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Top tax tips for the self-employed

According to a recent study by Manchester Metropolitan University there are now some two million full-time home workers across the UK.

Probably everyone commuting to work on a daily basis will have that dream of working for themselves from home so that they no longer have to face the traffic jam or the tube. However, whilst the home-based entrepreneurs have turned their dreams into reality, they have soon realised that they have swapped the hassle of commuting with other nightmares like preparing VAT returns and wrestling with the vagaries of the self-assessment system of income tax.

So how does one avoid the dream of starting up a business from home becoming too ‘taxing’? Richard Mannion, Head of Tax at Solomon Hare provides some tips:

  1. Register with HM Revenue & Customs (HMRC). You only have three months to do so and failure to meet this requirement will mean an automatic £100 fine. So recommendation number one for anyone starting self-employment is to file Form CWF1 with the tax office straightaway. This form is your official gateway into starting off on the right track for tax purposes and is required to alert HMRC to your business’s existence. This form can be found on http://hmrc.gov.uk (just plug the form name into the search engine on that site) or it can be obtained from a local tax office.

  2. Join the self-assessment system. An individual starting in business during the tax year 2005/06 and who does not receive a 2006 tax return (which will cover that period from the business starting up until 5 April 2006) will have until 5 October 2006 to put their hand up and notify HMRC that they have joined the club. Failing to do so could crystallise another penalty up to the amount of unpaid tax!

  3. Keep cash by for a raining tax day. The income tax due for 2005/06 would be payable on 31 January 2007 which sounds a long way off. However, a payment on account of the 2006/07 liability will be payable on the same day, so that the total payment could be hefty and a new entrant will therefore need to plan ahead to make sure the cash is there to pay the bill. HMRC does not regard themselves as a bank and therefore do not provide extended credit terms. Interest will start to run immediately on unpaid tax and any delay in payment will result in pressure from the Collector of Taxes.

  4. Meet the standards for record keeping and book keeping, which have gone up dramatically over recent years. HMRC has issued an excellent ‘Janet and John’ style booklet explaining what records they would expect a self-employed individual to keep (booklet SA/BK4 available free from the local tax office or on the website mentioned above). In simple terms it is necessary to keep a record of all income and all expenses and to keep the backing documentation.

  5. Do not think you can use all kinds of expenses to lower the tax bill. Various myths go round as to what expenses can be claimed for tax purposes against self-employed income. The reality is that tax relief is due only for expenses which are incurred wholly and exclusively for the purposes of the business, although in practice HMRC does allow proportionate claims to be made for assets like cars, which are used partly for business and partly for private purposes.

  6. Think carefully about dedicating a room in the home for business use. If one room was used exclusively for the business then it would be possible to apportion all of the household expenses (including heating, lighting, rates and mortgage interest) and claim a proportion. However, an individual doing so would be in danger of losing some capital gains tax exemption when they come to sell the property. The usual advice here is not to set aside any one particular room just for the business so that the capital gains tax exemption is preserved. In other words the room should be used for private purposes as well as for the business, but then it will only be possible to claim the additional costs of heating, lighting and cleaning relating to the business use.

  7. Consider the risk involved in the business as this will help determine whether you wish to set up as a sole trader, partnership or a company. If any actions taken within the business could result in a significant liability, (for example an uninsured negligence claim) then it may be necessary to use a limited company in order to protect the individual’s own assets. Assuming that the risk of an uninsured claim is not a material factor then the question will come down to personal choice and the tax environment. Directors of companies pay Class 1 National Insurance contributions on their remuneration and suffer horrendous benefit in kind charges on their company cars, but their entitlement to social security benefits will be greater than that available to a self-employed individual. As a general rule, operating via a company does make life somewhat more complicated and involves rather more bureaucracy. However, it is important to consider the best trading entity to use and it may pay to take some professional advice at the outset to choose the best way forward.

    Whether the business is operated through the medium of a sole trader, partnership or company it will be necessary to join the VAT system as soon as taxable supplies have exceeded £60,000 during the previous 12 months. For cash-based businesses with taxable supplies not expected to exceed £660,000 in their next year, they may be able to reduce their administration by joining the VAT cash accounting scheme.

  8. Be aware that you may not be immune from anti-avoidance legislation. Many small businesses involve various members of the family and it is quite common, for example, for one family member to use their specialised skill to build up the business with another family member providing secretarial assistance and moral support. One might be forgiven for assuming that this commonplace scenario would be immune from anti-avoidance legislation, but HMRC has recently reinterpreted rules originally introduced in 1936 which they say can be applied to a family business. A case is currently making its way through the Courts involving a small family company where the shares were owned equally between husband and wife. The husband provided the computer skills offered by the company, whilst the wife carried out a relatively small amount of administrative duties. The bulk of the company’s profits were paid as dividends equally to husband and wife. HMRC is arguing (successfully in this case to date) that the dividend received by the wife should be assessed on the husband on the basis that it was he who effectively earned the profits for the company.

The legislation here is very complicated, but the taxman’s attack does mean that anyone setting up a family business will need to take great care and should consider having an ownership structure which reflects the respective contributions of both spouses and, in the case of a company, ensures that the individual making the greater contribution receives a level of remuneration in line with the market place.

 

Richard Mannion is a partner and Head of Tax at Solomon Hare with over 30 years experience in the accountancy profession. He is a Past President of the Chartered Institute of Taxation and specialises in the tax problems of family businesses and individuals and leads the Private Client Group at Solomon Hare.