For many small businesses, December and January can very stressful. Not only are there Christmas expenses to meet, often with less income over the Christmas period, but you are also waiting with dread to find out what your January tax bill is going to be. Will there be enough money to cover everything? How will you and your business make it into February!
January can provide a double-whammy due to the HMRC payments on account scheme. If your profit is over the HMRC threshold (currently £1,000 in 2014-15), then on 31 January, on top of any tax you owe for the previous year, you will also have to pay half of your tax for the next year as well. HMRC will estimate this based on your previous tax bill. If this works out to plan, the payments on account more or less cover the tax for the previous year. However, if you are slipping over the threshold for the first time or the business has had a particularly good year, then you can end up paying a hefty bill in January. If you haven’t allowed for the expense it can be a very nasty surprise and a real blow to the cash flow. Budgeting in advance across the year can be a way to spread the cost and avoid surprises.
The best way to budget for your tax bill is to pretend that you are employed. One of the big advantages of employment is the way that your income tax is taken out via PAYE before you receive your pay. You don’t have to worry about putting money aside, it is gone before you can miss it. The way that you chose to put money aside will depend on the nature of your work. If you send monthly bills or have reasonably regular income, then it makes sense to save monthly. If your income is very irregular, then you could save a percentage of the income as it it comes in.
The big questions is how much do you need to put aside? This can get quite complicated, but here is some simple guidance if your circumstances are straightforward. If your situation is more complex or you are a higher rate tax payer, then you will need to speak to an accountant to get some more specific advice.
Step 1 – How much income will you be taxed on?
Everyone has a personal allowance; this is the amount you can earn before you pay any tax. Currently it is £10,000 for 2014/15 rising to £10,600 for 2015/16. If you have a job as well as being self employed, the personal allowance will be used against your employment income first with anything left used against your self employment income. The first step is to work out how much of your personal allowance is going to be available to use against your business profits.
If you are employed as well as self employed then take the personal allowance and deduct your gross salary e.g. £10,000 – £8,000. You have £2,000 personal allowance left.
If you are just self employed then you have the whole personal allowance to use against business profit.
Step 2 – How much profit?
Next you need to know approximately how much profit you are making as you are taxed on the business profit not the income, so any business expenses can help reduce the amount of tax. Very broadly profit = income less expenses. The amount of detail you go into for this calculation is very much up to you and will depend on how many transactions you have, how regular your income and expenditure is, how easily you can keep on top of the information. However, any estimate is better than nothing!
1. Add up your your income for the period (or contract).
2. Add up your expenses for the period (or contract) – this might include direct costs such as any materials or labour and also overheads such as advertising and marketing, printing, stationery, postage, small equipment and tools, travel and subsistence.
3. Add in any regular monthly expenses such as rent, rates, utilities, phone bills and insurance.
4. Deduct the expenses from the income to give a rough estimate of profit.
Step 3 – How much to put aside?
Once you have used up your whole personal allowance against your business profit (and employment) then you need to start putting aside for tax. Basic rate tax is currently 20%. Your tax bill will also include class 4 national insurance at 9% on any earnings from £7,956 to £41,865 and 2% earnings over £41,865 (for 2014/15).
There are a couple of calculation options:
1. Put aside approx 30% of profit once you hit the personal threshold amount. This method might not be appropriate as it does not spread your tax free allowance evenly across the year.
2. Use HMRC ready reckoner tool to work out approx how much to save each month. This is a better method if you want to spread your budgeting more evenly across the year.
If you have a more regular income you might find that after a few months that you can decide on an “average” amount to put aside, but this might not be the case for everyone. The main thing is that you are saving a reasonable estimate of the tax.
Obviously this is very simple and there are other source of income such as interest, dividends and property that do need to be taken into account as well. Again, if these amounts are significant then you will need specific advice from an accountant. Also this does not take into account class 2 national insurance which is paid separately from your tax bill, unless you have an exemption.
5 Tips for tax budgeting
1. Hold onto the idea that it isn’t all your money in the first place. If you can think about your tax money in this way (unfair as it seems), then letting go might not be so hard.
2. Keep the tax money separate, ideally in a different bank account. Most of the high street banks have business savings accounts that sit alongside your main business account and allow you to transfer money easily between the two.
3. Get organised with your bookkeeping. The more regularly you can do your bookkeeping (or get someone else to help you with it), the more accurate your tax estimate will be. You will find that the business will really benefit as well if you are able to keep on top of your figures.
4. Use an accounting package. There are many reasonably priced, and even free, cloud accounting packages available. Your accountant may also be able to provide them as part of their service or at a reduced rate. This will help you keep track of income and expenses more easily and many also give you a running estimate of your tax bill as the year progresses. We use Xero and Clearbooks which are paid versions with lots of excellent features and also Brightbooks which is very basic but free (and also very pink).
5. You don’t have to wait for the deadline to prepare, submit or pay your tax bill. If you are self employed, the personal tax return can be submitted any time from 6th April to 31st January. Earlier preparation will also help if you need figures for other purposes such as tax credits, business loans or mortgage applications. Also you accountant will love you if you don’t leave it all until January!