Coffee shop owner smiling at the till

Tax-saving tips for self-employed sole traders

November 8, 2021

When starting a business, one of the first things you'll need to settle on is your business structure — that is, whether you'll be operating as a sole trader or a limited company.

There are pros and cons to both structures, and ultimately what may work for one small business might prove to be a complete disaster for another. However, if you're expecting to make losses in the first few years of trading, you might find it more beneficial to operate as a sole trader.

The reason? As a sole trader, you'll be able to claim for any losses you make both faster and more efficiently, especially if you have a taxable income. It's important to note, however, that once your profits exceed £30,000 a year, you might find it more profitable to change your business structure from sole trader to limited company.

In this article, we'll be covering the best ways to make your business tax efficient, from the tax breaks you're entitled to, to how to claim for losses.

Allowable expenses

If you're looking for a simple way to slash your tax bill, knowing the business expenses you can claim against your income is one of the best ways to ensure tax efficiency.

After submitting your Self Assessment tax return, HMRC will work out how much your taxable income is and subsequently base the total amount of Income Tax you need to pay on the final figure. On this basis, the higher your profits are, the higher you can expect your Income Tax bill to be.

However, as a sole trader you're going to incur running costs, regardless of the nature of the work you do. These costs, known as allowable expenses, can be subtracted from your total profit, ultimately shrinking your taxable profit — and subsequently your Income Tax bill.

Taxable profit = Total profit - Allowable business expenses

As a rule of thumb, you can claim back on expenses that are wholly and exclusively related to your business. Purchases that are classified as dual purpose — for example, a mobile phone that is used to make both business calls and personal calls — can count as an allowable expense, but you can only claim back on the proportion that it is used for business.

For certain expenses, such as utility bills or mileage costs, separating the business use from the personal can be more complicated. Fortunately, HMRC offers sole traders the option to calculate these allowable expenses through simplified expenses, a method that uses flat rates to work out their actual business costs.

Pension Contributions

As the captain of your own ship, you're now responsible for doing all the things your previous employers would have done for you, including putting money into your pension pot.

When employed, any contributions to your pension are deductions from your pay packet as part of PAYE. For sole traders, however, your pension contributions are not deducted from your sole trader profits as expenses — but you will receive an increase in your tax bands by the total amount contributed.

What does this mean exactly? To get a clearer picture of how much tax you'll be paying after adding to your pension, we'll need to take a look at tax bands.

If you're a basic rate taxpayer earning less than £37,700, you'll be taxed at the standard rate of 20%. You will also have a personal tax allowance of £12,570 that remains tax-free.

Now, imagine you made a pension contribution of £1000. For basic and higher rate taxpayers, your pension contribution is increased by 25%, bringing the total amount added to your pension pot to £1,250.

This £1,250 is also added onto your tax band, bringing the original threshold from £37,700 up to £38,950. As a result, an extra £1,250 of your income is taxed at 20%, as opposed to the 40% you would have to pay as a higher-rate taxpayer once you've passed the threshold.

Donations

Once you've wrapped your head around pension contributions, you'll be relieved to find that donations work in the same way.

For example, if you donate £100 to a charity through Gift Aid, the government will increase it by 25% for basic and higher rate taxpayers, bringing the total amount to £125. This is then added onto your tax bands, meaning that higher rate taxpayers will be charged only 20% tax on the extra £125 added to the basic rate tax threshold of £37,700.

Money point surrounded by coins

Trading Allowance

If you're new to the sole trading game, you don't need to worry about paying tax on the first few pennies you earn. In fact, you don't have to worry about paying tax on the first £1000 you earn, as this is your trading allowance.

The trading allowance guarantees that the first £1000 made by sole-traders within a tax year is kept tax-free, giving sole traders the runway they need to get their business off the ground before adding taxes into the equation. It also means that casual and miscellaneous income — for instance, cash made from dog walking or babysitting — can be kept untouched.

The full amount of the trading allowance is available if you've only been trading for part of the year. For instance, if you started working in January 2021 and made £400 by April 6th 2021, this would be covered by your trading allowance and would not need to be reported on your Self Assessment, unless you received Self-Employed Income Support during this period.

However, if you run a full-time sole trader business, it's likely that you'll be earning over £1000 within a tax year. In this case, you can choose to deduct the trading allowance from your trading income instead of deducting your business expenses for the period.

With this in mind, you can work out the most tax efficient way to optimise your allowance. For instance, if your allowable expenses are less than £1,000, it would be more tax efficient to claim your trading allowance, as it would mean more money taken off of your taxable profit, and subsequently a lower Income Tax bill. Remember, when it comes to working out your Income Tax, the lower your taxable profit is, the lower your tax bill will be.

Sole Trader Losses

If you're expecting to make a loss in your first few years of trading, you might find it more beneficial to operate as a sole trader. Unlike limited companies, sole traders claim back on tax to offset any losses made, with different tax relief schemes available based on individual circumstance.

Early year loss relief

When starting any business, you mat find yourself making a loss in your first few years. If you've been trading as a sole trader for less than four years, you will be able to offset your losses against your general income of the last three years.

Sideways relief

If you've been trading for a while and have another source of income, you might find it beneficial to claim sideways relief for trading losses incurred during an accounting period. This relief offsets the loss against total profits of the current year, prior year or both. The most efficient year will be dependent on your other income.

Additional relief due to Covid for 20/21 and 21/22

With Covid causing chaos for a lot of sole traders, HMRC has introduced an additional relief that allows sole traders to claim back on losses made against their income from three years ago.

Carried forward relief

Unable to claim any of the above? If this is the case, any losses that have not been offset can be carried forward and can be used to offset any future profits made.

Terminal loss relief

If you make a loss in the last twelve months of trading, you can offset your losses against your trading profits from the last three years.

Summary

Taking the leap from full-time employment to self-employment can feel like a risk, especially if you're expecting to make some losses. However, with the various tax reliefs available for you to claim, you can expect to hold on to more of your money, making your runway just that little bit longer before lift off.

If you're not sure where to begin when it comes to making these claims, or you're not sure if your situation matches the proposed criteria, don't sweat. With our Pro Plan for sole traders, you'll get unlimited round-the-clock support from our team of qualified accountants to help you with any tricky tax questions you may have.

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Steven Anderson

Drawn to Ember for its clear vision and super software, Steven joined the CX team in August 2021 as a Senior Accountant. Boasting over 6 years of accounting experience, Steven brings a wealth of accounting knowledge to the team, and is the person to talk to if you ever need any advanced accounting questions answered.