Sole trader tax: What tax do businesses pay

One of the most important decisions you’ll need to make when setting up a company is to determine which business structure is right for you.

The majority of small business owners either register as a sole trader or as a limited company – and both have pros and cons.

Using accounting software tools will help, but it would also be worth reading on to find out how sole trader and freelancer tax works.

Business tax types

Registering as a sole trader is often the go-to when businesses first set out as it’s inexpensive, quick to do and there is very little red tape. However, it’s worth bearing in mind that one of the key components of operating as a sole trader is the way in which you are taxed; you and your business are taxed as one single entity.

What this means is that any business debt is accountable to you personally.

In contrast, limited companies are taxed as a separate legal entity from its owners.

Sole trader and self-employed tax

As a sole trader, your profits are taxed the same as any other income by HM Revenue & Customs. And as you are self-employed your tax will be self-assessed.

The amount you owe is calculated after business expenses and personal allowances have been deducted.

You will need to complete your sole trader tax return annually using the self-assessment system by January 31 for the tax year to the previous April.

How much can you earn before paying tax as a sole trader?

The threshold for paying income tax is the same as for any employee – and relates to the current personal allowance.

For the 2022/23 tax year, the personal allowance is set at £12,750.

This is the amount you can earn without paying any income tax at all.

Once you exceed that threshold you will be subject to these tax rates:

National Insurance Contributions

As mentioned above, as a self-employed person, many of your business expenses can be deducted from your taxable income, such as overheads on your premises, travel, delivery costs and trade association subscriptions. But you will have to pay capital gains tax if you sell or give away any assets.

As a sole trader, you will also be paying Class 2 and Class 4 National Insurance Contributions (NICs) to the Department for Work and Pensions. The amount you pay is dependent on your earnings.

Class 2 National Insurance Contributions

• Class 2 NICs are charged at a small weekly rate of £2.85.
• The level remains the same for Class 2 contributions, even if you generate profits of over £45,000. This is not true of Class 4 contributions (see below).
• You don’t have to pay them at all if your profits are less than £6,025 for the tax year in question.
• You pay through self-assessment (as with income tax).

Class 4 National Insurance Contributions

• Class 4 NICs are charged as a percentage of your profits.
• If you generate profits of less than £8,164 you will not need to pay Class 4 NICs.
• For profits of between £8,164 and £45,000 you will need to pay NICs of 9% of that amount.
• For profits of more than £45,000 you will need to pay NICs of 9% for the amount between £8,164 and £45,000, plus an extra 2% for anything over the upper figure.

Sole trader payments on account

Once you are registered as a sole trader and paying tax and National Insurance via self-assessment, you may need to start making advance payments towards your tax bill, known as ‘payments on account’.

These must be made twice a year unless your self-assessment bill was less than £1,000 or if you’ve already paid more than 80% of your tax through your tax code.

The payments are due on January 31 and July 31 – and are calculated as half the amount of tax you owed for the previous year. (This works on the assumption you will pay at least the same level of tax in your current year as you did previously).

If you still have tax to pay after your payments on account, the difference will be due at midnight on January 31 the next year. Visit the gov.uk site for a detailed example of how the process works.

You can apply to HMRC to ask to reduce your payments on account if you know your tax bill will be significantly lower than it has been previously.

Failure to make payments or late payments can result in a fine – so you need to make sure you’re prepared for upcoming bills, and put sufficient funds aside throughout the year.

Are under-16s required to pay tax?

While you may not be able to have a say on who sits in the Houses of Parliament until you’re 18, if you’re earning, you unfortunately still have to line the chancellor’s pocket with all sorts of tax related bank notes.

Everyone who is self-employed must register with HMRC. Registration covers both income tax and national insurance.

Because you are under 16, Class 2 National Insurance Contributions are not due. You will also be exempt from paying Class 4 if you are under 16 at the start of the tax year (April).

While previously you needed to apply for an exemption form, today there is a box on the online form that says ‘tick here if you’re exempt from paying class 4 national insurance’ – this just needs to be selected.

Once registered as self-employed, income tax will be due under the self-assessment process. You need to fill in a tax return each year and give details of your income and expenses which you can do online. Whatever your age, your profits will then be taxed after your personal tax allowances have been taken into account.

When to register for vat

Some individuals, if their income is above a certain level, (currently £85,000 per annum, although this is subject to Budget announcements) must apply for value added tax (VAT) registration.

This means you will be collecting VAT from your customers and paying it to HMRC less the VAT you have paid out in the course of business.

You can find out more about VAT and when you need to register and how to register here.

All of this may seem quite daunting at first, but if managed properly it’s really not as overwhelming as it seems.

The best thing you can do is stay organised, maintain your paperwork and flag up any tax or self-assessment deadlines in your diary well in advance so you have adequate time to prepare for them.