Introduction to the UK Tax system for freelancers
In the United Kingdom, freelancers are generally classified as self-employed individuals for tax purposes. As a freelancer, you are responsible for managing your own taxes and reporting your income to Her Majesty's Revenue and Customs (HMRC), the UK's tax authority. Here's an overview of the key aspects of the UK tax system for freelancers
Self-Assessment: Freelancers are required to complete a Self-Assessment tax return each year to report their income and calculate the tax owed. The tax year in the UK runs from April 6th to April 5th.
Income Tax: The income tax rates for the tax year 2022-2023 are as follows:
Personal Allowance: The tax-free portion of your income is up to £12,570.
Basic Rate: Income between £12,571 and £50,270 is taxed at the basic rate of 20%.
Higher Rate: Income between £50,271 and £150,000 is taxed at the higher rate of 40%.
Additional Rate: Income above £150,000 is subject to the additional rate of 45%.
National Insurance Contributions (NICs): Freelancers operating as sole traders are liable to pay two types of NICs:
Class 2 NICs: For the tax year 2022-2023, the flat-rate Class 2 NICs are £3.95 per week if your annual profits exceed the Small Profits Threshold (currently £6,515 per year). Class 2 NICs are paid through the Self-Assessment tax return.
Class 4 NICs: For the tax year 2022-2023, the Class 4 NICs rate is 9% on profits between £9,880 and £50,270, and 2% on profits above £50,270.
Value Added Tax (VAT): If your annual turnover exceeds the VAT threshold (currently £85,000 per year), you may need to register for VAT. VAT-registered freelancers charge VAT on their sales (output VAT) and can usually reclaim VAT on business expenses (input VAT).
Record-Keeping and Expenses: Maintaining accurate records of your freelance income and expenses is essential for completing your Self-Assessment tax return. Keep track of invoices, receipts, and other relevant documents. Allowable business expenses can be deducted to reduce your taxable income.
Making Payments: Once you have calculated your tax liability, you need to make the required payments to HMRC. Payment deadlines vary depending on whether you pay your tax bill through the Self-Assessment payment on account system or in a single payment. Ensure you meet these deadlines to avoid penalties and interest charges.
Dividend Allowance: The dividend allowance is the amount of dividends you can receive tax-free each year. For the tax year 2022-2023, the dividend allowance is £2,000. This is being halved to £1,000 for the 23/24 tax year.
Dividend Tax Rates:
Basic Rate: Dividends above the dividend allowance and up to the basic rate threshold (£50,270 for the tax year 2022-23) are taxed at the basic rate of 7.5%.
Higher Rate: Dividends above the basic rate threshold and up to the higher rate threshold (£150,000 for the tax year 2022-2023) are taxed at the higher rate of 32.5%.
Additional Rate: Dividends above the higher rate threshold are subject to the additional rate of 38.1%.
It's important to note that the dividend tax rates apply to the amount of dividends received after deducting the dividend allowance. Also, if you receive dividends from shares held in an Individual Savings Account (ISA), they’re tax-free and don’t count towards your dividend allowance.
Please note that tax regulations may change, and it's always advisable to consult HMRC or a qualified accountant for the most up-to-date and personalised advice regarding your specific tax situation.
Recommended salary for directors
Below are the recommendations for the tax efficient amount of salary and dividends to take. Please note these are based on the assumption that no other income has been received during the tax year and that no personal pension or gift aid contributions have been made.
Your company will need to be PAYE registered to draw the recommended salary amounts.
Tax Efficient Salary/Dividend Amounts:
We have also assumed you are a UK tax resident and that you live in England.
23/24 Tax Year – 06/04/2023 to 05/04/2024 [22/23 Tax Year 06/04/2022 to 05/04/2023]:
The basic rate tax band for both the 22/23 and 23/24 tax years is £50,270. However, the national insurance threshold has risen for 23/24. There are two tax efficient ways to withdraw money from the company as below:
Option 1 23/24:
Salary: £12,570 (£1,047.50 per month) [22/23: £11,908 (£992 per month)]
Dividends: £37,700 [22/23: £38,362]
There will be no Tax or Employee National Insurance to pay on this salary however there will be a small amount of Employers National Insurance to pay towards the end of the quarter.
