A Guide to Self Employment
We hope our Guide to Self Employment will assist you - click on a link to read more information on that subject:
- What is Self-employment?
- How you are taxed?
- Books and Records
- Annual Accounts
- Tax Returns
- Compliance and Penalties
- National Insurance Contributions
- Partnerships
- Limited Partnerships
- Disclaimer
1. What is Self-employment?
Self-employment means that you are carrying on a trade or profession. To put it another way you are in business on your own account. You sell goods or services in the market place and you hope to generate an income from that.
If you are in business on your own you are a sole trader. When jointly with others you are in partnership.
If you carry on your business as a sole trader or in partnership you are the business. Any profits that you make are your earnings. Any debts that you run up are your liability.
An alternative is to choose to create a private limited company and trade through that. However a limited company arrangement is quite different to self-employment with very different rules and compliance obligations (see our limited companies page).
2. How you are taxed
The profits of your business are the equivalent to the top line of your pay. The profits are simply the difference between the value of the work you have done or sales you make and the cost of generating that income.
There are a number of rules that determine what expenditures may be deducted from the income of the business. The most important is that only expenditures incurred wholly and exclusively for the purpose of the trade may be deducted. That means just what it says, therefore any sums which you take out of the business for your own account are not a deductible expense and nor are any private expenditures. It is permissible however to apportion the cost of certain expenditures between business and private use such as a private car that you use in your business.
You no longer receive wages. The sums that you withdraw from your business for private purposes are called private drawings. They have no impact upon your tax liability whatsoever – it does not matter how much or how little you draw from the business, it will not make a penny piece of difference to the amount of tax that you pay - remember, your profits are the equivalent of your gross pay.
The Revenue does not concern itself with how you choose to spend your net pay from employment and nor does it concern itself with how you choose to spend your earnings from self-employment.
Expenditures are distinguished between those which are immediately deductible and capital expenditures, the benefits of which are obtained over a period, for example an expensive piece of plant, a lorry, and so on. A deduction is permitted for such items but the relief is usually given over a period of years to reflect that the asset will be in use for that period.
3. Books and Records
You are required by law to maintain records of your business transactions. From those records your accounts are prepared, typically but not necessarily, by your accountant. Your books and records and your accounts are therefore not the same thing.
You must record the value of all work done or sales made and all expenditures.
Most small businesses find simple records maintained either manually or on a PC to be quite adequate. There are also numerous accounting software packages around. They are not essential.
If you ask us to act for you we will provide you with layouts for you to keep and instruct you how to maintain them.
4. Annual Accounts
In order to establish your earnings, accounts must be prepared. Accounts will consist either of a profit and loss account alone, which sets out the income and expenditures of the period and the profits arising, or it may have in addition a balance sheet.
A balance sheet is a statement of the affairs of the business as it stood on at the close of business on the final day of the accounting period.
- It is a snapshot if you like, recording the assets e.g. motor vehicles, plant and equipment, stocks, sums owed to you, balances at the bank etc., and your liabilities e.g. sums owed by you, hire purchase loans, bank overdrafts and such like. The difference between the two represents the net assets or liabilities.
- It will also disclose the beneficial ownership of those net assets in the form of a capital account. The capital account represents your interest in the business. If you are in partnership there will be a capital account for each partner.
- It will also compare your profit as against your private drawings and your tax liabilities.
- It can reveal matters such as the adequacy of working capital, whether or not capital is being built up in the business (or depleted), and explain cash flow problems.
Preparation of a balance sheet is conventional where a business bank account is retained and the Revenue is empowered to demand one if they wish. It provides a much greater qualitative assurance to your accounts.
The accounts of very small businesses may only require a profit and loss account. At our discretion we will determine whether a balance sheet should also be prepared. Ordinarily we shall do so where there is substantial trading or a business bank account.
