How UK Tax Works | A Beginner’s Guide
If the UK tax system looks confusing then you are in the right place with our beginner’s guide to income tax, corporate tax and more. Before we go any further, do not forget that it is against the law to:
- evade tax payments of any amount
- not register as self-employed with HM Revenue and Customs (HMRC)
- not register your limited company or limited liability partnership with Companies House
Committing any of these offences could land you with fines, imprisonment or both.
The UK has a progressive tax system, which means that the tax rate progresses from low to high and takes significantly more money from the rich than the poor. The system aims to alleviate income inequality by reducing the impact on lower income families and increasing the tax burden of higher income families.
For businesses, there are several different tax obligations: income tax, National Insurance contributions, value added tax, corporation tax and business rates. The tax revenue generated funds the UK’s health, welfare and social services, transport systems, schools and universities, defence services, as well as financially supporting industry, sport, heritage and culture.
Company and employment types
The UK has four main types of business structures:
- Sole trader (self-employed)
- Limited liability partnership
- Limited company
Each of these has its own various tax obligations.
Employment contract types and tax codes
If you are an employer, there will be additional tax responsibilities that depend on your employee’s contract or their employment status. Contract types include:
- full-time and part-time contracts
- fixed-term contracts
- agency staff
- freelancers, consultants, contractors
- zero-hours contracts
There are also special rules if you employ family members, young people or volunteers.
As the employer, you are typically responsible for deducting and paying tax on behalf of your employees before they are paid.
To calculate how much income tax to withhold from their salary, a tax code is worked out by HMRC and it is then used by you or your accountant.
Tax codes usually start with a number and end with a letter. The most common tax code is 1250L and it means that they have a standard Personal Allowance.
Don’t forget that you must set up PAYE (pay-as-you-earn) with HMRC before the first payday so you can deduct the relevant tax and national insurance from salaries.
National Insurance acts as a form of social security in the UK and the amount paid depends upon your earnings during the 2020/2021 tax year. It affects both individuals and businesses.
If your profits are between £6,365 and £8,631.99 a year, then you will in Class 2. Contributions are a fixed weekly payment of £3.00 a week and are collected as part of the self-assessment process. There are exemptions available if you are a low earner.
If your profits are between £8,632 and £49,999, you will be categorised in the Lower Profits Limit (LPL) of Class 4. The amount due is calculated based on figures supplied during self-assessment and is 9% of your profit. If you go over £50,000, then you enter the Upper Profits Limit (UPL) and profits are taxed at 2%.
How to pay income tax if you are self-employed or in a partnership
Income tax is what you will pay according to your business’s profits.
If you are self-employed and without any other sources of income, then you are exempt from paying any income tax until your profit goes over your Personal Allowance. For the 2019/20 tax year, the standard tax-free allowance is £12,500.
This also applies if you are in a partnership or limited liability partnership.
With the progressive tax system in use across England, Wales and Northern Ireland, you will move through different income bands the more profit you make:
- £12,501 to £50,000 – basic rate of 20%
- £50,001 to £150,000 – higher rate of 40%
- over £150,000 – additional rate of 45%
Note: Scotland’s income tax bands are different.
It is your responsibility to calculate how much tax to pay on self-employed income, as well as pay your National Insurance liabilities. This means annually completing and submitting a Self Assessment tax return to HMRC, who provide a self-employed income tax calculator.
You will be automatically sent a Self Assessment notice at the end of each tax year, which runs annually from April 6 to April 5. The deadline for submitting a paper tax return is October 31, while January 31 is the deadline for submitting a return online and paying any tax owed.
Watch out for ‘payments on account’, which are advance payments for tax you might owe for the current tax year and could result in a larger tax bill than expected. You can make those payments in two instalments (January 31 and July 31).
How can you get tax relief?
If you are a sole trader or in a partnership, tax relief allows you to make deductions for work expenses, namely what you spend to run your business.
Some types of tax relief are applied automatically, but some you must apply for, such as office and travel costs, clothing expenses, advertising or marketing, and training courses.
Remember to save every receipt for anything you plan to deduct from your taxes.
What is trading allowance?
A tax emption of up to £1,000 is available to self-employed businesses in the form of a trading allowance.
If you expect your annual gross income to be less than the threshold, then you do not need to tell HMRC, unless you cannot use the allowance or need to register for Self Assessment.
You will need to register if your gross trading income exceeds the £1,000 threshold.
What tax does a limited company pay?
Owned by its shareholders and run by its directors, a limited company is a separate legal entity with its own legal rights and obligations. Your company is responsible for everything it does, and its finances are separate from your personal affairs and the other owners.
After your limited company has paid corporation tax (currently 19%) on net earnings, the profits are then distributed to the members or shareholders in the form of dividends. Recipients must claim their distributions on a Self Assessment form.
Note: You will also pay income tax on your personal income.
Corporation tax is paid once your company begins to make a profit. In addition, payment must be made nine months and a day after the end of your accounting year.
What other taxes does a business have to pay?
Value Added Tax (VAT)
The VAT registration threshold is £85,000, so register when your annual turnover exceeds that limit. This applies to self-employed, partnerships and limited companies.
Business rates are like a commercial council tax and are one of the largest overheads for businesses, typically equating to approximately 50% of annual rent.
Generally, if you work from home, you won’t have to pay business rates and council tax.
Top tax tips
Here are some tips to help you avoid those tax pitfalls:
- Put tax money immediately into a separate bank account
- Create a tax liability plan so you fully understand your obligations
- Remember that all income, including foreign income, is subject to tax
- Stay organised and keep track of your finances
- Keep all receipts, bank statements, invoices and paperwork for at least three years
We hope this beginner’s guide has helped to demystify the UK tax system and instil more confidence as you begin to run your own business. Good luck and please get in touch if we can help you with any other taxing issues!