Option 2 22/23 & 23/24:
Salary: £9,100 (£758 per month)
Dividends: £41,170
There will be no Tax, Employee National Insurance or Employers National Insurance to pay on this salary.
Overall option 1 is more tax efficient than option 2. However, option 2 does decrease the amount of admin as there will be no need to make any payments to HMRC.
Please be aware there are exceptions to the above figures, please see below for further information.
Exceptions
Basic Rate Bands
The basic rate band added to your personal allowance for both the 22/23 and 23/24 tax years is £50,270. This includes the £12,570 tax free personal allowance and then £37,700 of the basic rate band. This is what we use to work out the above amounts of salary and dividends as any income earned up to this threshold (after the personal allowance of £12,570 has been deducted) will be taxed at the basic rate of tax.
The basic rate band can change if you have made any personal pension contributions (these are those made by you personally and not through your limited company or through employment - unless the scheme is "Relief at source") or personal charitable donations. The basic rate band would increase by the gross amount contributed/donated.
For example, a person who contributed a gross of £500 personally to their pension would have a basic rate band of £50,770 (£50,270 + £500). Therefore an extra £500 would be taxed at the basic rate rather than the higher rate if they were a higher rate tax payer. In this situation you could then take the recommended salary of £9,100 and dividends of £41,670 (recommended £41,170 + £500)
Therefore if you are a higher rate taxpayer it is beneficial to make personal pension contributions or make charitable donations to allow you to draw more dividends out of the limited company tax efficiently.
Employment Allowance
If you have more than one director (or other employees) you could be eligible for the employment allowance. This means you can take the recommended salary of £1,047.50 a month and be exempt from paying employers NIC.
Please be aware that both directors would need to take the higher salary for this allowance to be claimed.
The tax efficient salary and dividends to take to claim this allowance for 23/24 would be:
Salary: £12,570 (£1,047.50 per month) [22/23: £11,908 (£992 per month)]
Dividends: £37,700 [22/23: £38,362]
There will be no Tax, Employee NI or Employers NI to pay on this salary.
Other Income
If other income has been received this will decrease the amount of dividends you can take efficiently from your limited company.
If you are unsure on the tax efficient amounts due to having other income please get in touch and we can advise on this.
An example of this would be if you have received £10,000 of income in the 22/23 tax year from a PAYE role. This would then reduce the amount of dividends you could take tax efficiently by that £10,000. Therefore the tax efficient amounts to take would be £9,100 in salary and £31,170 (this is the originally recommended £41,170 - £10,000).
Becoming a director part way through the tax year
If you became a director part way through the tax year the salary will need to be pro-rata’d. You are also likely to have other income so please get in touch with us and we can advise on tax efficient salary and dividends you can take for the remainder of the tax year.
Self employed vs Limited company
Self-Employed (Sole Trader)
As a self-employed individual, you operate your business as an individual and are personally responsible for all aspects of the business.
You are not required to set up a separate legal entity, and the business income and expenses are included in your personal tax return.
Advantages:
Simplicity: It is relatively straightforward to set up and manage as a sole trader.
Flexibility: You have full control over the business and decision-making.
Less admin: Lower administrative and compliance burden compared to running a limited company.
Disadvantages:
Unlimited Liability: You are personally liable for any business debts or legal issues.
Taxation: As a sole trader, you pay income tax and National Insurance Contributions (NICs) on your profits based on the prevailing tax rates for self-employed individuals.|
Limited Company
A limited company is a separate legal entity from its owners (shareholders), providing limited liability protection.
You need to incorporate the company with Companies House and follow the legal requirements of running a company. You can incorporate a business for free with Ember here.
Advantages:
Limited Liability: Your personal assets are protected as the company is a separate legal entity.
Tax Efficiency: Limited companies can offer more tax planning opportunities.
Professional Image: Operating as a limited company can enhance your credibility with clients and business partners.
Disadvantages:
Increased Administration: There are more administrative obligations, such as maintaining statutory records, filing annual accounts, and managing company finances.
