Setting up as a sole trader

When setting up your business, you need to decide which legal structure your business will take. There are a number of options available to you, including becoming a sole trader, and setting up a limited company or a partnership. Before you begin, make sure you have determined which structure is best for you.

What is a sole trader?

A sole trader is an individual who runs and owns their own business. Becoming a sole trader is the easiest and most common way to set up a small business in UK - it's a simple business structure that allows people to start working for themselves and pay tax directly to HMRC through self-assessment. You do not need to incorporate and register your company with Companies House, or file confirmation statements or full accounts with them each year. You can still employ staff as a sole trader and grow your business.

As a sole trader, you are responsible for all of the business decisions you make, and all of the business's profits (after tax) go to you. However, you are also personally liable for any losses, debts and liabilities your business incurs. This is because your business is not considered to be a separate legal entity from yourself - so your personal assets could be at risk if you cannot pay.

Your responsibilities as a sole trader

Running your own business as a sole trader means you’re self-employed, so you’ll be responsible for looking after your own tax and National Insurance. You are responsible for running your business and meeting the legal requirements that are applicable to you (and not just in your business administration, but across all of your business operations, staff, etc).

To set up your business, you must:

• register with HMRC as soon as you start trading, and complete a Self Assessment tax return on time each year
• keep accurate business records depending on your accounting basis (including income, PAYE records, grants received, and further records if needed) and accurate records of allowable expenses
• ensure you pay any income tax due on your profits and also pay Class 2 and Class 4 National Insurance (You can use HMRC's tax calculator to help you calculate your tax and budget for your tax bill)
• Register as an employer with HMRC if you bring on staff (before their first pay day) and set up a 'Pay as you earn' PAYE payroll scheme to ensure you deduct the correct amount of income tax and national insurance payments from your staff and pay these to HMRC.

Pros and cons of becoming a sole trader

There are many advantages to becoming a sole trader. These include:

• Ease of start up: It is the easiest way to get your business started and has lower start up costs
• Simple structure: Ongoing business administration is also simpler and lower cost. You do not need to file annual confirmation statements, formal corporate tax returns or full annual accounts with Companies House. (You still need to keep accurate records of your invoices, income, expenses, etc and file your self-assessment tax returns).
• Business control: As the business owner, you are in control of all of the decisions you make for your business.
• Profits: As the business owner, all profits after tax belong to you.
• Easier to change structure: As a sole trader it is easier to change the business legal structure if you wish. For example, as your business grows, you may decide to set up your company as a limited company, which is relatively straight forward to do.

However, there are also disadvantages to being a sole trader. These include:

• Unlimited personal liability: As you and your business are the same legal entity, you are personally responsible for all of the losses, debts or liabilities of your business. This means that, should your business fail, your personal assets would also be at risk. For businesses that require heavy investment, opting to be a sole trader can be very risky.
• Harder to gain finance: As a sole trader it can be harder to raise large amounts of capital. Banks can be more reluctant to loan large sums to sole traders as there is less accounting transparency and more personal responsibility. A sole trader also does not have any shares to exchange for investment.
• No legacy: As you and your business are one, if you cease to work (e.g. through retirement, illness, or death) then your business also ceases to trade. It is also harder to sell the business.

Becoming a sole trader can be an excellent choice if you want to be self-employed and want to quickly set up and run your business working for yourself. This structure can be particularly well suited to people:

• working as contractors or freelancers
• offering a service such as photographers, hairdressers, caterers, dog-walkers, book-keepers
• working as an individual trades person, such as plumbers, electricians, decorators, gardeners

The two types of National Insurance you may have to pay are Class 2 and Class 4. Class 2 pays for benefits such as basic state pension and maternity allowances, and is a flat rate for every week you’re self-employed (that includes weeks when you’re on holiday or have no work). You can choose to pay this by monthly Direct Debit or twice yearly, in January and July. HMRC’s site will tell you more about how to pay your National Insurance.

Class 4 NI contributions are based on your taxable profits above a certain limit. They’re calculated (and payable) with your income tax, when you submit your self-assessment.

Watch a short video about National Insurance for the self-employed.

Accurate record-keeping helps you – and your accountant, if you have one – to keep track of your business. In fact, HMRC can fine you if you don’t keep sufficiently accurate financial records – preferably for the last six years of trading.

Your records should cover all money coming in and going out of your business, whether it’s by cash, cheque or credit card. As you’re self- employed, you’ll also need to differentiate between personal and business use of equipment such as computers, as HMRC will need to know that too. Just update all this information regularly, and your record keeping will become a little easier. You can also speed things up with one of the many financial record keeping software packages.

Accounting periods

Your accounting period – the length of time your financial records apply to – is up to you. It’s normally twelve months. The last day of your accounting period is known as your ‘accounting date’, and it’s usually simplest to keep this to April 5th, the last day of the tax year.
HMRC also introduced a new approach to accounting periods called ‘cash basis’, in 2013/14. This means you only record money when it goes in or out of your business, rather than when it’s invoiced. It’s optional, but not right for everyone. Find out more about cash basis.

Read more about keeping records for business.

What you can claim as a business expense

Allowable business expenses can be deducted from your business income, reducing the amount of your profit that becomes taxable. But you need to separate the money you spend on business from private use, because you can’t claim for personal expenses or money you pay to yourself. Likewise, if you buy something that you use mostly for business but sometimes for personal use, then you can only claim for a percentage of it – and that needs to be based on the evidence of your financial records.

Your business may have two types of expenses – business expenditure and capital expenditure.

