Tax Guide to Going Self-Employed (Becoming a Sole-Trader)
Our guide to the tax implications of branching out on your own.
Here we outline the tax implications of working for yourself in this simple to follow guide. What exactly is self-employment? We also run through what you’ll need to do to get started, and what your reporting responsibilities are once you’re up and running.
5.7million people can’t be wrong
Over 5.7million of the working population are registered as self-employed, which by any means is a significant proportion of the UK workforce. For many this fulfils their ambition of being their own boss, with the ability to determine their own destiny.
This guide deals with ‘directly’ working for yourself, not doing so via a limited company, or other corporate entity like a partnership. In the recent COVID crisis those who worked for their own limited companies found out that they were considered ‘employed’, rather than ‘self-employed’. A very important distinction. A self-employed person would have been potentially eligible for the ‘Self-Employed Income Support Scheme’, whereas a person working through their own limited company would have had the option to furlough themselves to receive support through the Coronavirus Job Retention Scheme.
This is how the Government defines self-employment:
A self-employed earner is defined at section 2(1)(b) of the Social Security Contributions and Benefits Act 1992 as: ““self-employed earner” means a person who is gainfully employed in Great Britain otherwise than in employed earners employment (whether or not he is also employed in such employment).”
A person who is liable to Income Tax on the profits of a trade, profession, or vocation will generally also be a self-employed earner for National Insurance Contributions (NICs) purposes. As a self-employed earner, they will be liable to pay Class 2 NICs.
It’s rather long-winded. A self-employed person earns their income conducting their business on their own behalf, which attracts income tax and national insurance on the profits of this activity. You wouldn’t be ‘conducting a trade’ by earning your income from a savings account, share dividends or in the majority of cases, renting out a property (e.g. the flat you lived in before moving in with your new partner). There are occasions where being a landlord can be classed as self-employed. One cited by HMRC is:
Bob owns ten properties which are let out to students. He works full time as a landlord and is continually seeking to increase the number of properties he owns for letting. Bob is running a business for NICs purposes.
Examples of work you may do as a self-employed person could range from a domestic cleaner through to a copywriter or a builder.
If you are considering working for yourself in some capacity, or you may have already started, this guide will give you a high-level view of considerations to bear in mind and actions you should take.
The tax implications of becoming self-employed may, on first glance, put people off the move. In fact, it is quite simple to do, and with a little 'reading up' and organising, the tax reporting requirements can be easily managed.
Pros and cons
Let’s start with the positives. It’s very easy to become self-employed. You simply conduct your trade or business and invoice your clients/customers. That’s a vast over-simplification – but you get the point. You have to notify HMRC of your work status, record transaction data, provide HMRC with income and cost information, and then pay your tax and national insurance. That’s it.
Unlike other forms of trading, like working through your own limited company, setting up as a sole-trader/self-employed is very inexpensive. The administrative side of self-employment is also fairly light, and nothing that can’t be handled with the support of a low-cost software package, working hand-in-hand with a good business bank account.
Some people like the idea of working ‘directly’ with the person who is doing the work, rather than via a limited company – there’s more accountability. For example, it is easy for a builder to close a limited company, if it suits their purposes.
This all sounds very rosy, but self-employment does have its drawbacks. The big one, is that you are directly personally liable for any debts your business runs up, and you can be sued for compensation if something you’ve done goes wrong. Your house will potentially be on the line. If you were to run your business through a limited company, it would be much harder, although not impossible, to create this direct personal liability. This is a fundamental difference. You will need to assess the level of risk in your line of business before deciding which trading structure is for you.
Some clients and customers may prefer to contract with a limited company, in fact in some circumstances they may insist.
You may also find that working through your own limited company offers tax advantages over being self-employed.
Sole-trader vs Limited Company
We recognise that for some there can be a tough decision to make between trading as yourself (as a sole-trader), and trading through a limited company that you own and are employed by. We’ve produced a guide to help you unravel the arguments for and against - Sole-trader vs Limited – Our analysis
So you have either already started trading (writing your first piece of freelance copy/ you’ve just taken on a design brief/ you’re midst laying your first timber deck), or you’re just about to start…….who do you have to inform and by when?
Notifying HMRC and registering for Self-Assessment
All self-employed people have to submit an annual Self-Assessment tax return. HMRC says you have to:
Register by 5 October in your business’s second tax year. You could be fined if you do not.