Stricter Regulations: Limited companies need to comply with company law and financial reporting standards.
Less Privacy: Financial information, such as annual accounts, is publicly accessible through Companies House.
Tax Efficiency and Optimal Point for Limited Company
The point at which operating as a limited company becomes more tax-efficient compared to being self-employed depends on various factors, including your level of income and expenses, and individual circumstances. Generally, when your profits exceed a certain threshold, it can be more tax-efficient to operate as a limited company due to the following reasons:
Corporation Tax: Limited companies pay corporation tax on their profits, which is typically lower than income tax rates for self-employed individuals.
Dividend Tax: Limited companies allow for more flexibility in distributing profits, and dividends may attract lower tax rates compared to income tax rates.
You are only taxed on what you draw down from the company and profit can be left to be later distributed as a capital gain on closure which can benefit from 10% tax via business asset disposal relief.
However, it's important to note that tax considerations are just one aspect to consider when deciding on the business structure. Other factors, such as legal responsibilities, personal liability, administrative requirements, and business goals, should also be taken into account. It is recommended to seek advice from a qualified accountant or tax professional who can assess your specific circumstances and provide tailored guidance on the most tax-efficient structure for your situation.
IR35
The rules
The IR35 rules, also known as the "off-payroll working" rules, were introduced in the UK to determine the employment status and tax obligations of individuals providing services through an intermediary, typically a personal service company (PSC). The rules assess whether the individual is genuinely self-employed or should be considered an employee for tax purposes.
This legislation does NOT impact sole traders. This legislation is aimed at Limited company contractors.
The current IR35 rules for contractors in the private sector are as follows:
Determining IR35 Status:
The responsibility for determining the IR35 status of a contractor lies with the client (the organisation receiving the contractor's services) rather than the contractor themselves.
The client must assess whether, if directly engaged, the contractor would be deemed an employee for tax purposes (inside IR35) or genuinely self-employed (outside IR35).
The Three Main Tests for IR35 Status: The following three main tests are considered when determining a contractor's IR35 status:
Control: This test examines the degree of control the client has over how the contractor carries out their work. If the client has significant control over the contractor's work, including the tasks performed, working hours, and methods used, it may indicate an employment relationship (inside IR35).
Personal Service/Substitution: focuses on whether the contractor is obligated to personally perform the services or if they have the right to send a substitute in their place. If the contractor cannot send a substitute and must provide their services personally, it suggests an employment relationship (inside IR35).
Mutuality of Obligation (MOO): MOO refers to the obligation for the client to provide work and for the contractor to accept it. If there is an ongoing obligation for the client to provide work and for the contractor to accept it, it suggests an employment relationship (inside IR35).
Determination and Tax Implications:
If a contractor is deemed inside IR35, the client or the party responsible for paying the contractor (such as an agency) must deduct income tax and National Insurance Contributions (NICs) from the contractor's payments and remit them to HMRC.
Contractors inside IR35 may not receive the same tax advantages as those outside IR35, as they are treated more like employees for tax purposes.
If a contractor is determined outside IR35, they remain responsible for their own tax and NICs, and the client is not required to make deductions.
Useful links
HMRC’s own tool to check employment status - be aware it’s a little bit harsh and does not always hold up to scrutiny.
Self Assessment
The basics
The self-assessment regime in the UK is a system that individuals use to report their income, calculate their tax liability, and settle any tax owed to Her Majesty's Revenue and Customs (HMRC). It applies to individuals who are self-employed, freelancers, partners in a partnership, company directors, or have other sources of income outside of PAYE (Pay As You Earn) employment.
Here are the key aspects of the self-assessment regime:
Registration: If you are new to self-employment or meet other criteria for self-assessment, you need to register for self-assessment with HMRC. This can be done online through the HMRC website or by completing the relevant forms.
Tax Year and Deadlines: The tax year in the UK runs from April 6th to April 5th. Self-assessment taxpayers need to meet various deadlines:
October 5th: Notify HMRC if you need to register for self-assessment for the previous tax year.
