Sole traders are subject to Income Tax.
This is a tax on income. Not all income is taxable and you're only taxed on 'taxable income' above a certain level. Even then, there are other reliefs and allowances that can reduce your income tax bill. In some cases, this will mean you don't have to pay any tax.
Trading profit is the income of your business that HM Revenue and Customs (HMRC) will be taxing. It's calculated by adding all the trade receipts of a business together and deducting its expenses. Not all expenses are deductible; if in doubt, get professional advice, or contact.
Most receipts of a trade, like those from sales, can be easily identified. Others are more complicated. For example, money received as a token of personal appreciation when a trading relationship ends wouldn't be a trade receipt. However, money received as compensation when a trading contract is cancelled would be a trading receipt.
In calculating trading profit, you can deduct expenses that are:
These expenses are called 'deductible expenditure'.
To be deductible, expenses must be income in nature. This means they're regular or recurring expenses rather than one-off expenditure. Payments for electricity, telephone charges, staff salaries and interest on loans, etc. are likely to be expenses of an income nature as they're incurred repeatedly.
One-off expenditure on assets that will be kept by the business for a longer period are capital expenses. These aren't deductible from trading profits. However, you may be able to deduct capital allowances instead. See 'Capital allowances' below for more information.
For example, if you're an antique dealer, the cost of buying stock is an expense of an income nature, as your business will sell this stock to earn income. Therefore, when calculating trading profits, you can deduct the expenses of buying stock from trade receipts. However, the cost of buying an antique desk for your office is of a capital nature. You'll keep this desk and use it in your business in the long-term, rather than sell it to generate income. It isn't a deductible expense.
'Capital expenditure' is money spent on buying machinery and equipment used for your business. You generally can't deduct the entire amount of your capital expenditure for the year from your trading profits for that year. However, you're allowed to claim tax relief on capital expenditure in certain instances. This tax relief is known as a 'capital allowance', and it allows you to deduct a set percentage of the capital expenditure from your trading profits. The percentage is set by the government. This amount isn't the same as depreciation.
You can claim capital allowances on:
You can't claim a capital allowance for things that you buy or sell as your trade - these are deducted from profits as deductible expenses. If you buy on hire purchase, you can claim a capital allowance on the original cost of the item, but the interest and other charges count as deductible expenses.
You may be able to claim 100% of the purchase price of capital items bought during the tax year where the following allowances apply:
Annual Investment Allowance
If you buy new plant and machinery that doesn't benefit from the 100% allowances mentioned above, you may be able to deduct an Annual Investment Allowance (AIA) from your profits. The purpose of this is to speed up tax relief on qualifying expenditure, as otherwise the writing-down allowance will apply. This is explained below.
The value of the investment on which businesses can claim this allowance has fluctuated. From 1 January 2019 until 31 December 2020 it will be £1 million. The previous rate, from 1 January 2016, was £200,000. Before that it was £500,000. The intention, currently, is for the limit to return to £200,000 in 2021.
This means that if, for example, you spend over £1 million on plant and machinery in your accounting period from 1 January 2019 to 31 December 2019, you could deduct 100% of the first £1 million from your profits. You could then claim the standard writing-down allowance (see 'Writing-down allowance' below) of 18% on amounts in excess of this spent on buying new plant and machinery.
If, however, the only item of plant and machinery you bought in that period was a machine for £300,000, this expenditure would fall completely within the AIA. Therefore, you could deduct 100% of the cost (i.e. the full £300,000) from your trading profits for that year.
It's more complicated if the accounting period in question straddles the date that the limit changed – many business's accounting periods are from April to March. In that case:
1. The limit is apportioned according to how much of the AIA period falls within the accounting period in question. For example, your accounting period is April 2018 to March 2019: for 75% of the period the AIA limit was £200,000, 75% of which is £150,000. For the remaining 25% of the year, the limit was £1 million, 25% of which is £250,000. The limit for the period is therefore £400,000. Accordingly, even if you spend £500,000 during January 2019 (i.e. when the limit is £1 million), only £400,000 will qualify for this allowance.
2. If all the expenditure was during the previous limit, that limit applies. For example, if you spent £400,000 in December 2018, the £200,000 limit applies.
3. This limit also applies when the rate is reduced. So for example, if your accounting period ends on 31 January 2021 and you spend £200,000 in January 2021, the limit will be £16,667 – so you should have spent the money a month earlier.
