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Contractor Accounting Guides: Sole traders

If you have chosen to become a contractor, you need to select one of the several legal structures for managing your business. In the UK, contractors have the option of operating as a sole trader, setting up a limited company or working under an umbrella company. The choice of your business ventures legal structure is determined by many factors such as your motive or reason behind becoming a contractor, your growth aspirations, your level of expertise, and your appetite for managing responsibilities. Each of the above-mentioned legal structures have different accounting and taxation implications and so it is advisable to choose one structure right at the commencement stage of your business.

To continue with our series 'Path of Education for New Contractors', we will try to explain one of the legal structures for starting a contracting business in the UK - operating as a sole trader.

What is a sole trader?

As a sole trader, you are offering your services to prospective customers independently, without an employer. Sole trading is the fastest, easiest, and the most common way of running a contracting business. As of 2012, 62.7% of the total businesses in the UK were run by sole traders.

Some examples of sole traders:

  • Plumbers
  • Decorators
  • Hair stylists
  • Electricians
  • Landlords
  • Farmers
  • Doctors

Sole trader in Detail

Registration: Before starting, you need to register yourself with Her Majesty's Revenue and Customs (HMRC) as a sole trader. You need to provide details like name, date of birth, details of National Insurance, business start date and so on. You can register as a sole trader with HMRC for free either online, by phone or via post; if you don't register within three months, you may end up paying a fine of £100.

Accounts: As a sole trader, you need to manage your accounts independently and will have to maintain records of income and expenses. Examples of documents include client invoices, utility bills, documents for any purchases, bills for expenses like stationery, travelling, and practically any document that is a proof of you receiving or spending money related to your business. Using these documents, you will have to prepare a profit and loss statement and a balance sheet.

Expenses: As a sole trader, you will have to pay tax only on the profit left after deducting all of your business expenses from your business income. Your taxable income will be the money remaining after deducting expenses including; business expenses, financial expenses and costs for travel and advertising. Note, you can only deduct your business expenses and not your personal expenses from your business income. However, if you are running your business from home you may be able to claim a portion of expenses like mortgage interest, internet, telephone, etc. as part of business expenses.

Taxes: Sole traders have to calculate taxes and file tax returns on their own. You will have to pay tax at the normal income tax rate, just like any other income. As an example, if as a sole trader you make a profit of less than £10,000 during the financial year (the personal allowance limit), you do not have to pay any tax. In the first year, you will have to fill a self-assessment registration form with HMRC. For sole traders, the deadline for filing of self-assessment is 31st October by paper and 31st January 31 for online (for the year ending April 30th).

Example 1: You are a hair stylist working as a sole trader. Suppose your annual income is £12,000, and your annual expenses are £5,000 on items like scissors, shampoo, apron, etc. In such a scenario, tax will be calculated not on the income of £12,000, but on the profit of £7,000. Moreover, because £7,000 is within the personal allowance limit, you don't have to pay any tax.

National Insurance: If your earnings are less than £5,885, you may not have to pay Class 2 National Insurance Contributions (NIC). Otherwise sole traders pay £2.75 weekly in Class 2 NIC. In addition, sole traders are eligible to pay Class 4 NIC. If profit is between £7,956 and £41,865, sole traders pay Class 4 NIC at 9% of the profit. For any profit above £41,865, the rate is 2%.

Liabilities: Sole traders have complete responsibility for all the debts of their business and also any potential losses caused to their clients. Unlike a limited company, your enterprise is not a separate legal entity and you will have to bear all the risks on your own. This also means you will be risking your personal assets. However, there are many insurance products dedicated for sole traders, which provide cover for any business losses. Hiscox offers insurance for sole traders that provides professional indemnity which covers them from any losses caused to clients because of their mistakes. The Hiscox product also covers any personal accidents which may lead to losses due to inability to work and includes office insurance for accidental damages, theft or losses in the office.

Business Name: You can operate as a sole trader either under your name or a separate business name. However, your business name should not have the words like Ltd., Limited, etc. or other terms, which may make the business appear as a limited company. You can find detailed naming guidelines for sole traders on the UK Government's website.

Hiring: As a sole trader, you can employ people but you will be responsible for your employee's income tax and National Insurance Contributions. Also, before hiring, you need to register with HMRC as an employer and start your own PAYE (Pay as You Earn) scheme. PAYE is the system used by HMRC for collecting taxes and National Insurance from employers.

Sole trading with full-time employment: It is possible to register yourself as a sole trader while being employed full time elsewhere. However, you need to be careful that your practice is not violating any terms of your employment contract as this could lead to legal issues. Also, your tax calculations will become more complicated, as the employment part of the tax is managed by your employer, but the sole trader profits need to be managed separately by you. If you are functioning as a sole trader, whilst also being employed full time, it is wise to use the services of a professional accounting firm.

Special requirements: Certain sole traders such as restaurant operators, childminders, taxi drivers and street traders need to obtain a licence from a local authority before starting their business. If your turnover crosses the VAT threshold of £81,000, you will also need to register for VAT. In addition, if you are a contractor in the construction sector, you need to register with the CIS (Construction Industry Scheme). You can find more information about the CIS on the HMRC website.

Summary

Sole trader is a good option to start off as a contractor because it requires the least effort. Sole trading is particularly suited for small businesses. However, if the business income is higher, as a sole trader you may pay a higher tax and national insurance as compared to, say, a limited company. Many large companies prefer to work with limited companies as opposed to sole traders, so there may be issues with having a regular work schedule.

As mentioned above, as a sole trader you need to keep a record of your own accounts and file your tax returns. If you are looking for a professional accounting firm, Accounts Direct can help in managing your accounts and taxes assessment for a fixed fee.