Income tax, VAT & legal form of business

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Key facts

  • You must establish your income tax position and whether you are claiming all the expenses and capital allowances you are entitled to.
  • There are different tax and legal implications, depending on whether you operate your business as a sole trader, a limited company, a partnership or a charity.
  • Tax and VAT are very large and complex areas of legislation that are constantly being revised and amended. For this reason, it is advisable to contact your accountant or financial advisor to discuss all related issues.

Income tax

It is important that you establish your income tax position and whether you are claiming all the expenses and capital allowances you are entitled to claim.

You must keep records of your business income and expenses for your tax return if you are self-employed as a:

  • sole trader
  • partner in a business partnership (if you're the nominated partner in a partnership, you must also keep records for the partnership)
  • charity.

There are different rules on keeping records for limited companies and you are advised to consult an accountant for advice if your business is structured as a limited company.

Regardless of whether you are a sole trader, a partner in a business partnership or run your business as a limited company, you will need to keep records of your personal income.

Many businesses use traditional accounting where you record income and expenses by the date you were invoiced or billed. However, there is an option of using cash accounting if you are a small business.

Cash basis accounting

The Government has introduced a 'cash basis' tax scheme for self-employed individuals or partnerships carrying on the smallest trading businesses.

You can use cash accounting if:

  • you run a small, self-employed business as a sole trader or partnership (you cannot use the scheme if your business in is a limited company)
  • you have a turnover of £150,000 or less a year.

You can stay in the scheme up to a total business turnover of £300,000 per year. Above that, you’ll need to use traditional accounting for your next tax return.

VAT Cash Accounting Scheme

In addition to the cash accounting scheme, there is also the VAT Cash Accounting Scheme. Under this scheme, you:

  • pay VAT on your sales when customers pay you
  • reclaim VAT on your purchases when you have paid your supplier.

To join the scheme, your VAT taxable turnover must be £1.35 million or less.

Further information is available on the cash basis accounting pages on the Gov.uk website

You can speak to an accountant or a financial advisor, or visit the HM Revenue & Customs (HMRC) website, which has a range of helpful information and contact numbers. 

VAT

VAT threshold

You do not have to register for VAT if your turnover for the previous 12 months is less than £85,000 (2020/21). This figure is known as the VAT registration threshold. The Government adjusts this figure regularly so it is important to check on the HMRC website to find the current level.

You must also register for VAT if:

  • you think your VAT taxable turnover may go over the threshold in the next 30 days alone
  • you take over a VAT-registered business as a going concern.

VAT deregistration threshold

The deregistration threshold is £83,000 (2020/21). If your VAT taxable turnover for the year falls below £83,000, or you expect it to fall below £83,000 in the next 12 months, you can ask to be deregistered for VAT.

Flat Rate VAT Scheme

If your VAT taxable turnover is less than £150,000, you can simplify your VAT accounting by calculating your VAT payments as a percentage of your total VAT-inclusive turnover. The current flat-rate VAT percentage for accommodation businesses is 10.5% and the rate for museums and cultural activities is 9.5% of your VAT-inclusive turnover. Once you join the scheme you can stay in it until your total business income is more than £230,000.

In 2017 the Government introduced changes to the Flat Rate Scheme for businesses with a very low-cost base. These businesses are now called 'limited cost traders'.

A limited cost trader is defined as one that spends less than 2% of its sales on goods (not services) in an accounting period. The amount spent on goods cannot include purchases of:

  • capital goods (such as new equipment used in a business)
  • food and drink (such as lunches for staff)
  • vehicles or parts for vehicles (unless running a vehicle hiring business).

A firm can also be a limited cost trader if it spends less than £1,000 a year, even if this is more than 2% of the firm's turnover on goods.

Limited cost traders can still use the Flat Rate Scheme, but their percentage is 16.5% rather than 10.5%.

It is recommended that you talk to your accountant as to whether joining the Flat Rate Scheme would be beneficial for your business.

