Alan Pink looks at how to start with a tax advantage over your competition, when you set up a business …
Right in the midst of what is probably the worst “winter of discontent” in most people’s memories, it would seem an odd time to look at the topic of business start-up’s. But hopefully, by the time you read this, the “green shoots” both of spring and of returning confidence may be making their shy first appearance. As an adviser to business, I’ve seen a lot of people going through a very tough time – and indeed a lot of them still are. This isn’t surprising in the circumstances. But what has surprised me has been the confidence which so many of those seeking my advice have shown in things getting better – and quite soon. Unexpectedly, this is one of the busiest times I’ve ever known for tax advisers!
As the nationwide – some say manufactured – scare begins hopefully to die away, I expect to see even more of a surge in business start-up’s, and people needing tax advice. So I thought it would be good to have a quick roundup, in my blog this month, of all the ways you can get the taxman to help you if you are in the early stages of setting up or running a business – whether he wants to or not.
Bread and Butter
Before we start tucking into the cake, and particularly the icing on the tax cake, some straightforward and down to earth comments about record keeping. If you’re running a business for the first time, you’ll need to give some thought to how to keep records, because inadequate records are probably the prime reason why a lot of small and start up businesses pay too much tax.
What records do HMRC require you to keep? Well, they don’t specify any particular format for the records, either manual or computer; and subject to the point below they certainly don’t say that you have to use a given computer program – yet. If you’re VAT registered, because your business makes the sort of supplies that are subject to VAT (not all are) and because either your turnover has already exceeded the turnover threshold of £85,000 or because you decide to register voluntarily (of which more below), the rule under the infamous “Making Tax Digital” initiative is that you now have to do your VAT online, using one of an approved series of programs. But Making Tax Digital, which should have been rolled out for direct tax as well by now, has been deferred because of the (some would say predictable) difficulties of requiring everyone to prepare what are basically quarterly profit and loss accounts. So we don’t know what the rules are going to be, in their detail, as yet: and it may be that those in a small way of business (or who have only so far carried out a few transactions), wont be required to don the digital straitjacket if they don’t want to. (More positively, though, surely computers do provide a very good way of keeping records?) The purpose of keeping records, as far as the taxman is concerned, is to make sure that you have a complete record of all of your incomings and outgoings, such that you can prepare a reliable profit and loss account.
And that’s it. As I say, there’s no rigid rule for how you do that, so long as your records are complete. There are a large number of computer programs out there, though, which genuinely make life easier once you’ve got over the initial headbanging that any new computer function brings with it. A very popular one these days, in fact, threatening to take over the market, is Xero. Then there is Sage (formerly a market leader) and Quickbooks, all of which have their pluses and minuses. If we were going to do a complete review of accounting software here, it would probably put off a lot of my regular readers! In overview, though, I would say that all of the mainstream programs basically do the same thing, although with different “bells and whistles”, and it’s probably sensible just to select one, almost at random, and see how you get on with it – unless know someone who is willing to help you and is strongly in favour of one program or another, of course.
The essential point is to ensure that your system, whatever it is, captures all the data, and in particular all the data about the expenses you are incurring. It’s very common for a lot of start-up expenditure to be made out of private resources and without the benefit of being put into an accounting system. Whatever piece of paper you lose, though, is going to cost you money, so do have some kind of arrangement, even if it’s only one of those box files with a spring for trapping paper, to ensure that there is a note of everything somewhere.
VAT
With apologies for using this obscene three letter word so early on in my discussion of business start-up’s, this is clearly something you are going to have to grapple with, perhaps at an early stage. So let’s have a very quick run down of VAT here, so that you know what, if anything, you need to do to avoid getting into trouble.
First of all, you need to ascertain whether any of what you sell is subject to VAT, because not everything is. If all of the business supplies you make are exempt from VAT, or all but an amount which is less than the £85,000 turnover threshold, then you don’t need to register for VAT – indeed if all of your supplies are exempt you can’t, and so you can move on to thinking about something more productive than an obligation to be an unpaid tax collector for the government. The types of business which are VAT exempt are the following:
· Betting gaming, dutiable machine games and lotteries
· Undertakers
· Certain types of “cultural services”
· Education when provided by schools, universities etc or private tutors
· Finance
· Fundraising events by charities
· Health and welfare
· Insurance
· Renting or sale of land which is residential or has no “option to tax”, and doesn’t consist of a new building
· Postal services
· Sport, sports competitions and physical education
· Works of art etc
Plus one or two others that probably won’t apply to any business start-up’s.
Joining the VAT Club Voluntarily
But some peculiar people, even when they’re not required to register because their taxable (that is not exempt) turnover is less than the threshold, still elect to do so voluntarily. Why would you do this? The answer is that, if you’re VAT registered, you can reclaim the VAT element of those expenses which include it. The quid pro quo is that you have to put VAT on your sales, which otherwise you wouldn’t have had to. But if you are the sort of business that’s working for other businesses which are all also VAT registered, this doesn’t matter because they in their turn can reclaim the tax that you charge to them. So you haven’t made yourself more expensive by registering, and you can get the VAT back on your expenses.
