Sole Trader Tax Essentials: What You Need to Know About the Tax Return

The Connection Between Income Tax, National Insurance and the Sole Trader Tax Return

The connection between Income Tax, National Insurance, and the tax return is integral to the process of calculating and paying your personal tax liabilities.

Income Tax

Income Tax is a tax levied on an individual’s earnings, including their salary, wages, and various other sources of income such as self-employment income, rental income, and investment income. The rates and thresholds for Income Tax are set by the government and vary depending on an individual’s total income. Income Tax is calculated on an annual basis for each tax year (running from 6 April  of one year to 5 April of the next year).

National Insurance

National Insurance Contributions (NICs) are payments made by individuals to fund certain state benefits, including the state pension, unemployment benefits, and healthcare services. NICs are categorised into two main classes: Class 2 and Class 4 for the self-employed. Class 2 NICs are usually a flat rate, while Class 4 NICs are based on profits for the self-employed.

The Tax Return (Self-Assessment)

The tax return, or Self-Assessment Tax Return, is a document that individuals must complete and submit to Her Majesty’s Revenue and Customs (HMRC) each year. This form serves as a financial statement that includes details of an individual’s income from various sources, allowable expenses, tax deductions, and other financial information.

The connection between these elements is as follows

• When completing the Self-Assessment Tax Return, individuals report their total income, including self-employment income, rental income, and other sources of earnings. They also include details of allowable business expenses.
• The tax return is used to calculate the individual’s taxable profit, which is the income subject to Income Tax. It also determines the Class 4 NICs for the self-employed.
• The tax return then calculates the individual’s income tax liability based on the taxable profit and applies the relevant Income Tax rates and thresholds.
• It also calculates the National Insurance liability (Class 4 NICs) for the self-employed, which is based on their profits.
• The tax return serves as the basis for the total amount of tax owed, including both Income Tax and National Insurance.
• Individuals are required to make payments to HMRC for their Income Tax and National Insurance liabilities, and the payment is usually due in two instalments, in January and July, along with any payments on account for the upcoming tax year.

The Role of the Sole Trader Tax Return

If you’re a sole trader, the Sole Trader Tax Return, or Self-Assessment Tax Return, holds immense importance. This document serves as a cornerstone for ensuring that the correct amount of tax and National Insurance contributions are paid. It requires you to provide an account of your income from various sources, expenses, and allowable deductions. Doing this ensures that tax is calculated accurately based on your financial circumstances.

The Sole Trader Tax Return plays a role in maintaining tax compliance and financial transparency. It not only helps individuals fulfil their legal obligations but also prevents underpayment or overpayment of taxes. For sole traders and the self-employed, accurate tax reporting is essential for financial planning, budgeting, and overall business sustainability. Additionally, it facilitates access to state benefits and services, including the state pension, by ensuring individuals have contributed the correct amount of National Insurance.

The SA100 Tax Return Form

The SA100 Tax Return form is the central document used for Self-Assessment Tax Returns. It is accompanied by various supplementary forms, each designed to capture specific financial information.

The SA100 form itself comprises several sections, including personal details, income, and expenses. The personal details section is used to provide essential information such as name, address, National Insurance number, and Unique Taxpayer Reference (UTR). The income section is where individuals report various income sources, including employment income, self-employment income, rental income, and dividends. The expenses section allows for the deduction of allowable business expenses, reducing the taxable profit.

Supplementary forms are attached as needed, depending on an individual’s financial situation. These forms, such as SA101 (for additional income), SA103 (for self-employment), and SA105 (for UK property), provide detailed information on specific income sources. Completing the SA100 and its supplementary forms accurately is vital to ensure the correct amount of tax is calculated and paid and to avoid potential penalties or investigations by HMRC.

Who Should Complete a Sole Trader Tax Return?

If you’re a self-employed individual who earns less than £100,000, the personal allowance for the 2023/4 tax year is £12,570. This means that if you earn anything above this, you will need to pay the sole trader tax rates as follows:

Basic Income Tax rate of 20% on income between £12,571 and £50,270

Higher Income Tax rate of 40% on income between £50,271 and £150,000

Additional Income Tax rate of 45% on income over £125,140

It’s important to note that even if your self-employment income is less than the annual personal allowance, you are still obligated to complete a tax return if certain conditions are met.

