Tax 101 for small businesses

When you start your own business, you'll probably run into the UK tax system at an early stage. In fact, tax for businesses of all sizes is a detailed and generally unavoidable obligation.

But knowing which of the rules are relevant to your small business - and when they're relevant, won't just help you to avoid any unwelcome penalties, it will also help to ensure that you don't miss out on any exemptions or tax reliefs (of which there are a number that small businesses who are tax compliant can claim).

Tax compliance is also considered compelling evidence of good business management and integrity; factors often critical to success in sales, investment and recruitment opportunities.

Here are some of the most common taxes, and reliefs or exemptions, that you're likely to encounter as a small business owner.

Different approaches apply to different types of business model.

Sole traders

If you're a sole trader, you'll pay income tax on your business's profit. (Profit is what you make once you've deducted all your costs of running your business from the sales or other income that you've received, within a defined time period.)

If you're at a pre-sales stage and don't have any income yet, then you'll only start paying income tax on your business's profit once it goes over the legal personal allowance threshold. You can check the current threshold on the government's website.

Partnerships

Partnerships established in the UK can be divided into:

• General partnerships
• Limited partnerships
• Limited liability partnerships
• Scottish partnerships

The rules regarding the different types of partnership are detailed and only very brief details have been given here. We recommend taking both tax and legal advice to help you draw up any of these types of partnership and to consider the related options and risk mitigation solutions applicable to you. Each model has its pros and cons.

(1) General partnership

The most common form of partnership in the UK is a general partnership. A general partnership is not a separate legal entity like a company, but an association of persons, usually individuals, and sometimes including one or more companies. You can find out more on how to set up a general partnership in our guide to setting up a partnership. And you can use our template general partnership agreement to help too.

(2) Limited partnerships

You won't come across these often. Limited partnerships are formed under the Limited Partnership Act 1907. They have one or more general partners and one or more limited partners.

Limited partners restrict their overall liability for how the business is run and whether it succeeds longer term, to a pre-determined sum.

These type of partnerships are not used much except in certain specialised areas, such as venture capital investments.

It's important not to confuse limited partnerships with limited liability partnerships.

(3) Limited liability partnerships

Legislation introducing the possibility of limited liability partnerships (LLPs) came into existence for the first time in 2000.

LLPs combine the flexibility of partnerships with the benefit of limited liability for their members. The liability of an LLP member for the LLP's debts is restricted to their capital contribution, unless that partner is negligent in relation to the work carried out for a client.

Far more like limited companies than general partnerships, LLPs are regarded as 'bodies corporate' in commercial law and have a legal personality separate from their members. Each LLP must be registered at Companies House and file audited accounts.

You can find out more on how to set up an LLP in our guide to setting up limited liability partnership. And you can use our template limited liability partnership agreement to help too.

(4) Scottish partnerships

A Scottish partnership is similar to a general partnership, but it's treated as a legal entity. This means that the partnership can enter into contracts and hold property in its own name.

Tax treatment of partnerships

All UK partnerships are treated as transparent for tax purposes (including LLPs and Scottish partnerships, despite the fact that they have a legal personality). This means that you 'look through' the partnership vehicle and tax the partnership income in the hands of the partners themselves.

Even though the partnership is transparent, the first step in working out the partners' tax position is to calculate the profits from a trade or profession as if the partnership were a UK resident individual, using the normal rules.

Once the overall tax-adjusted trading profit or loss is established, it's divided up between the partners in their agreed profit-sharing ratios. These are normally set out in the partnership agreement.

Each individual's share is taxed or relieved as if it derived from a trade or profession carried on by him/her alone. This means there is a 'notional trade' carried on by each partner separately.

If you run your business as a limited company, you'll pay income tax on any salary or dividends that you take from the company.

Whether you pay income tax, and how much you pay, depends on how much salary and/or dividend that you take out.

Income tax is payable on your salary if it's over £12,570 and you have no other income.

If your situation is different - for example you have another job as well as working for your own company - then you may start paying income tax on your salary sooner.

If you're paying income tax on your salary, your employer, in this case your own company, should deduct it from your salary under the PAYE (Pay As You Earn) scheme. PAYE is a method HMRC use to collect income tax and National Insurance contributions.

Your company is legally required to use the PAYE process for all employees who receive a salary above the current PAYE salary threshold and who must pay National Insurance contributions above a given threshold also (see below). There are a few other conditions that you can also explore in the link provided above.

Our guide to NI and PAYE for employers (coming soon) contains more information on how PAYE works and what you should expect.

Strictly speaking, National Insurance (NI) is not actually a tax but is a contribution paid to the government to fund certain state-provided benefits, including unemployment benefits and the state pension.

You pay National Insurance if you're 16 or over and are either:

• An employee earning above a certain threshold each week (currently £242)
• You're self-employed and making a profit above a defined level each year (currently £6,725)

Check the current thresholds here.

There are different types of National Insurance (known as classes). You can find out which apply to your business here. The type of NI that you pay depends mainly on your employment status and how much you earn.

(1) Self-employed

If you're self-employed, you usually pay 2 types of National Insurance (for all National insurance classes check out this link).

• Class 2 - if your profits are £6,725 or more a year, you'll usually pay Class 2 contributions.
• Class 4 - if your profits are £12,750 in 2023/24, you'll also pay Class 4 contributions.

The Class 2 and Class 4 NI rates for 2023/24 are as follows:

• Class 2: £3.45 a week
• Class 4: 9% on profits between £12,570 and £50,270 and then 2% on profits over £50,270.

For the government's official figures, click this link.

To protect your entitlement to the state pension and other state benefits, you might want to pay NI voluntarily if your profits are below £6,725 per year according to this guide from the gov.uk website.

(2) Limited companies

There are rates applicable to both the corporate employer and any employees.

If your business is a limited company and you're employed by the company and/or the company has other employees, the employees are liable to pay Class 1 National Insurance contributions. The company will pay this to HMRC for the employees, deducting the amount from the employees' wages, at the same time as paying income tax under PAYE - usually monthly.

The current Class 1 NI rates for most employees for the 2023 to 2024 tax year are:

• On pay of £242 to £967 a week (£1048 to £4,189 a month): 12%
• On pay of over £967 a week (£4,189 a month): 2%

And then there are the additional rates that apply to the company, as an employer.

The company will also have to pay Class 1 employer's NI to HMRC, usually at the rate of 13.8%, unless, exceptionally, you're a business covered by the Employment Allowance.

When do you stop paying NI?

If you're employed, you stop paying National Insurance when you reach the state pension age.

If you're self-employed you stop paying:

• Class 2 National Insurance when you reach State Pension age
• Class 4 National Insurance from 6 April (the start of the tax year) after you reach State Pension age.