October 31st (paper filing) or January 31st (online filing): Deadline for submitting a self-assessment tax return for the previous tax year.
January 31st: Deadline for paying any tax owed for the previous tax year.
Completing the Self-Assessment Tax Return: The self-assessment tax return is a form where you report your income, gains, and other relevant information to HMRC. It includes sections for different types of income, such as self-employment income, rental income, savings and investment income, and capital gains.
Income: You need to provide details of your income, expenses, and deductions. This includes self-employment income, employment income, pensions, benefits, and any other relevant income sources.
Allowable Expenses: You can claim allowable business expenses, deductions, and reliefs related to your self-employment or other income sources. These expenses should be incurred wholly and exclusively for business purposes.
Tax Calculation and Payment: Once you have completed your self-assessment tax return, HMRC calculates the tax owed based on the reported income and relevant tax rates. The tax liability includes income tax, National Insurance Contributions (NICs), and other applicable taxes.
Payment on Account: If your tax liability exceeds a certain threshold, you may need to make payments on account for the following tax year. Payments on account are advance payments of tax made in two instalments (January 31st and July 31st) based on the previous year's tax liability.
Balancing Payment: The balancing payment is the amount of tax owed after taking into account any payments on account and tax already deducted at source (such as through PAYE). It is payable by January 31st following the end of the tax year.
Penalties and Interest: Late filing or late payment of taxes can result in penalties and interest charges. It is important to meet the deadlines and make accurate and timely payments to avoid such penalties.
Record-Keeping: As a self-assessment taxpayer, you are required to maintain accurate records of your income, expenses, and other relevant documents for a specified period. This helps support the figures reported in your tax return and assists in case of any HMRC enquiries or audits.
It's worth noting that the self-assessment regime can be complex, and it is recommended to seek guidance from an accountant or tax professional to ensure compliance with all the regulations and to receive tailored advice based on your specific circumstances.
Who needs to complete a Self Assessment?
Several individuals in the UK are required to file a Self-Assessment tax return with Her Majesty's Revenue and Customs (HMRC). Here are some common categories of individuals who need to file a Self-Assessment:
Self-Employed Individuals: If you are self-employed, running your own business or trade, you must file a Self-Assessment tax return.
Directors of Limited Companies: If you are a director of a limited company, regardless of whether you receive a salary or dividends, you are required to file a Self-Assessment tax return.
High Earners: Individuals with high income or certain types of income may need to file a Self-Assessment tax return. This includes individuals whose income exceeds the higher rate tax threshold, those who receive income from rental properties, or those with significant savings and investment income.
Individuals with Other Income or Gains: If you have income or gains from sources other than employment, such as rental income, dividends, or capital gains, you may need to file a Self-Assessment tax return.
Partners in a Partnership: If you are a partner in a partnership, you are typically required to file a Self-Assessment tax return to report your share of partnership income and expenses.
Non-Resident Individuals: Non-resident individuals with UK income or those who have UK tax obligations may need to file a Self-Assessment tax return.
Individuals with Complex Tax Affairs: Individuals with complex tax affairs, such as those with multiple sources of income, overseas income, or claiming certain reliefs or allowances, may need to file a Self-Assessment tax return.
Useful links
VAT
VAT Registration
In the United Kingdom, Value Added Tax (VAT) is a consumption tax imposed on most goods and services. VAT registration rules determine when a business must register for VAT and start charging VAT on its sales. Here's an overview of the VAT registration rules in the UK:
VAT Threshold:
Standard Threshold: If your business's taxable turnover exceeds the VAT threshold within a 12-month period, you must register for VAT. VAT threshold is £85,000 of taxable turnover per year.
Voluntary Registration: Even if your turnover is below the threshold, you can choose to register for VAT voluntarily. This might be advantageous if you want to reclaim VAT on your business expenses or if your clients are mostly VAT registered, as it allows you to charge VAT and recover input VAT.
Taxable Turnover:
Taxable turnover refers to the total value of your sales that are subject to VAT. It includes both standard-rated (currently 20%), reduced-rated (currently 5%), and zero-rated supplies. Exempt supplies and supplies outside the scope of VAT are not included in the taxable turnover.