For information go to The VAT Guide or contact the HMRC’s National Advice Service on 0845 010 9000, which is available from Monday to Friday, 8:00am to 6:00pm. 

Setting Up a Charity

Some businesses, especially historic, cultural or environmental attractions, can be established as a charity. Charities don’t pay tax on most types of income as long as they use the money for charitable purposes. Charitable purposes that help the public can include:

  • education
  • religion
  • community development
  • the arts
  • the protection of the environment
  • animal welfare.

However, you may need to pay tax if you have:

  • received income that doesn’t qualify for tax relief
  • spent any of your income on non-charitable purposes.

Charities can also claim back tax that has been deducted e.g. on bank interest and donations (this is known as Gift Aid).

There are six steps to setting up a charity:

  1. Find trustees for your charity - you usually need at least three.
  2. Make sure the charity has a ‘charitable purpose for the public benefit’.
  3. Choose a name for your charity.
  4. Choose a structure for your charity. There are four different structures that have different responsibilities and obligations.
  5. Create a ‘governing document’.
  6. Register as a charity with the Charity Commission. You need to do this if your annual income is over £5,000, if you set up a charitable incorporated organisation (CIO) and if you want to get tax relief from HMRC.

Detailed information on how to set up a charity is available from the Charity Commission website.

Gift Aid

Gift Aid is a scheme whereby charities can claim an extra 25p for every £1 visitors donate.

To claim Gift Aid on donations from individuals, the donor must:

  • have paid the same amount or more in Income Tax or Capital Gains Tax in the UK during that tax year
  • make a Gift Aid declaration that gives you permission to claim it.

This means that Gift Aid cannot be claimed for overseas visitors or donations by businesses.

There are special rules if you want to claim Gift Aid on your entrance fees. Generally, entrance fees to visit and view your charity property do not qualify for Gift Aid because they are not a gift. But a voluntary donation that allows visitors to view your property do qualify for Gift Aid if they:

  • are 10% or more than the normal admission fee
  • allow admission for at least 12 months.

There are also special rules for:

  • funds from sponsored challenges, for example, overseas treks or marathons
  • charity membership fees
  • charity auctions
  • charity events
  • volunteer expenses donated back to your charity or CASC.

More information on how to claim Gift Aid can be found on the Gift Aid pages on the Gov.uk website

Tax and your staff

For information on PAYE, National Insurance, download the Employer Further Guide to PAYE and National Insurance Contributions from Gov.uk.

There is a range of guidance available from the HM Revenue & Customs on their website and you can also contact the HMRC’s helpline: 0300 200 3200. You will need your employer reference number or accounts office reference number when you call.

Legal form of the business

There are different tax and legal implications depending on whether you operate your business as a sole trader, a limited company or a partnership. There are advantages and disadvantages for each category. You need to seek professional advice from lawyers or independent financial advisors.

Legal advisors

The Law Society is able to provide you with a list of solicitors within your area. Your local destination organisation may also be able to give you names of suitable local firms.

Independent financial advisors

The IFA consumer website allows you to find a list of independent financial advisors, accountants or solicitor in your area.

Making Tax Digital

Making Tax Digital is a major HMRC initiative to move all business accounting to a digital format. This is a staged process over the next five years.

The first component of Making Tax Digital is VAT payments. All VAT-registered businesses with a taxable turnover above the VAT threshold (£85,000) are now required to follow the Making Tax Digital rules by keeping digital records and using software to submit their VAT returns to HMRC.

If you are below the VAT threshold, you can voluntarily join the Making Tax Digital service now but you will be required to follow Making Tax Digital rules for your first return starting on or after April 2022.

The next stage of Making Tax Digital is to require self-employed businesses with an annual business or property income above £10,000 to follow the rules for Income Tax from their next accounting period starting on or after 6 April 2023.

For Corporation Tax, the Government has started to provide businesses with an opportunity to take part in a pilot ‘Making Tax Digital for Corporation Tax’ scheme and will not mandate its usage before 2026.