Understanding the Tax Implications for a Sole Proprietor

A sole proprietorship is the most basic business structure in the corporate world. For individual-owned businesses, it’s also the default business structure. For instance, if you set up a side gig to independently offer outsourced IT services, you’re considered a sole proprietor. As a result, you won’t be required to pay a filing fee, submit documentation, or have a separate account for your side hustle. However, this doesn’t mean you’re exempt from paying taxes.

This guide will help you understand the tax implications of a sole proprietor in the UK, how much you need to pay in taxes, and how you can pay the due tax amount. Let’s begin with the taxes paid by sole traders: 

Taxes Paid by Sole Traders in the UK

Sole proprietors in the UK need to pay income tax, but not the same way as ordinary employees. For each tax year, their income tax is based on their profits. Apart from the income tax, they need to pay two National Insurance contributions types, namely Class 2 and 4. When calculating the tax payable, you need to consider the reasonable expenses incurred in the ordinary course of business during the year and offset them against your earnings. 

These expenditures include utility bills, advertising and marketing, rent for premises, stock or materials, travel expenses (including fuel and business vehicle), and internet or phone used exclusively in business activity. 

How much tax you pay depends on your yearly profits, calculated by deducting the expenses for the year from the self-employed income for the same period. 

How Are Sole Traders Taxed?

Sole traders in the UK pay their taxes via the annual self-assessment scheme managed by the HMRC. There is a tax-free personal allowance of £12,570 for the 2021/22 tax year each year. This allowance is non-taxable is remaining the same for self-employed sole traders and those employed through PAYE.

If the earnings of the employees in the UK exceed their allowance, they pay tax on their salary, receiving a payslip that shows the breakdown of the amount deducted by their employer in income tax and national insurance and the amount they receive. 

Since sole traders are their employers, they must organise and file their taxes independently. Therefore, as soon as you register your sole trader business with the HMRC, you’ll receive an online self-assessment account with a unique tax reference (UTR), activation code, and password. Usually, you should receive this information within ten days by post to the address you entered when registering your sole proprietorship. 

You can log in to your account via the Government Gateway using this information. Make sure you have sufficient time to sign in and file your tax return within the deadline. The HMRC will keep reminding you that your self-assessment is due throughout the year.

When it’s time to pay your tax bill, you can use your corporate credit card or debit card, online bank account, CHAPS, telephone banking, etc.

How Much Do Sole Traders Pay in Taxes?

The tax payments you make each year will reflect the profits generated over the year. The higher the profits, the more will be payable in taxes. As mentioned earlier, sole traders have a £12,570 personal allowance, which means you can earn up to this level without being taxed. Only if your profits exceed this figure will you be required to pay tax in the following way:

  • The basic 20% Income Tax rate applies to profits exceeding £12,570 but less than £50,270.
  • 40% Income Tax rate applies to earnings over £50,271 but less than £150,000.
  • 45% Income Tax rate applies to profits exceeding £ 150,000. 

Besides, Class 2 National Insurance applies to annual profits exceeding £6,515, and Class 4 National Insurance applies to earnings over £9,569. These contributions need to be calculated and paid via self-assessment. With the Class 2 National Insurance, you become eligible for certain benefits, and you can make voluntary contributions if your earnings are under the threshold. 

For the 2021/22 tax year, the rate for Class 2 is £3.05/week and for Class 4 is 2% on earnings exceeding £50,270 and 9% applicable to profits between £9,569 and £50,270. 

You don’t need to pay VAT unless your business’s annual turnover equals or is greater than £85,000. You pay VAT when your yearly income as a sole proprietor exceeds this limit. VAT is payable on most items you sell, and you need to register for it yourself. While you must charge VAT on sales, you can reclaim it on purchases. 

The amount of tax you owe, the balancing payment, will be the final amount for the last year. In other words, the amount you file on 31st January 2022 will be for the 2020/21 tax year. 

If your tax bill exceeds £1,000, you’ll get an additional payment on your bill that will go toward the bill for the following year. That is called “payment on account.” 

Every year, payments on account are due twice—first, advance payments toward your upcoming bill of 50% of your past year’s bill. You must pay them by 31st July and 31st January latest by midnight. 

Conclusion

By now, you should have developed a profound understanding of the tax implications of a sole proprietor in the UK. It should now be much easier to stay on top of your deductions as a sole trader. If you lack the time or aren’t good with numbers, you may consider hiring a bookkeeper. 

The bookkeeping professional will keep your financial reporting up-to-date and provide access to accurate and critical information about the financial health of your business. Then, when tax season rolls around, we will help you file taxes using your financial reports. We genuinely hope that this guide helps you file your taxes correctly as a sole proprietor and in a way that enables you to avoid legal action.

Book your free appointment with ISA Consortium

For more information and professional advice, please get in touch for a free appointment. We will discuss all the needs of you and your business, and head you in the right direction for future business .

All this and more

We offer all the above as part of our full Tax Services and Accounting and can also help you with Capital Gains Tax, Inheritance Tax, Retirement Planning, even filling out your Self-Assessment Tax Returns for you.

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