Business expenditure

Business expenditure refers to the running costs of your business. Here are a few examples:

Vehicle running costs

You can claim the cost of any business journey you make using a car or van using one of these two methods:

1: Mileage allowances

Work out how much you claim using a fixed rate per business mile. You’ll need to log the date, destination, purpose of the journey and mileage covered. You can use this method as long as your turnover is below the VAT threshold.

2: Actual running costs

This is a record of all costs, including fuel, repairs and servicing. Again, you can only claim costs for the business use of your vehicle throughout the business year.

Wages, salaries and other staff costs

If you take on staff, you can claim the cost of the wages, salary, commission, bonuses and employer’s National Insurance.

Rent, rates, power and insurance costs

If you have business premises, you can claim for rent, business rates, water rates, light, heat, power and any other associated costs. Or if you run your business from home, you can claim a proportion of your utility bills, based on the size of your home and how frequently you use it for business.

See some examples of claiming home business expenses.

Repairs and renewals of property and equipment

Like for like repairs (not improvements) and maintenance of your business premises are allowable expenses. You can also claim the cost of repairing business equipment and replacing small tools.

Accountancy, legal and professional fees

If you decide to use an accountant or bookkeeper, you can claim the cost of their fees. You can also claim the cost of other professionals, such as solicitors or architects. Professional fees such as public liability or professional indemnity insurance are allowable expenses too.

Phone, fax, stationery and office costs

The costs of your phone, stationery, postage, running a computer and Internet charges are all allowable expenses. If you use a phone privately and for business, you can only claim for the business calls – itemised bills help with this. The same applies to Internet use.

Clothing

Clothing that’s essential to your business (such as protective overalls) is an allowable expense. Everyday clothing, even a business suit, is not.

Training

You can claim for any training to update existing skills or expertise. However, you can’t claim for training for new skills or qualifications or academic qualifications

Capital expenditure

If you’re using the cash basis for your expenses, you can claim the cost of buying large items for your business, such as a car, van, computer or other equipment. This is known as capital expenditure, and you can claim a percentage of their cost or value.

Find out more about capital expenditure.

Simplified expenses

If you buy or use something in your business and also privately, you just need to work out the business part. To help with this, HMRC have introduced three simplified expenses schemes, using flat rates instead of actual costs. These cover motoring costs, using your home for business and business premises that are also used as the family home. This saves you from having to make complicated calculations.

These schemes are optional for all unincorporated businesses, regardless of income.

You can find out more in this video – Simpler income tax – cash basis and simplified expenses.

When you need to complete your tax return, the easiest way is to use HMRC’s self-assessment website. It’s more secure, and you also get a little longer submitting your return online: 31st January, as opposed to 31st October for paper returns. Bear in mind that late submission can mean paying a penalty, on paper or online.

Unlike Class 2 National Insurance, which you’ll pay either by direct debit or twice yearly, Class 4 is paid along with your income tax by 31st January. This is known as a ‘balancing payment’.

Payments on account

If your combined income tax and Class 4 National Insurance bill for the tax year is more than £1,000, on 31st January you’ll pay your balancing payment and your first payment on account. Then on 31st July, you’ll pay your second payment on account.

Payments on account are based on your previous tax year, and put your account for the coming tax year ‘in credit’. So in January you’ll pay your previous year’s tax bill, plus 50% of it. Then by the end of July, you’ll pay a further 50% of the previous tax year’s bill.

Here’s an example:

This payment cycle will continue until John closes the business.

You can pay electronically or by post, although electronic payments are safer, more secure and more convenient.

Find out more about how to pay.

How to budget for your payments

Planning for your payments means avoiding late payment penalties – particularly as you won’t get your first bill for quite some time. To help you decide how much money to set aside for your tax and National Insurance, take a look at HMRC’s self-employed ready reckoner.

If you prefer, you can set up a budget payment plan to help your business stay on top of payments.

Larger businesses have greater responsibilities than smaller ones, such as VAT and staff. So as your business grows, you’ll have more to think about.

Taking on staff

If you need to take on staff, you might need to register as an employer. You can do this using HMRC online, by phone or email. You can register up to four weeks before your first payday. Find out whether you need to register as an employer.

As an employer, you’ll also have other responsibilities such as paying your employees at or above minimum wage, paying statutory sick pay (or using your own company scheme), workplace pension schemes, and other statutory payments.

Read more about employing people.

Running your payroll

If you hire staff, you’ll need a system to pay them and make the appropriate deductions for National Insurance, income tax, or student loan payments.

Read more about software packages and payroll options.

Basic PAYE tools package

This is from HMRC, and it features a ‘Learning Zone’ to guide you through your responsibilities as an employer.

Download the Basic PAYE tools package.

What is VAT?

Value added tax (VAT) is charged on products and services from VAT registered businesses. If your business’s taxable turnover reaches the VAT registration threshold, you’ll need to register for VAT.

How and when to register for VAT.

HM Revenue and Customs (HMRC) has launched a new interactive online tool and clearer guidance for people working for themselves and individuals considering self-employment.

Aimed at supporting new and existing 'sole traders' to better understand their responsibilities, the new interactive tool explains the records they may need to keep, taxes that may apply to their business, and includes other useful information, for example how to pay a tax bill.

HMRC’s new Set up as a sole trader: step by step guide supports people working for themselves to understand when they may need to register as a sole trader and how to do so.

There are several HMRC interactive tools available, including one to help businesses estimate what VAT registration may mean for them.

The VAT Registration Estimator was developed after feedback from small businesses suggested an online tool would be helpful to show when their turnover could require businesses to Register for VAT: When to register for VAT - GOV.UK and its effect on profits.

The guidance and interactive tools are free to use and available directly from GOV.UK.

To find out who has topay VAT payments on account, how HMRC works out your payments, the alternatives of how when to pay, see VAT payments on account - GOV.UK