The accounts that we prepare from your books and records have to be prepared in accordance with certain accounting conventions and we are professionally obliged to carry out a certain amount of validation to satisfy ourselves that the records from which the accounts are prepared are reasonably reliable.
We will carry out a number of tests and checks and we will ask you for explanations where necessary. We shall not however be auditing your accounts.
In the accounting profession the term audit has a very special meaning – it means to pass an opinion as to the truth and fairness of your accounts, and as such it is only ordinarily required for larger private limited companies and particular businesses. It is not normally required for small businesses.
Once the accounts have been completed we will attach a certificate to them to confirm that they are in accordance with your books and records and with the explanations you have provided.
5. Tax Returns
If you are carrying on a business you have an untaxed source of income. It is quite unlike employment whereby you have a taxed source of income i.e. when you receive your pay subject to Pay As You Earn. That means your pay is taxed before you receive it. When you are carrying on a trade that is not the case and the Revenue will take a greater interest in you.
You are required to submit a Self-Assessment Tax Return each year. The tax year ends on 5th April. Your Tax Return must contain your earnings from your business as disclosed by your accounts and any other sources of income such as employment income, savings income and so on.
Your total tax liability taking account of all your income sources is calculated and you are given credit for any tax deducted at source, for example from employment (your P60), under the Construction Industry Scheme and from savings interest.
The balance of your tax liability is normally due on 31st January following the tax year. You may also be required to make payments each January and each July on account of the tax year, leaving only a final balance to be paid up in the January or refunded as the case may be.
6. Compliance and Penalties
The Revenue are keen that all your income be declared and taxed and have a wide range of enforcement powers to ensure that it is.
Penalties for failing to disclose the true profits can be up to 100% of the tax lost together with interest. Additionally a penalty of up to £3,000 can be levied for a failure to keep proper books and records. Neither maximum is routinely charged but penalties can be severe nonetheless.
7. National Insurance Contributions
If you are self-employed you will normally be required to pay Class 2 NI contributions (the self-employed stamp).
Nowadays there are no stamps but rather the sum is taken periodically from your bank account under direct debit. They count as contributions towards your entitlement to state retirement pension.
In addition you pay Class 4 National Insurance contributions together with your income tax. They can be a significant additional liability. They are, rather like income tax, charged on your profits.
8. Partnerships
A partnership is two or more persons carrying on business together in common with a view to profit.
Partnerships may be established with a formal partnership agreement or none at all, in which case they are known as partnerships at will. But in both cases each individual remains self-employed for taxation purposes. The Inland Revenue however recognises the existence of a partnership, from which a Partnership Tax Return is expected.
The partnership will maintain one set of books and records and prepare one set of accounts. The profits of the business will be apportioned between the partners in accordance with their profit shares.
Profits may be apportioned in a variety of ways. Partners’ salaries may be paid as a first charge on profits but they are not salaries in the sense of being subjected to PAYE. Where the partners contribute unequal work time then the capacity to set salaries is helpful. Similarly partners may contribute in other ways. While one may be able to contribute time and effort another may be able to contribute capital, or make property available, or contacts and so forth. Profits may be apportioned in whatever manner the partners agree to and they may be varied from time-to-time.
Ordinarily it is sensible to have a formal partnership agreement in writing before trading begins although it is not uncommon for partnerships between spouses and within families to be merely partnerships at will. As such their additional flexibility can be useful in apportioning profits (whisper it.....) in the most tax advantageous way within the family.
The agreement can be vital should problems arise such as the death or retirement of a partner, or a breakdown in relations between the partners and so on. A good partnership agreement may not be dusted off for many years. But when it is needed it is likely to be seriously needed and its absence can cause no end of problems.
Regardless of the existence or otherwise of a partnership agreement another commonly overlooked component of a partnership is the need for there to be goodwill between the partners. If a partnership is to be a success over a sustained period of time then tolerance and give and take is essential. It has been observed that partnerships have all the problems of marriage but without any of the fringe benefits.