The trigger point for being self-employed is earning more than £1,000 from that activity in the current tax year. A busy ebay or car-boot habit could actually push you into being in the category of self-employment.
You may also want to register earlier than the October deadline to be able to prove you are self-employed, for example, to claim for Tax-Free Childcare, or to be able to pay your National Insurance contributions to ensure you can qualify for certain benefits.
It’s very easy to register with HMRC, assuming you already have a National Insurance number (if you don’t visit), you simply either register for Self-Assessment . If you have in the past submitted a Self-Assessment, then head down a slightly different route, for which you’ll need your UTR number (Unique Tax Reference). Here you’ll sign up for the online account. (Can’t find your UTR then follow this link. )
Recording my trading information and reporting it to HMRC
Being self-employed you will have to pay income tax and National Insurance on the difference between your trading income and your allowable expenses, which is known as your profit. You’ll have to be able to provide this information via your Self-Assessment tax return.
If your income is going to be below £150,000, you can operate using a simple record keeping system called ‘cash basis accounting’. Most of you will fall into this bracket, and frankly if you are above this level you should be giving serious consideration to setting up a limited company.
The MoneyAdviceService says of keeping records:
Acceptable records include receipts, bank statements, invoices and till rolls.
You will not need to send your records when you submit a tax return, but you will need to keep them for five years after the relevant tax return submission deadline. For example, for your 2019/20 tax return, you will need to keep your records until 31 January 2025.
Listentotaxman, has been working with the tax self-assessment online software company, GoSimpleTax for a number of years now. Their system allows you to input your receipts and your income, as you go through the year, it then calculates your tax and national insurance, and will even submit your tax return directly to HMRC. From £46 per year it’s a very simple and inexpensive way to keep your records straight and deal with HMRC – a lot cheaper than an accountant. Unlike some accounting software you can also use it for your other incomes, which may include property rental, investments and even employment.
Tax calculation including national insurance
The big question is how much tax and National Insurance will you have to pay. Let’s start with the easy one – tax. You will be taxed at the current personal tax rates – see our table below.
2020/21 and 2019/20
Personal allowance: 0%
£0 to £12,500 you will pay zero income tax on your profits
Basic rate: 20%
£12,501-£50,000 you will pay 20% tax on your profits
Higher rate: 40%
£50,001-£150,000 you will pay 40% tax on your profits
Additional rate: 45%
Over £150,000 you will pay 45% tax on your profits
National Insurance is somewhat more complicated to calculate, so here goes. You’ll usually pay two types of National Insurance (2020/21 tax year). The first type is Class 2, which is £3.05 per week, and then you’ll pay Class 4 at 9% for any profit between £9,501 and £50,000, and then 2% on profits over £50,000.
Paying tax – and payment on account
The first time you submit your Tax Self-Assessment which could be as late as Jan 31st the following year from your tax year ending in previous April, you’ll have to pay both your tax and National Insurance.
At this point you’ll also have to pay a payment on account for the current tax year. This will be calculated as half of the tax and National Insurance you paid in the previous tax year.
Paying on account may sound worrying, particularly if you are earning less than the previous year. That’s fine, because you can simply ask HMRC to reduce this amount to reflect your current situation. In any case you are still effectively paying your National Insurance, hopefully, after you’ve paid invoices and collected monies owing for that period. The vital thing here is to keep good records during the year otherwise you won’t know how much you owe. You should not get into the position where you are confronted by a surprise tax or National Insurance bill. Many fall into this easily avoidable trap.
VAT – do I need to register?
You only have to register for VAT if your turnover is in excess of £85,000 (for the last 12 months) or you know it will be so within the year ahead. You will need to register in the month that you realised your turnover would exceed £85,000.
Even if you sell good/services over £85,000, it’s only those that attract VAT that counts towards the total.
If you registered late, then you will owe VAT from the point at which you should have registered, and you may get a penalty.
If you believe you might temporarily go over the VAT limit you can write to HMRC to ask for an exception. They’ll confirm one way or the other.
Bear in mind that adding VAT to a client’s bill can make you less competitive – so something to consider when nearing that level of income.
You can, if you so wish, register for VAT voluntarily.