In 2017, a trading allowance of £1,000 was introduced. Put simply, you can earn up to £1,000 from self-employment or miscellaneous activity in a tax year and not need to pay tax on it. The trading allowance applies to your gross income before deducting tax and expenses and can be applied as follows:

Earn less than £1,000 from self-employment = completely tax-free (no need to complete a tax return)

Expenses are under £1,000 = claim this allowance instead (it’s bigger, and you don’t need to worry about receipts)

Expenses are over £1000 = use the Trading Allowance as a partial relief.

Self-Assessment Registration and the Importance of the UTR Number

Setting up as a sole trader with HMRC is a straightforward but important process.

To begin, you must inform HMRC that you are self-employed and intend to work as a sole trader. This can typically be done online via the HMRC website. One of the crucial steps in this process is obtaining a Unique Taxpayer Reference (UTR) number, which is a unique identifier assigned to each taxpayer by HMRC. This UTR number is essential for all tax-related communications and transactions with HMRC. It helps ensure that your tax affairs are correctly linked to you as a self-employed individual. Once you’ve registered as a sole trader and received your UTR number, you can start reporting your self-employment income and expenses through the Self-Assessment Tax Return process, which is filed annually to calculate and pay the correct amount of Income Tax and National Insurance.

Properly setting up as a sole trader and obtaining a UTR number is fundamental to meeting your tax obligations and avoiding any potential legal issues with HMRC.

Completing and Submitting Your Tax Return

There is a clear distinction between traditional and modern methods of tax return submission.

Traditional methods typically involve paper-based submissions, where individuals fill out physical tax return forms and mail them to HMRC. In contrast, modern methods utilise online services and tax software. Online tax return submission has become increasingly popular and convenient, with taxpayers being able to complete and submit their returns electronically through the HMRC website. Additionally, there are various tax software options available, both from HMRC and third-party providers, that simplify the tax return process. These digital tools offer features such as automatic calculations, prompts for required information, and electronic filing, making it easier for individuals to meet their tax obligations accurately and efficiently. Modern methods provide real-time validation, quicker processing times, and immediate confirmation of receipt by HMRC, reducing the risk of errors and facilitating a more streamlined tax return process compared to the traditional paper-based approach.

Deadlines and Penalties

For online submissions, the deadline for filing your Self-Assessment Tax Return is midnight 31 January following the end of the tax year, which runs from 6 April to 5 April.

For paper submissions, the deadline is much earlier, typically set at midnight on 31 October following the end of the tax year.

Late submissions for both online and paper returns can result in financial consequences. If you miss the deadline for filing your tax return, you may face penalties. The penalty amount increases the longer the delay, with additional fines if the tax return remains outstanding for several months. It is important to file your tax return on time to avoid these penalties and any interest charges that may accrue on unpaid tax liabilities. Additionally, late submissions can lead to difficulties in budgeting for tax payments and may result in inquiries or investigations by HMRC.

It’s also worth noting that the deadline for telling HMRC that you need to complete a tax return and have not done so before is 5 October.

What Expenses Can Be Claimed

As a sole trader, you can claim various business expenses to reduce your taxable profits and lower your overall tax liabilities. These expenses must meet specific criteria to be considered valid for tax purposes. Some expenses commonly claimed include:

• Costs related to business premises, such as rent, mortgage interest and utilities.
• Other typical expenses that involve running a business, like office supplies, stationery and phone bills.
• Travel expenses, including fuel and public transport costs for business-related journeys.
• Costs associated with marketing, advertising, and professional fees, such as accountants or legal advisors.

The criteria for valid business expenses require that the expense is incurred wholly and exclusively for business purposes. They should be well-documented with receipts, invoices, and records, and they must not be for personal use or considered capital expenses, such as buying assets or equipment.

The Importance of Record-Keeping

As a sole trader, effective bookkeeping plays a central role in ensuring accurate financial records are maintained, including income, expenses, and any claims for tax deductions. It not only enables a clear understanding of the financial health of the business but also supports the efficient completion of the annual Self-Assessment Tax Return.

Equally significant is the role of record-keeping. Keeping meticulous records safeguards a sole trader’s interests in the event of a potential HMRC investigation. Accurate and well-organised records not only help demonstrate compliance with tax regulations but also provide evidence to support any claims, deductions, or income reported on the tax return. Failure to maintain proper records can lead to difficulties in responding to HMRC inquiries, potential penalties, and the risk of misreporting income or expenses. Overall, precise record-keeping is essential for the financial transparency and stability of a sole trader’s business and ensures a smooth tax compliance process while mitigating risks associated with potential investigations.