more than £67,000 (from 1/4/2008 - previously it was £61,000).

It’s turnover not profit that is measured. This is a rolling period so keep a close eye on your turnover, as you will be fined if you don’t register within 30 days of hitting the limit.