Taxable turnover should be calculated based on the cumulative value of sales over a rolling 12-month period, not a calendar year.
Other Factors Affecting VAT Registration:
Distance Selling Threshold: If your business sells goods to customers in other European Union (EU) countries, you may have to register for VAT in those countries once you exceed their distance selling thresholds.
Acquisition Threshold: If your business purchases goods from other EU countries, you may have to register for VAT if the total value of acquisitions exceeds a certain threshold.
VAT Registration Process:
To register for VAT, you need to complete an application with HM Revenue and Customs (HMRC). You can do this online via the HMRC website or by filling out the appropriate forms and mailing them to HMRC.
During the registration process, you will need to provide information about your business, turnover, and other relevant details.
Once registered, HMRC will issue you a VAT registration number and provide guidelines on how to charge, collect, and reclaim VAT.
VAT Reporting and Payment:
After registering for VAT, you will be required to submit regular VAT returns, usually on a quarterly basis, detailing your sales, purchases, and VAT owed.
The VAT owed to HMRC is calculated by subtracting the input VAT (VAT you've paid on purchases) from the output VAT (VAT you've collected from sales).
Payment of VAT owed to HMRC is typically due one month and seven days after the end of the VAT return period.
Benefits of early VAT registration
There are several benefits to early VAT registration, even if your business's turnover is below the VAT threshold. Here are some advantages of voluntarily registering for VAT:
Reclaiming Input VAT: Once registered for VAT, you can reclaim the VAT you've paid on business-related purchases and expenses. This includes VAT on goods, services, and assets used in your business. Reclaiming input VAT can help reduce your overall business costs.
Enhanced Credibility: Registering for VAT can enhance your business's credibility, especially when dealing with larger companies or public sector organisations. Being VAT registered may give the impression of an established and professional business.
Competitiveness: If your competitors are VAT registered, it may put your business at a disadvantage if you cannot charge VAT on your sales. Voluntarily registering for VAT allows you to compete on a level playing field.
Dealing with VAT Registered Customers: If your customers are VAT registered businesses, they may prefer to work with other VAT registered suppliers. By registering for VAT, you can accommodate their requirements and potentially attract more customers.
Simplified Accounting: VAT registration often requires maintaining more detailed records and adopting proper accounting systems. While this may initially involve additional administrative effort, it can lead to more organized and accurate financial management for your business.
Flat rate vs standard
The UK VAT system offers different VAT schemes, including the Flat Rate Scheme (FRS) and the Standard VAT Scheme. Here are the benefits of each scheme:
Flat Rate Scheme (FRS) Benefits:
Simplified Accounting: The FRS simplifies VAT accounting for eligible businesses. Under this scheme, you calculate VAT owed to HMRC based on a fixed percentage of your gross turnover, rather than calculating VAT on each individual sale and purchase. This simplifies record-keeping and reduces administrative burden.
Time-saving: Since you don't have to record VAT on individual transactions, it saves time and effort in VAT calculations and reporting.
Potential Cash Flow Advantage: In some cases, businesses on the FRS may pay less VAT to HMRC compared to what they collect from their customers. The difference can provide a cash flow advantage, although it varies based on the applicable flat rate percentage for your sector.
Less Record-Keeping: FRS businesses don't need to keep detailed records of VAT on purchases unless they relate to capital assets costing £2,000 or more (including VAT).
Simpler VAT Returns: FRS businesses typically have simpler VAT returns, with fewer boxes to complete.
Standard VAT Scheme Benefits
Input VAT Recovery: Under the Standard VAT Scheme, you can claim input VAT on your business-related purchases. This allows you to recover VAT you've paid, reducing your overall VAT liability.
Greater Control: Unlike the FRS, the Standard VAT Scheme provides more control over VAT. You can identify the VAT on each purchase and sale, allowing for accurate calculations and a clearer understanding of your VAT position.
Sector-Specific VAT Rates: Certain goods and services may have reduced or zero VAT rates under the Standard VAT Scheme. For example, some essential items, like children's clothing and food, have a reduced VAT rate or are zero-rated. This can be advantageous for businesses selling goods or services falling into such categories.
