Alan Pink looks at key issues and opportunities to be considered by those starting up in business for the first time.
Whether you’re completely new to business or are simply opening up a new line of business, there’ll be an awful lot to think about and attend to as part of the process of getting the business off the ground.
Tax may well seem like the sort of thing that can be left until later (preferably much later!). But it’s important not to forget tax because getting things right when you start, or even before you start, can make a very substantial difference to the tax costs that your business will face. I’ll explain how, in what follows.
For the record
It has never been more important to get your record keeping right at the outset of a business than it is now. This is because of the government’s ‘making tax digital’ (MTD) programme, which is basically a legal requirement to use certain types of software to keep your records, which come on an approved list of software programs.
MTD is currently compulsory for all businesses whose turnover is over the VAT threshold (£85,000 at the time of writing). Those who are below that limit, but have decided to register voluntarily for VAT (of which more later) currently don’t have to apply MTD but shortly will have to. It’s suggested that, from 6 April 2023, MTD will also come in for income tax as well, so even non-VATable businesses, and small businesses (if their turnover is more than £10,000) will have to buckle under the new regime.
So much for MTD. But more generally, the important thing as far as record keeping is concerned when starting a business is to ensure that, one way or another, your system picks up all the expenditure (and income) that the business incurs.
Unpaid tax collectors!
Like PAYE, VAT is an example of the government using businesses as unpaid tax collectors. First of all, you need to decide whether your business provides the sort of goods of services which have VAT charged on them.
Basically, almost all goods and the majority of services are chargeable to VAT at 20%. But there are a series of exemptions, of which probably the most common are letting, doing up and selling homes, medical services, insurance and financial services, undertakers, education, and letting commercial property on which there is no ‘option to tax’. If you are VAT exempt, it doesn’t matter how high your turnover is, you aren’t obliged to register and can’t register even if you wanted to.
For those who make taxable supplies (which is basically everything else), they have the choice whether to wait until their turnover (over an annual period of reckoning) has exceeded the threshold or to register voluntarily below that figure.
At first, the idea of volunteering to become a government tax collector for nothing might seem crazy. However, in certain circumstances it can actually be very good for your business’s financial health. This is because of the way VAT works; giving registered traders the right to reclaim VAT on expenses they incur, as a corollary to the obligation to charge VAT on the services and goods they supply. If a business’s customers are all VAT registered and can reclaim all the VAT charged to them, making yourself VAT registered voluntarily does not, effectively, make you any more expensive as far as they are concerned, even though 20% is added to what they pay you for your goods and services. But the difference it does make is that you can generally reclaim VAT yourself on purchases and expenses, and hence hopefully make a lot more profit.
Pre-trading expenses and assets introduced
If you’re starting a business, it can be important not just what money you pay out or receive after the business has commenced, but what has happened beforehand; sometimes many years before. The tax rule is that pre-trading expenditure (i.e. expenses that relate to the trade but are incurred before commencement) are basically all carried forward and treated as if they had been incurred on the first day of trading. So it’s obviously very important to have a substantiated note of these.
VAT can also be incurred on pre-trading expenditure and reclaimed when you register, subject to certain time limits. But a point which is often forgotten, and which can make a considerable difference to the amount of tax payable by the business when it does start, is the question of assets previously owned which are then pressed into service for the needs of the business.
Probably the most common examples of these are computer equipment that was previously used privately, and cars. But it can also apply to furniture and fixtures in your home, if part of it comes into use as an office, for example. The way the tax rules work is that the assets are treated as being brought into the business at their market value on the first day of trade, and capital allowances (i.e. a form of ‘depreciation’ which applies for tax purposes) can be claimed on them.
If you are using an accountant to do your year-end accounts and tax returns, make sure you bring all these previously-owned assets to his attention, because most accountants aren’t psychic and won’t know about these assets unless you tell them!
How to structure the business
Such is the complexity of our tax system that a very considerable difference to your tax burden can also be made by how you structure the business. The fundamental difference is between two types of business vehicle: sole traders, partnerships, and limited liability partnerships on one side of the fence; and limited companies on the other.
The essential difference here is that for partnerships etc. the tax falls on the individual partners rather than on the business itself, and is chargeable at whatever the top rate of tax applying to that person is. It makes no difference, in these structures, whether you draw the money out of the business or leave it in; the tax is the same.
With companies on the other hand, there is a fixed rate of corporation tax that applies to a company’s profits, which at the time of writing is 19%. In the company sphere, however, it does make a difference (and sometimes a very considerable difference) whether you draw the money out of the company or not. Drawings out of a company are generally either by way of remuneration as director or dividends, with remuneration being an allowable expense for corporation tax purposes, and dividends being non allowable. Because dividends are non-allowable (i.e. because they come out of profits which have borne corporation tax) they are taxed at a lower rate of income tax than other types of income. So a 40% taxpayer pays 32.5%, not 40%, on dividends, and a 45% taxpayer pays 38.1%. Basic rate taxpayers pay a relatively miserly 7.5%.
Rules of thumb
There isn’t space here to go into great detail about the ‘pros and cons’ of starting your business as a company on one side, or a sole trader/partnership on the other. I’ll probably have to content myself with a few very simple rules of thumb, in the hope that these are helpful. The first rule of thumb is that, if your type of business is the type which shows start-up losses (including losses as computed for tax purposes arising from 100% write-off of capital equipment purchases, for example) it may be unfortunate to start off by running your business through a company. That is because losses in a company are basically ‘trapped’ there.
By contrast, losses incurred by an individual or partner can be offset against their other income, and even be carried back three years in the first periods of a business’s operation. On the other hand, limited companies can be very advantageous if the profits of the business are so high, or your other income is so great, that you would be paying 40% tax if you were receiving the income as a sole trader/partner. However, this is only helpful if you are able to, or have to, retain profits within the company rather than simply pay them all out as dividend.