Each year, instead of depreciation, you're allowed to deduct from your trading profits a 'writing-down allowance' for your capital expenditure. This allowance therefore reduces your trading profits before they're taxed.
Instead of calculating separate writing-down allowances every year for every item of plant and machinery, plant and machinery is generally put in a pool. The writing-down allowance is calculated for the pool.
In the tax year in which you buy an item of machinery, you would deduct any capital allowances available in the first year, such as the AIA:
The value of the pool of plant and machinery would be the total value of plant and machinery you've bought less all the capital allowances you've claimed for this plant and machinery.
The value of the pool is reduced by the writing-down allowance for each year, so that you start the next tax year with a lower pool. Writing-down allowances are a percentage of the balance of the pool rather than a percentage of the original cost of the plant and machinery.
Since April 2012, the standard writing-down annual allowance that you can claim each year on a pool of plant and machinery is 18% of the value of that pool. There is a special rate of 8% that applies to the pool of integral features of buildings, like electrical systems, thermal insulation and equipment with a planned life over 25 years, as well as cars with CO2 emissions of more than 130g/km.
If the balance of the pool of plant and machinery is less than £1,000 in a 12-month accounting period, instead of the normal writing-down allowance, you may be able to claim a 'Small Pools Allowance' of up to £1,000 to completely write it off.
Example of standard writing-down allowance calculation
If in June 2019, a builder buys new plant and machinery worth £1.5 million, he would deduct his AIA of £1 million from his trading profits in 2019/20.
Assuming the builder has no other plant and machinery, the capital expenditure for which a capital allowance hasn't been claimed, £500,000 would form his pool of plant and machinery ('main pool') for the next tax year.
Year 1: Capital allowance = AIA of 100% of £1 million, leaving £500,000 as the pool
In the following tax years, his writing-down allowance would be 18% on the balance of the pool each year.
His writing-down allowances are as follows:
Year 2: 18% of £500,000 = £90,000, leaving £410,000 as the reduced balance of the pool
Year 3: 18% of £410,000 = £73,800, leaving £336,200 as the reduced balance of the pool
Year 4: 18% of £336,200 = £60,516, leaving £275,684 as the reduced balance of the pool
Suppose that the builder's trading profits (after deducting expenses) are £1.5 million, £1.2 million, £1.8 million and £1.5 million for Years 1, 2, 3 and 4 respectively. The builder's income for tax purposes is as follows:
Year 1: £1.5 million - £1 million (AIA) = £500,000
Year 2: £1.2 million - £90,000 = £1,110,000
Year 3: £1.8 million - £73,800 = £1,726,200
Year 4: £1.5 million - £60,516 = £1,439,484
Income Tax on trading profits is assessed under the following rules:
The first tax year of a new business
In the first tax year, Income Tax will be assessed on the profits made during that tax year, i.e. from the date you started your business to the following 5 April.
The second year of a new business
In the second tax year, the Income Tax assessment period depends on the accounting date that you've chosen for your business, i.e. the last date in your accounting year. If, in your second year of business, there is less than 12 months between the start of trading and your accounting date, you'll be taxed on the income for 12 months since the start of trading. If your accounting date is 12 months or more from the start of trading, you'll be charged income tax on the profit in the 12 months ending with your accounting date.
Subsequent years of a new business
In the third and subsequent years, Income Tax will generally be assessed on the profits of the 12-month accounting period ending in that tax year.
These rules may result in you paying tax twice on 'overlap profits' in the first 3 years of business. For example, if you started business on 1 January 2014 and drew up your accounts for the year ending 31 December 2014, you'd have an accounting date of 31 December. You'd pay Income Tax for profits for the period 1 January 2014 to 5 April 2014 in the 2013/14 tax year. In the 2014/15 tax year, you'd pay income tax on profits for your accounting period of 1 January 2014 to 31 December 2014. You'd therefore end up paying twice on the profits of the overlap period of 1 January 2014 to 5 April 2014.
If you started the business on 1 February 2014 and prepared your accounts at the 31 December each year, you would pay tax:
In this example, you'd pay tax twice on profits between 1 February 2014 and 5 April 2014, and on profits between 1 January 2015 and 31 January 2015.
However, you could reclaim this Income Tax by 'overlap relief' if you end the business. It might be useful to discuss with an accountant the effect of when you start business on your cash flow.
The closing tax year of a business
In the final year, Income Tax will be assessed on the profits made from the end of the most recent accounting period until the date the business ends. However, you can then make a deduction for overlap relief.