Self-employed – How to calculate your payments on account

Self-employed – How to calculate your payments on account

The deadline for filing the self-assessment tax return for 2018/19 is 31 January 2020. This is also the date by which any outstanding tax for 2018/19 must be paid and, where payments need to be made on account, the date by which the first payment on account of the 2019/20 liability must be made.

What is a payment on account?

As the name suggest, a payment on account is an advance payment towards a taxpayer’s tax and Class 4 National Insurance bill. Where payments on account are due, the tax is payable in two instalments on 1 January in the tax year and on 31 July after the tax year rather than in full in a single instalment of 31 January after the tax year.

As the payments on account are based on the previous year’s liability, it is not an exact science – there may be more tax to pay or the taxpayer may have paid too much. Any balancing payment must be made by 31 January after the end of the tax year. If the taxpayer has paid too much, the excess will normally be set against the next year’s payments on account or refunded if none are due.

When must payments on account be made?

Payments on account must be made where tax and Class 4 National Insurance for the previous tax year was £1,000 or more, unless at least 80% of the tax owed has been deducted at source, for example under PAYE.

Payments on account are not required when tax and Class 4 National Insurance bill for the previous year was less than £1,000.

Calculating the payments on account

Each payment on account is 50% of the previous year’s tax and Class 4 National Insurance liability.

Class 2 National Insurance contributions are not taken into account in calculating the payments on account and must be paid in full by 31 January after the end of the tax year.

Example

Richard is a sole trader. In 2018/19 his profits from self-employment were £30,000. He has no other income.

His income tax liability for 2018/19 is £3,630 (20% (£30,000 – £11,850)) and his Class 4 National Insurance liability is £1,941.84 (9% (£30,000 – £8,424).

His combined tax and Class 4 National Insurance liability is thus £5771.84.

As this is more than £1,000, he must make payments on account of the 2019/20 tax year of £2,785.92 on 1 January 2020 and 31 July 2020. Each payment is 50% of the previous year’s liability of £5771.84. If the liability for 2019/20 is more than £5,771.84, the balance must be paid by 31 January 2021, together with the Class 2 National Insurance for 2019/20.

Beware fluctuating years

Where the tax and Class 4 liability is under £1,000 one year but not the next, the payments can fluctuate widely – this may hit the taxpayer hard.

Example

Tim has a tax and Class 4 National Insurance liability of £900 in 2017/18. As a result, he is not required to make payments on account for 2018/19. However, 2018/19 is a good year and his tax and National Insurance liability is £4,000. As payments on account were not made, the amount is due in full by 31 January 2020. Also, because it is more than £1,000, he must make payments on account for 2019/20.

As a result, he has to pay £6,000 on 31 January 2019 – the full liability for 2018/19 (£4,000) and the first payment on account of £2,000 (50% of £4,000) for 2019/20. The second payment on account for 2019/20 of £2,000 is due by 31 July 2020.

Reduce payments on account

If the taxpayer knows that income in the current year will be less than the previous year, they can ask HMRC to reduce the payments on account. However, interest is charged on the shortfall if the payments are reduced below the level they should be.

Can we deduct entertaining expenses?

Can we deduct entertaining expenses?

The tax rules on the deductibility of entertaining expenses are harsh and often misunderstood – the fact that the expenditure is incurred for businesses purposes does not make it deductible. Subject to certain limited exceptions, no deduction is allowed for business entertaining and gifts in calculating taxable profits.

What counts as business entertainment?

Business entertainment is the provision of free or subsidised hospitality or entertainment. Hospitality includes the provision of food drink or similar benefits for which no payment is made by the recipient. It also extends to subsidised hospitality whereby the charge made to the recipient does not cover the costs of providing the entertainment or hospitality.

Examples of business entertaining would include taking a supplier to lunch, taking customers to a day at the races, or inviting them to a box at rugby match, and suchlike. The definition is wide.

Exception 1: Entertaining employees

One of the main exceptions to the general rule that entertaining expenses cannot be deducted is in relation to staff entertainment. A deduction is allowed for the cost of entertaining staff, as long as the costs are incurred wholly and exclusively for the purposes of the trade and the entertaining of the staff is not merely incidental to the entertaining of customers. So, for example, a company would be able to deduct the cost of the staff Christmas party in calculating its taxable profits. However, if a company takes customers to Wimbledon, the fact that a number of employees also attended is not enough to guarantee a deduction as the entertaining provided for the employees is incidental to that for customers.

It should be noted that unless an exemption is in point, employees may suffer a benefit in kind tax charge on any entertainment provided.

Exception 2: Normal course of trade

The disallowance does not apply where the business is that of providing hospitality, and as such a deduction is allowed for the costs incurred in providing that hospitality as long as they are incurred wholly and exclusively for the purposes of the business. Businesses such as restaurants and events management companies would fall into this category.

Exception 3: Contractual obligation to provide entertainment

Where entertainment is provided under a contractual obligation, this is not treated as business entertainment and a deduction is allowed for the cost. A common example would be where hospitality is provided as part of a package. However, the business should be able to demonstrate that they have received a full return for the entertainment provided.

Exception 4: Small gifts carrying an advert

The provision of business gifts is treated as business entertaining with the result that a deduction for the costs is not generally allowed. However, there is an exception for gifts costing not more than £50 per year per recipient which bear a conspicuous advert for the business. An example of a deductible gift would be a diary or a water bottle featuring an advert for the business.

Remember…

Just because entertaining is incurred for business purposes does not mean that it is allowable – business entertaining needs to be added back in the corporation tax computation.