In the absence of a partnership agreement then the partnership at will is governed by the terms of the Partnership Act 1890. This provides amongst other things that unless it can be demonstrated to the contrary, partners will share equally in profits and capital whether or not they may have contributed money or property or time equally or unequally. In such situations then it is clearly vital that the partnership agreement be set out in writing. Furthermore one partner giving notice to the other can terminate the partnership and the business of the partnership must be wound up and the assets sold if one partner or another insists upon it. In general then, even within families (and some would argue particularly within families) partnership agreements are a good thing.
Within the books of account of a partnership, with the possible exception of husbands and wives, each partner will maintain a separate capital account that reflects their interest in the assets of the partnership. Typically it will record any capital which is introduced into the partnership business, be credited with the share of profits generated but reduced by private drawings and the share of any losses incurred. It is permissible for the partnership to pay each partner’s personal tax liability but that sum is then charged to each partner’s capital account. Thus each partner bears his own tax liability.
There is a concept of joint and several liability with regard to partnership debts which means that if the partnership does not have the funds to meet its liabilities then the creditors can seek settlement of the whole of the sums due from either partner.
The partnership agreement will set out the terms under which a partner may resign or retire. It will usually provide for certain assets of the business to be revalued, for example property and goodwill, as well as permitting the continuing partners a period of time over which to pay out the partner who is leaving. Property acquired by the partnership belongs to the partnership although for tax purposes each partner is treated as having a share in accordance with his entitlement under the agreement.
Partners have a general duty of care to their other partners and must act in the best interest of the partnership. There may be a provision, occasionally used, for the expulsion of a partner in particularly serious circumstances.
Property may be made available to a partnership and the partnership may pay rents for that property. When assets, including and especially property, are acquired then it should be clearly understood by all partners as to whether the property so acquired belongs to the partnership or is a private asset albeit owned jointly by the partners. Partnership assets, particularly in an acrimonious parting of the ways, are a common source of dispute.
The agreement may set down the duties and responsibilities of each partner.
It should have an arbitration clause for the resolution of disputes.
9. Limited Partnerships
Limited liability partnerships (LLP’s) are separate legal entities and have the considerable advantage of having limited liability, broadly up to the amount of the capital disclosed by the capital accounts of the various partners.
Its members manage the LLP in much the same way that partners conduct the affairs of a partnership. There must be a minimum of two members.
The Partnership Act 1890 has no impact upon an LLP. Instead it is governed by the Limited Liability Partnership Act 2000 and certain regulations. Rather like a partnership however it is not necessary for an agreement to be drawn up in which case default provisions apply and these are a little similar in their impact to those of the Partnership Act 1890. It is conventional however to have a written agreement and the advantages may be summarised as set down for partnerships.
Members are subject to Income Tax and Capital Gains Tax on their shares of the profits and gains. The LLP is not taxed as a separate entity, unlike a limited company. If substantial losses are incurred there can be a particular disadvantage in an LLP by way of a restriction on the extent to which those losses may be set off against other sources of income that the members may have.
If the issue of limited liability is a concern but the demands and obligations that accompany private limited companies are considered to be too onerous, then an LLP may be the solution.
The LLP agreement will set down many of the matters that will be dealt with under an ordinary partnership agreement.
The appropriate details of an LLP must be maintained with the Registrar of Companies and be available for public inspection. The rationale being, as with limited companies, that if the members are to be granted the privilege of limited liability then the public is entitled to know with whom they are dealing.
The accounts of the partnership must be lodged with the Registrar for public display in order that the creditworthiness of the LLP be better judged. An Annual Return must be delivered to the Registrar. There are penalties for failure to make submissions on time.
10. Disclaimer
While we hope the above has been found to be useful it is intended only as a general guide, may not reflect the very latest developments in tax law, and cannot be a substitute for professional advice.
We cannot accept any responsibility for loss occasioned to any person acting or refraining from acting as a result of material contained in this guide.