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Being self-employed and running your own business as a sole trader comes with a lot of freedom, but also significant responsibility – especially when it comes to properly filing taxes and staying compliant with HMRC. Knowing the following terms included in this guide should help you understand all of the key terminology used when dealing with your taxes and accounts as a Self-Employed worker.
The process of calculating and paying your own income tax and National Insurance contributions. Self-employed workers are required to report their income and calculate how much tax they owe through the Self Assessment system. This involves completing an annual tax return where you declare all your sources of income, allowable expenses, and claim any tax reliefs you’re entitled to. HMRC will then calculate how much income tax and National Insurance you need to pay based on the information provided.
Payments you make that go towards your entitlement to certain state benefits, such as the State Pension and Jobseeker’s Allowance. As a self-employed worker, you are required to pay certain classes of National Insurance contributions alongside your income tax. These contributions go into a fund that provides you access to benefits like the State Pension, Jobseeker’s Allowance, Employment and Support Allowance, and Maternity Allowance should you ever need them. The amount you pay depends on your taxable profits each year.
The total amount of money you earn before any deductions. Your gross income is the total revenue coming into your business before any deductions like expenses or taxes are taken out. This includes all your self-employment income from sales of goods/services, as well as any other income streams like earnings from employment, rental income, interest, dividends etc. Recording your full gross income accurately is crucial for tax purposes.
The costs you can deduct from your income when calculating your taxable profit. You can deduct any allowable business expenses from your gross income to calculate your taxable profit. Allowable expenses are costs that are incurred ‘wholly and exclusively’ for the purposes of running your business. Common examples include operating costs, equipment, travel, premises, advertising and staff costs. Keeping detailed records of your expenses with receipts is important to claim these deductions.
A tax added to the price of certain goods and services. Self-employed people may need to register for and charge VAT. VAT is a consumption tax of 20% that gets added to the price of most goods and services in the UK by VAT-registered businesses. Self-employed sole traders must register for VAT with HMRC if total VAT-able sales exceeds £85,000 in a 12-month period. Once VAT-registered, they need to charge 20% VAT on top of their sales, submit regular VAT returns, and pay the VAT due (less VAT paid on purchases).
A simpler way of calculating taxable profits for self-employed people with a turnover of less than £150,000. The cash basis is an alternative way for eligible self-employed people with lower turnovers to calculate their taxable profits each year. Rather than accounting for income when invoiced and expenses when incurred, the cash basis allows you to report profits based purely on money that actually enters/leaves your business during the tax year. This simpler cash flow method can make accounting easier for smaller businesses.
Expenses you can deduct from your income to reduce the amount of tax you have to pay. Sole traders can deduct certain allowable expenses from their gross income to reduce the taxable profits and thus lower the income tax bill. These tax-deductible expenses are costs that are incurred wholly and exclusively for the purposes of running your business. Common examples include vehicle costs, premises costs like rent/utilities, staff costs, equipment purchases, advertising and marketing expenses, professional fees like accounting/legal, use of home costs, travel expenses and many more. Keeping detailed records of your tax-deductible expenses with receipts/invoices is crucial.
Tax relief available for the purchase of certain business assets. Capital allowances allow you to deduct some or all of the value of certain assets you’ve purchased for your business from your taxable profits. This provides tax relief for investments in things like equipment, machinery, business vehicles, premises renovations etc. The most common form is the Annual Investment Allowance which allows 100% upfront deduction on most plant and machinery purchases up to a set annual limit. Capital allowances can significantly reduce your tax bill, especially in the first year of purchasing assets.
The code used by HMRC to determine how much tax should be deducted from your income. As a sole trader who only has income from self-employment, you won’t have a tax code in the traditional sense, as you don’t have taxes deducted automatically from a salary by an employer. Your income tax is calculated based on the profits you report through Self Assessment each year. However, if you do have additional income from employment or pensions, you will be given a tax code by HMRC for these income sources. This code is used by your employer/pension provider to determine how much tax to deduct at source via PAYE.
Advance payments towards your annual tax bill, made in instalments during the year. If you owe income tax of more than £1,000 as a sole trader after completing your annual Self Assessment, HMRC will expect you to make interim Payments on Account towards your next tax bill. These are essentially prepayments of the following year’s tax liability made in two instalments – one by January 31st and the second by July 31st. Each instalment is calculated as 50% of your previous year’s tax bill. This helps spread the cost rather than a single lump sum due on January 31st.
The annual form you must submit to HMRC to report your income and calculate your tax liability. The Self Assessment tax return is the key document all UK sole traders must complete annually to report all their income sources, claim allowable expenses/reliefs, and calculate their tax and National Insurance owed for that tax year. Sole traders typically use the Self-Employment pages of the main Self Assessment tax return form. Missing this filing deadline of January 31st after the end of the tax year can incur penalties from HMRC.
You should now have a good grasp on some of the most used and important aspects of accounting as a Self-employed worker. Knowing the meaning of these terms and what they are used for are important to ensure that you can do it all correctly and avoid receiving penalties. Arming yourself with the right guidance and tackling it head-on is essential for fulfilling your responsibilities and protecting your hard-earned profits.
