Understanding self-employment tax

Some people who are new to the world of self-employment become worried about what they need to do to work out their tax return at the end of the financial year. Unless you have complicated financial affairs already, then the chances are you will be able to complete a satisfactory return without requiring any special accountancy skills. Most self-employed businesspeople sort out the majority of their tax issues for themselves, so why shouldn’t you?

Registering for self-employment tax returns

In order to settle your income tax as a self-employed individual, you will need to first inform Her Majesty’s Revenue and Customs (HMRC) that you are self-employed. You can phone the tax office with your National Insurance number or simply register online. All that is needed to begin is the date you started trading. Do so even if you are still an employee who is working for him or herself as a self-employed person part-time. Even if you haven’t yet made any money from which you’ll be taxed, it is advisable to inform HMRC – the UK’s equivalent of the IRS – of your status. This way, you will be able to obtain a unique tax reference, or UTR, prior to filling out a tax return. If you don’t have one and try to file a return close the deadline, then you won’t be able to proceed which could result in a late filing and a subsequent fine. Registering takes moments of your time. HMRC usually sends you a UTR within a matter of weeks.

Assessing your own tax

When you are an employee, your employer will deduct any expected income tax from your pay as well as the mandatory National Insurance contributions you need to pay. These go towards the government’s coffers to be redistributed in the form of social security. Unemployment benefit and old-age pensions are supposedly funded by these payments but the fact is that social security is actually paid for from the overall tax receipts the government’s Treasury receives. That said, the important thing to note is that when you are employed, the process is handled throughout the course of the tax year. When you are a business owner or a freelancer, you complete your return after the end of the financial year.

Although some people use a paper version of the self-assessment form to work out how much taxable income they must pay, most use an online process these days. To do so is advisable because the process is flexible. It can be started and saved as you make progress. Self-assessments work in a modular fashion and by progressing through a series of questions, the online form will only ask you to complete the relevant modules. For example, if you don’t earn money from overseas investments, if you only have one address and if you don’t derive any income from land, then you can simply progress to the next module.

Many self-employed people have relatively simple accounts to work from with an easily worked-out net income. As such, an annual return for the entire tax year shouldn’t take much more than a few hours to complete so long as your invoicing and business payments are up-to-date. The online procedure will even give you a handy guide to how much of your tax return is left to complete before you submit it.

Working out your net earnings

Like any other taxpayer, your net income over the course of a tax year is how your personal tax will be worked out. It is important not to underestimate your income because if you are found to have done so deliberately – an even accidentally, in many cases – then this could be viewed as fraudulent. Thankfully, for most self-employed people who work on their own, their income is almost directly related to the profit they have made over the course of a year. In other words, their business’ income is the same as their personal income. This will differ in the case of company directors, however, who may pay themselves a salary or a dividend from their limited company accounts.

Regardless of how you pay yourself from your business, your self-employment income is worked out in a rather simple fashion. Firstly, you add up all of your turnover from the course of a tax year. For most small businesspeople, this means their total sales over the course of April in one calendar year until March the following year. However, this is not your net profit because from this you must also take away all of the business-related expenditure in the same period.

Self-employed people often need to pay for items and services to carry out their work. This might be parts or components that you have bought and then sold on. It might be a sub-contractor who did work for a customer of yours who you paid to act on your behalf. It could also be that you paid for insurance or professional fees in order to operate as a self-employed worker. All of these forms of expenditure can be taken from your annual turnover to work out your net income.

Handling business expenses

It is understandable that many people want to make their self-assessment tax return look as favourable as possible to minimise the amount of tax they end up needing to pay. You might, for example, want to claim back the VAT you spent on an item which you subsequently sold on. Equally, you might want to claim for other expenses which are not directly related to your business. Doing so is only possible if you can prove that the expense being claimed for is legitimate. For example, if you have a mobile phone that is used exclusively for business purposes, then you can claim back the cost of the line rental. However, if you use the phone’s data for personal web browsing or for making calls to friends, then this is simply not allowed.

People who derive incomes from property or trading can claim up to £1,000 per annum in tax-free allowances regardless of how much they actually spent. If so, then no further deductions for allowable expenses are permitted. Since many self-employed people don’t work in that way, it is best to simply keep all of your receipts and purchase invoices over the course of the year to come up with an accurate picture of how much you are going to deduct. HMRC won’t always ask you to prove this but it is worth keeping hold of them. If your return is questioned in future, then you’ll have the necessary documentation to satisfy any queries.

Things that you are allowed to claim as expenses include:

• Administrative costs, like paper and pens.
• Travel costs, but only if you move around for work.
• Clothes which you must have for work, such as work boots.
• Marketing costs, such as online advertising.
• Premises costs, such as rent and heating.

Payments for tax

Once calculated with your personal allowance taken into account, your tax payment must be made by January the year after the return was for. Payments may be reduced if you are entitled to certain benefits, such as tax credits. Your self-employment tax payments will take into also account any tax bill that has already been settled in advance, whether from employment or as a self-employed person. As a self-employed start-up freelancer or sole proprietor, you will be expected to make Class 4 National Insurance payments at the same time as your income tax – these used to be charged separately.

Finally, self-employed people who make sufficient levels of profit will receive a tax bill to pay by the following July. This is based on your current level of operating profit and constitutes a 50% downpayment on the following year’s income tax bill. HMRC send this so not all of your taxable income is deferred, making business owners more like a normal taxpayer.