When and how to incorporate

When and how to incorporate

Over the last decade, corporation tax rates for most companies – irrespective of size – have fluctuated between 19% and 21%. The main rate of corporation tax is expected to be cut to 17% from April 2020.

Current corporation tax rates are still pretty favourable and are indeed generally lower than those paid by many individuals. In addition, there are other areas where company formation may help save tax. Although the costs and regulations involved with running a company are usually greater than trading as a sole trader or in partnership, and more administration is generally needed, using a company as a vehicle through which to trade remains a popular choice.

The starting point for dealing with companies and company directors is to remember that a limited company exists in its own right, which means that the company’s finances are separate from the personal finances of the company owners. Strict laws mean that the shareholders cannot simply take money out of the company whenever they feel like it.

When to incorporate

The question of whether to incorporate commonly arises as a business expands – the limited liability status that company formation provides is often needed to start winning contracts with bigger companies. However, incorporating may not be such a good deal in the early days of trade, or if there is no intention to grow beyond the status of a solely owned business. This may be particularly relevant if losses are envisaged in the early years of trading – for sole traders and partnerships, it is possible to carry back losses made in the first four years and offset them, where applicable, against personal income of the three preceding years. This often results in a substantial refund of tax becoming due and may offer a much-needed cash boost to the business.

How to incorporate

Firstly, the company must choose a name, which cannot be the same as another registered company’s name. If it is too similar to another company’s name or trademark it may have to be changed.

The company must have at least one director who is a natural person, and a public company must have at least two directors. A private company need not appoint a company secretary, although in practice many choose to do so.

There must be at least one shareholder or guarantor, who can also be a director.

The company will need to prepare a ‘memorandum of association’ and ‘articles of association’, as provided for by Companies Act 2006. Broadly, these documents set out how the company will be run.

Private limited companies are also required to maintain a register of those persons who have significant control of the company – known as a ‘PSC Register’. The function of the Register is to increase corporate transparency for the purpose of combating tax evasion, money laundering and terrorist financing.

The company must register with HMRC for corporation tax and PAYE as an employer at the same time as registering with Companies House. This must be done within three months of starting to do business. The company may also be required to register for VAT if it meets the registration criteria.

Although there are disadvantages to incorporating a business, the lower tax rates and other reliefs currently on offer still make it an attractive proposition. Some advantages worth considering include:

  • ability to pay dividends to shareholders, which may in turn reduce liability to National Insurance Contributions (NICs)
  • flexible succession planning, particularly for inheritance tax purposes
  • great investment opportunities, for example potential to raise money through tax-efficient schemes such as the Enterprise Investment Scheme (EIS)
  • limited liability status for shareholders, although directors may be asked to give personal guarantees of loans to the company and may still be held liable for the debts of a company
  • potential increased saleability

Business owners are recommended to evaluate the advantages of incorporation on an on-going basis.

Closing a business – when a member’s voluntary liquidation is beneficial

Closing a business – when a member’s voluntary liquidation is beneficial

Although it is possible to strike off a company and for distributions made prior to dissolution to be treated as capital rather than as a dividend, this is not an option where the amount of the distributions exceeds £25,000.

Where the taxpayer’s personal circumstances are such that it is beneficial for the remaining funds to be taxed as capital (and liable to capital gains tax), rather than as a dividend, a member’s voluntary liquidation (MVL) can be an attractive option, as depending upon the level of funds to be extracted the costs of the liquidation may be more than covered by the tax savings that can be achieved.

What is an MVL?

An MVL is a process that allows the shareholders to put the company into liquidation. This route is only an option if the company is solvent (i.e. its assets are greater than its liabilities). The directors must sign a declaration of solvency confirming that the company is able to pay its debts in full within the next 12 months and 75% of the members must agree to place the company into liquidation. The shareholders must pass a special resolution to wind up the company. They will also need to pass an ordinary resolution to appoint liquidators. The liquidator must be a licensed insolvency practitioner.

What are the tax implications?

Under an MVL the capital extracted from the company is treated as a capital distribution and is liable to capital gains tax, rather than being taxed as a dividend. Where entrepreneurs’ relief is in point, the rate of tax will only be 10%, assuming enough of the entrepreneurs’ relief lifetime limit remains available. If significant funds are available for distribution, this can generate considerable tax savings.

Example

Edward and Oliver are directors of a company in which they both own 50% of the shares and 50% of the voting rights. Each is entitled to 50% of the profits available for distribution and 50% of the assets on a winding up.

They wish to wind the company up, but as they have cash and assets of £10 million to distribute, they opt for an MVL, to allow them to take advantage of the capital gains tax treatment. Both are additional rate taxpayers, and both meet the qualifying conditions for entrepreneurs’ relief.

Edward and Oliver each receive £5 million on the winding up of the company. They both have the full amount of the entrepreneurs’ relief lifetime limit (£10 million) unused, and it is assumed for simplicity that the annual exempt amount has been used elsewhere. The gain is therefore taxed at 10% and each will pay tax of £500,000 on their distribution of £5 million.

Had they not opted for an MVL and the extracted funds taxed as a dividend, they would have each paid £1,905,000 in tax on the £5 million distribution (£5m @ 38.1%).

Anti-avoidance

Anti-avoidance provisions apply which are designed to target ‘money boxing’ (where the company retains more funds than it needs in order to extract them as capital when the company is liquidated) and ‘phoenixism’ (where the company is liquidated, the value extracted as capital and a new company is set up to carry on what is essentially the same business). Liquidation distributions which are caught by the rules are treated as income rather than capital.