Thinking of starting your own small business or going freelance? Many people choose to become a sole trader (AKA self-employed), but before making your decision, what key facts should you know about becoming a sole trader?
1. Becoming a sole trader is the most popular option
According to the Government, in 2022, 74% of British businesses were sole traders (they did not employ anyone other than the owner), that’s about 4.1 million businesses out of a total of 5.5m. Sole traders – often alternatively called the “self-employed” – drive the UK economy. A sole trader is the exclusive owner of their business. What about sole trader tax? When you’re a sole trader, you pay tax on your profits and keep what’s left, also taking into account any allowances and reliefs.
2. Registering as a sole trader is dead easy
Want to know how to become a sole trader? You’ll need to register for self assessment to pay sole trader tax. Self assessment is the system HMRC uses to collect income tax. Registering to become a sole trader can be done online very quickly. If you haven’t registered to become a sole trader before, after registering, HMRC will send you a letter with your 10-digit Unique Taxpayer Reference (UTR) and set up your account for the self assessment online service.
If you have filed a tax return online before, you’ll need to re-register by filling out form CWF1. You’ll need your 10-digit UTR from when you registered before. You can find out your UTR if you don’t know it. You’ll need to register with HMRC for the Construction Industry Scheme if you’re working in the construction industry as a subcontractor or contractor.
3. You can be fined for not registering with HMRC
As soon as you become self-employed, you should register with HMRC. The latest you can register with HMRC is by 5 October after the end of the tax year during which you became self-employed. The tax year runs from 6 April one year to 5 April the next. Register too late to pay sole trader tax or not at all and there can be severe penalties.
4. Being a sole trader involves some personal financial risk
As a sole trader, you are the business. It’s not a separate legal entity, as it would be if you formed a limited company. Therefore, you’re liable for your business’ debts. If you’re starting a business that won’t build up big debts, becoming a sole trader isn’t too risky. You can take out insurance to mitigate for some risks such as business interruption. If you are likely to build up significant debts or you are unwilling to take on the personal risk, setting up a limited company would be a less risky option.
5. Sole trader tax admin costs are usually cheaper
You have to pay to set up a limited company and running it requires slightly more administrative effort when it comes to tax. Registering as a sole-trader costs nothing, while accounting costs and tax liabilities are likely to be cheaper than if you started a limited company.
6. Sole traders can still employ people
But if you do employ people, you must collect income tax and National Insurance contributions (NICs) from them and pay these to HMRC. You’ll need to operate a PAYE (Pay As You Earn) payroll scheme for this purpose.
7. Sole trader tax is simple enough to understand
You pay income tax based on your business profits. You (or your accountant) must fill in a self assessment tax return each year, detailing your income and expenses. You’ll also have to pay Class 2 NICs throughout the year if your profits are more than £12,570 a year (£3.45 a week in 2023/24). If your annual profits are more than £12,570 (2023/24), you’ll also have to pay Class 4 NICs. You pay this with your income tax and the figure is calculated from your self assessment tax return.
8. Sole traders must also keep detailed financial records
That includes details of all your sales. You must also keep proof of any expenses (eg receipts, invoices, utility bills, etc for any stock and supplies or other outgoings you might have). In any case, these will help when filling in your tax returns. Keeping basic financial records (aka bookkeeping) doesn’t have to be as arduous as it might sound.
9. Some sole traders must be VAT-registered
If your turnover exceeds the VAT threshold (currently £85,000 a year), you will need to register for VAT. When you’re VAT registered, you charge your customers VAT on VAT-able sales and pay it to HMRC. In turn, you can reclaim the VAT you pay on goods and services you buy.
10. Sole trader businesses can become limited companies
The size and nature of your business can change quickly. And for a range of reasons (including increased exposure to risk) you might want to set up your own limited company (“incorporate”) at a later stage. Providing someone else hasn’t already registered the name, you should be able to use your sole trader name (with Ltd added, of course).
11. 31 January and 31 July are key sole trader tax dates
Sole traders pay tax on the 31 January following the end of their tax year. Crucially, HMRC will request payments on account for the following year’s estimated tax – on 31 January and 31 July each year. That means, after your first year in business, your tax bill could be 150% of what you were expecting to pay, with another 50% payable in July.
12. Sole traders should open a separate business bank account and save money for tax each month
Opening a dedicated business bank account makes it easier to keep your business and personal affairs separate. Keeping them separate also makes it easier to keep track of your business income and expenses and to complete your self assessment tax, VAT and PAYE returns. There’s a wide range of online and high street business bank account providers and the best one for your business will depend on what services you want from your bank.
Once you have opened an account, it is wise to put away some money each month to cover your tax bills. When it comes time to pay HMRC, you’ll be glad you put a few quid away each month. Being faced with a large tax bill you haven’t saved for is a nightmare. Try to put 25% of your earnings into a separate bank account (and don’t dip into it). Failing to pay your tax bill on time will result in penalty charges.
13. Sole traders have to wear many hats
Crucially, you’ve got be good at sales and marketing. If you don’t make enough sales, your business will fail – simple. There will be admin tasks to take care of, too, including simple accounting/bookkeeping. Paying an accountant to do your tax return can save you time, but you’ll still have to maintain simple financial records. Having to manage employees for the first time could prove a big challenge, too. Online business tools such as Google Workspace will help you manage your admin better and allow you to communicate and collaborate with customers, staff and suppliers.
DISCLAIMER: This article should not be regarded as constituting legal advice in relation to particular circumstances, and is merely a general comment on the relevant topic. If specific advice is required in connection with any of the matters covered in this article, please seek the services of a legal professional.