Pay as You Earn
Another potential tax scourge for those in business is the payroll. If you take on employees, you have an obligation, as employer, to deduct tax and national insurance, and also you have certain pension obligations. I am certainly not going to weigh this article down with the detail of how the PAYE system works, but simply give those who need it one simple piece of advice: PAYE is normally dealt with on a very economical and cost effective basis by external payroll bureaux. These bureaux who do nothing else but payroll (what an exciting job that must be!) will take the information from you in your form and process it in such a way as to keep you compliant with the PAYE red tape. In my experience, these bureaux are worth their weight in gold, and very much better than the alternative of you, as a hard pressed new business manager, spending your time trying to get your head round all of the obligations and calculations.
The Business Structure
Now on to the true meat of my advice to business start-up’s. The way you choose to structure your business can make a huge difference to the amount of tax you pay. So let’s have a look at the various options, and I will comment on which ones are probably most appropriate in which circumstances.
First there’s the simplest form of business structure, which is that of a sole trader. An individual simply carries on a business in his or her own name, and that’s that. From the tax point of view, sole traders are charged as self employed individuals, which means that they pay income tax on their profits, and national insurance at the friendlier self employed rates (friendlier than the employed rates, that is). A sole trader is taxable on the full profits of the business regardless of whether he leaves them in the business bank or draws them out to spend privately.
In principle, partnerships are dealt with in the same way. That is, the partners are taxable on their share of the profits, and this is regardless of whether they draw the money out of the business or not.
It’s when you get to the limited company structure that things get more complex, and sometimes (but not always) more tax advantageous. Companies have their own tax exposure, and currently pay tax at a flat rate of 19% on all kinds of profits. In the company sphere it does make a difference whether the business owners draw the money out or not, because extraction of money from a company will normally be in the form of taxable income, either taxed as remuneration (that is a salary paid by the company to the individual as if he or she were an employee) or as dividends. But the important point to note, above all the others, is that taking money out of the company as income results in the individual’s who take that income being chargeable to income tax on it. Unlike corporation tax, which has a flat rate of 19%, individuals have a progressive series of rates, going up from 20% to 40% where total income goes over £50,000 in a year; and 45% where total income is over £150,000.
Finally, there’s my favourite business structure, the Limited Liability Partnership or LLP. In most ways this is taxed the same as a partnership, that is individual and company members pay tax on their share of the profits regardless of whether it’s drawn out or not. But there’s the difference that the LLP gives members limited liability, which means that, if anything disastrous goes wrong with the business financially, they are generally protected from the worst results from such a disaster. Because of this limited liability protection, it is possible that individuals who might otherwise have been employees, sheltering behind the protection from liability that an employee effectively has, might agree to become partners (or “members” as the jargon has it) of the LLP. This can be very cost effective for the business, because members of an LLP who are treated as self employed don’t trigger the high rates of employee and employer national insurance.
Which Structure?
So that’s a brief description of the options available for structuring a business. Which should you choose? The answer, as almost always in tax planning, is “it depends”. For a small business where the profits, perhaps divided amongst partners, are not going to put any individual into the 40% bracket, the sole trader/unincorporated partnership route has the benefit of simplicity. The effective difference between, say, running a partnership on the one hand and paying income tax and self employed national insurance, and on the other running a company and avoiding national insurance by paying dividends, but incurring the “dividend tax” surcharge, is a very small difference. It’s probably not enough, in most cases, to make up for the extra cost and formality of running a company. Companies, for example, have to draw up accounts in accordance with strict formats set out in company law, and your accountant’s bill will be higher if you’re running a company than if you are running a sole trader or general partnership.
If the business profits are such as to push you into higher rates as an individual if you receive those profits directly as a sole trader or partner, then a limited company may be a tax efficient alternative. I say “may” because the benefit of having a company is pretty illusory if you are actually going to draw all of the profits out as personal income, by way of say dividend. This is because the same ultimate rate of income tax, or indeed a slightly higher rate of tax overall, will apply if you receive the profits in the company initially and then pay them out as dividends. Although, as I say, the sole trader/partner route involves self employed national insurance, the dividend tax surcharge caused by the interposition of the limited company takes away most of the benefit of avoiding this national insurance, and you end up effectively paying a rate of tax in excess of 40%, if you are in that 40% bracket.
Running a business through a company is also not so favourable, often, from the point of view of the way benefits in kind are taxed.
Where a company does come up trumps in tax planning terms, therefore, is where you aren’t going to take out all of the profits; or not take them all out as dividends. For example, if the business needs capitalising, by leaving money in to buy stock or fixed assets, for example, this can be very effectively done through a company because the money which is ploughed back to invest in these business assets has only borne tax at 19% rather than, it may be, 40% or 45% as would be the case with a partnership. Also, if you have other ways of drawing out money from the company in non income form, this can be a highly advantageous structure.