Limited cost trader
The Limited Cost Trader (LCT) rules were introduced as part of the UK VAT Flat Rate Scheme (FRS) to prevent abuse and ensure that businesses using the scheme meet the intended requirements. Under the LCT rules, businesses classified as limited cost traders must apply a higher flat rate percentage to their gross turnover when calculating their VAT liability.
Here are the key aspects of the Limited Cost Trader rules:
Definition of Limited Cost Trader:
A limited cost trader is a business whose VAT-inclusive expenditure on "relevant goods" is either: a) Less than 2% of its VAT-inclusive turnover in a prescribed accounting period, or b) Greater than 2% but less than £1,000 per year, regardless of the VAT-inclusive turnover.
Calculation of VAT Liability:
For limited cost traders, the flat rate percentage to be applied is 16.5%. This is higher than the standard flat rate percentage of 20% used by most businesses under the FRS.
The calculation of VAT liability is based on the gross turnover, including VAT, rather than the individual transactions or purchases.
Definition of Relevant Goods:
Relevant goods are goods used exclusively for the purpose of the business and purchased from a VAT-registered supplier. The following are excluded from the definition of relevant goods: a) Capital expenditure goods, such as equipment, machinery, and vehicles. b) Food and drink consumed by the business owners, employees, or customers. c) Vehicles, vehicle parts, and fuel, except for businesses operating in the transport sector.
Impact on Businesses:
Being classified as a limited cost trader can result in a higher VAT liability under the FRS, as the flat rate percentage is increased to 16.5%.
It may reduce the benefits of using the FRS for businesses with minimal expenditure on relevant goods or those that predominantly provide services rather than goods.
Limited cost traders may find that reverting to the standard VAT accounting method is more financially advantageous, allowing them to claim input VAT on purchases.
Corporation Tax
Personally paid expenses
More often than not, clients forget to claim for personal expenses. By ensuring they’re being recognised in your accounts, not only do you get full tax relief but - as this is a directors loan drawdown - you can draw down the amounts owed to you from the company in the future, tax free!
Expense claim tips
Salary is a tax deductible expense, so as well as being a tax efficient way for directors to take a small salary out of the business, you’ll also get Corporation Tax relief.
Pension contributions can be paid through the limited company directly to a SIPP (Self Invested Personal Pension). You can normally contribute up to £40,000 a year into your pension, as well as being able to carry forward unused pension contributions for the 3 prior years. This can make a significant dent in your Corporation Tax bill.
Christmas parties are also claimable, even for companies with one director. HMRC allows you to claim £150 per director, plus another £150 for a plus one. This doesn’t need to be a Christmas party as such, but it’s good to know that you can claim up to £300 for an event.
Trivial benefits. As a director, you can claim for trivial benefits of up to £300 per year. Each benefit has to be £50 or less. Top tip: To get the most out of this relief, we would recommend claiming for a voucher of your choice for £50, six times a year.
Eye checks are claimable, as are a pair of glasses if they’re used wholly and exclusively for business purposes.
Working from home. HMRC currently allows £6 a week to go through as an expense for using your home for work. There may also be an option to claim for more tax via a rental agreement - see Appendix 1.
Asset purchases
Electric vehicles, you can claim 100% tax relief on the cost of a fully electric vehicle in the year of purchase. This includes cars purchased on a finance lease, where the risks and rewards of ownership have been transferred to the client. This does mean minimal P11D benefit, but this is expected to go up to 5% by 2025.
First Year Allowance for Electric Vehicle Charge points: The Spring Finance Bill 2023 will extend the 100% First Year Allowance for electric vehicle charge points to 31 March 2025 for Corporation Tax purposes, and 5 April 2025 for Income Tax purposes.
Recent budget change
From April 2023, the tax rate for Corporation Tax is changing to 25% for companies earning over £250,000. Companies earning between £50,000 and £250,000 will be paying a rate between 19% and 25%. Those companies earning under £50,000 will pay 19%.
Companies who have associated companies will have reduced tax thresholds. Associated companies are companies that share control and ownership.