If you do need to register, simply do so online at https://www.access.service.gov.uk/login/signin/creds , alternatively you can pay an agent to register on your behalf and then submit your quarterly VAT returns.
Tax free allowances
When working out how much profit you’ve earned, which is what you’ll will pay tax and national insurance on, you will want to offset as much cost as you are allowed. So what sort of items would count as a legitimate business expense?
- The costs of running your office – internet bills, or stationary
- Business premises – rent and heating
- Travel – fuel, train tickets or parking
- Clothes you have to wear for your work – this doesn’t include jeans and a t-shirt or even a suit, but would include a uniform and having it washed.
- Cost of staff
- The cost of materials – a carpenter would buy timber, or curtain maker cotton fabric. What we’re talking about is stock and raw materials
- Tools and equipment
- Bank charges, insurance and any professional fees, like your solicitor or accountant charges
- Advertising and marketing e.g. your website
- Training courses or professional subscriptions
This may all sound straight forward, but there are various rules about how you should apportion costs you share with your non-work activities e.g. how to work out how much of your mobile phone bill you can charge to the business or electricity charges if you have an office in your house.
We’ve written a more detailed guide to expenses for the self-employed.
One of the problems faced by most small businesses is simply getting paid on time, or in some cases, getting paid at all. Both are vital in terms of being able to meet your financial commitments. We suggest the following actions to help increase your chances of getting paid:
- Know your clients well – there’s nothing better than really knowing who you are doing work for, but this may not always be possible. If you’re engaging in a big contract you may consider performing a credit check.
- Taking pre-payment – part or full, or staged payments that keep you ahead of your outlay.
- Clearly worded signed contracts/agreements – you’ll ensure that there is proof of what you’ve agreed to do and by when, and the terms that your client has agreed to pay you on. This makes it much easier if you have to go to court.
- Timely invoicing – always send your invoice out promptly when the job is complete, or at an agreed milestone
- Chasing up on late invoices – don’t let things drift, be assertive and politely ask for payment if the client is running late
- Debt collection – a debt collection agency or just a freelancer to ring round to prompt your clients to pay will work wonders
- Using the Small Claims Court – this is inexpensive and really does work, as long as you have good evidence, such as a contract, emails, invoices etc
- Insurance – invoice insurance can cover against non-payment as a result of default or insolvency
As a self-employed person, you are personally liable for any debts you run up and for any liabilities you create. Depending on what you do, you should consider insuring against these. Some insurances that you may consider include:
- Professional liability
- Public liability
- Invoice insurance
- Employers liability
(There may also be specialist cover depending on what trade you work.)
We strongly recommend having a dedicated business bank account. It’s really important to keep your trading monies separate from your personal funds. If you have a business bank account it means that customers can make payments to a trading name – e.g. ‘Bob’s Pest Control’, rather than ‘Bob Jones’ himself. Sounds more professional don’t you think?
Now, business names are interesting and very emotive. You may wish to trade under your own name, or have an entirely different business name. There are certain rules you must follow with naming your business – so for instance you shouldn’t use Ltd or PLC in the title – as you are not one of these. You shouldn’t use an existing trade mark, should avoid being offensive, and should avoid certain words like ‘Accredited’. There are other words which may be deemed sensitive. If you think you’ve come up with a fabulous name, you may be wise to register this as a trade-mark. But, as you can see this all requires a little further research. Don’t get caught out.
Contracts are there to protect you, your customers, and your suppliers. Take them very seriously. Sadly, some traders view them as nothing more than meaningless small print. Understand what they mean. Read them through. Always use a contract. Make sure you use clear unambiguous language. Depending on the nature of your work you may source contracts from a solicitor, get a template off someone who works in the same industry or there are businesses who sell template agreements. You can use a clause to limit your liability to an agreed amount in certain circumstances. This is always worth doing.
Going self-employed, otherwise known as becoming a sole-trader, is a very straight forward way to get into business. It is low cost and simple. The ongoing reporting overhead is reasonably manageable, particularly with the range of online banking and accounting/invoicing software available. It suits those with lower turnover, and lower risk businesses. You are at a tax disadvantage compared with a limited company at high incomes (see our Limited vs Sole-trader guide to understand this more fully). Any liability is not just borne by your business but by you, which we see as a very important consideration. Contracts, insurance and disciplined credit management will help to reduce these risks. Good luck!