George decides to turn his substantial Victorian house until a hotel, and does the necessary extension and conversion work. The business is very profitable, making him typically somewhere between £150,000 and £200,000 a year, and the property is valued at £2 million as a working hotel. George transfers the business, including the property, into a limited company, and as a result of the transfer of the property the company “owes” him £2 million on director’s loan account. He is therefore able to draw this amount, personally, out of the company profits without paying any personal tax on these drawings: because it is simply a capital drawdown on the amount the company owes him. As a result, for the foreseeable future, George will only be bearing a 19% rate on his business profits, even though he takes these out in full to spend on living.
Ways of taking money out of a company in capital, rather than income form, actually proliferate: but because this is a piece about business start-up’s, I won’t allow these to hijack the discussion here.
And then there’s the question of how any start-up tax losses are treated. I’ll come on to this later on, but suffice it to say here, that the question of how useful any start-up losses are is also dependent on the business structure you choose. Specifically, if you set up as a limited company, they are generally not much use at all when they are most needed.
So very often, although all circumstances differ, of course, my suggestion to businesses which start up in a small way and may or may not grow in the future is to start in the relatively uncomplicated format of a sole trader or partnership (or LLP if limited liability is important in the context of the business). Conversion from an unincorporated business format like this into a limited company format is relatively easy later on if the business develops into a highly profitable one and the circumstances otherwise so suggest.
Pre Trading Expenditure
I’ve mentioned this already in context of making sure that you have a careful note of how much it is. From the tax planning point of view, there’s a distinction, which is important to grasp, between pre trading expenditure and expenditure after the trade has started. Pre trading expenditure is basically totted up and treated as if it were all incurred, for tax purposes, on the day when the trade begins. Once the trade has started, on the other hand, expenses incurred can give rise to losses if they exceed the income for the same period. These losses can then be used to put in a special loss relief claim, which involves carrying back the loss by three years, and offsetting against your other income received in the past. This can give you a much needed boost in the form of tax refunds when you most need it: and as I’ve already mentioned, the availability of this start-up loss relief depends on you being a sole trader, partnership or LLP, rather than a limited company. Losses made by a limited company can only be carried forward and used against profits in the future. So it can be important to determine the actual date your business started, for tax purposes. There’s a bit of case law on this issue, but if I can take the risk of summing it up, the commencement of trade is when “production” of whatever your product or service is begins. This might be before you actually “open your doors” to business. From this date, when the trade is commenced and you have gone “live”, start-up losses are usable to make claims in the way of have described.
Capital Equipment etc
Then there are some very interesting tax planning opportunities that arise when you start a business and you make use of any kind of capital equipment, including cars that you owned before starting the business. The way the tax rules work is that these assets are treated as having been acquired by the business at their market value on the day you began. So allowances, specifically the tax depreciation known as “capital allowances”, can be claimed on this equipment. Don’t be shy of doing a bit of lateral thinking here, because such equipment, which you may already have owned for a long time, but on which tax allowances can be claimed, isn’t confined to obvious things like computers and office furniture. There is the car, for example, even if this is used partly privately and partly on business; and there are even things like fixtures and equipment within the premises in which you are carrying on the business. Anything which can be regarded as contributing in any way towards the running of the business, and is in the nature of a capital item, should be carefully listed and valued as accurately as possible. This information can then go to your accountant (if you use one) to act as the basis for your first year’s allowances claims.
Professional Advisers
And this brings me on to my last point of all, which is whether you should use a professional adviser when you set up a in business? And if so, how you choose one. I’m no doubt biassed in answering this question, being a professional adviser myself. However I have seen so many instances of people trying to “go it alone”, and entirely predictably making mistakes because of their lack of a full grasp of our immensely complex tax system, that I would counsel against doing so except in the very smallest and simplest of businesses.
As to how you choose a good adviser, this is sometimes a tricky one. If you’ve come across an adviser in your life before business, either directly by meeting them in person or by, say, reading what they have written, and are impressed by them, that may be a good place to start. Obviously you can also ask around all your friends who have accountants, to see quite how enthusiastic they are about their particular man or woman! But do be sure that you keep clearly in mind the distinction between an accountant, pure and simple, and a tax adviser. In the old days, which are still in the memory of some of us not yet decrepit, it was traditional to go to your accountant for all forms of tax advice. That was in the days would you could get the whole of the UK’s direct tax legislation in a single volume. Now we have something like ten times the amount of tax law as there was in those days (which are not much more than 30 years ago), it becomes impossible for an accountant in general practice honestly to set himself up as a tax specialist. No doubt an accountant who is alert to your advantage (not all of them are at all proactive) is perfectly satisfactory for a “vanilla” business start-up situation. However, don’t assume that he will necessarily be advising you when things start getting a bit bigger or more complex. In most cases, it is going to be at this stage that you need to be talking to a tax adviser rather than a “mere” accountant.
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