An Introduction to Tax, National Insurance and VAT

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Introduction

There are three main types of tax that are relevant to most organisations: income tax; National Insurance; and value added tax (VAT). Limited companies are also liable to pay corporation tax.

This factsheet outlines these taxes, explains how they affect different organisations and individuals, and outlines any obligations under the law.

Income tax Sole traders pay income tax on the profit that their business generates. In partnerships, the profit is divided between the partners (according to the terms agreed in their deed of partnership) and each partner is taxed on the portion of the profit that is allocated to them.

Profit is what remains of a sole trader's or partnership's income after all material costs, overheads, wages for employees and allowable business expenses have been deducted. Capital allowances - based on expenditure on capital assets - may also be deducted before profits are calculated. A sole trader or partner's personal income tax allowance (£12,570 for the tax year 2022/23) is deducted from this profit and the remainder is subject to income tax at the current rate.

A sole trader or partner must assess their own tax under 'tax self-assessment', complete a tax return and pay any tax due to HM Revenue & Customs (HMRC) by the deadlines of 31 January and 31 July each year. Partnerships have to submit a partnership tax return in addition to individual returns.

If there is sufficient profit, limited companies can pay dividends to its shareholders. It can be advantageous for shareholders who also work in the company (usually directors of the business) to take a lower salary and a higher dividend, as dividends do not attract National Insurance contributions (NICs). However, tax must be paid on dividends above a £2,000 tax-free dividend allowance. In 2022/23, the dividend tax rate is 8.75% (for basic rate taxpayers), 33.75% (for higher rate taxpayers) and 39.35% (for additional rate taxpayers). If the directors of a limited company pay themselves a salary, they pay income tax on their salaries, as other employees do.

Employers are required to deduct income tax from their employees' wages and salaries and pay this to HMRC. This is known as Pay As You Earn, or PAYE.

PAYE Under the PAYE scheme, an employer must deduct income tax and NICs from their employees' earnings and pay these deductions to HMRC each month. Where the combined bill for PAYE and NICs is less than £1,500 per month, payments can be made quarterly.

Corporation tax If a business is registered as a limited company, it is liable to pay corporation tax on any profits the company makes.

The rate of corporation tax for 2022/23 is 19%.

From 1 April 2023, the rate will increase to 25% for profits over £250,000. The rate for small profits under £50,000 will remain at 19%. A tapered rate will be introduced for profits between £50,000 and £250,000.

National Insurance National Insurance is a contribution towards state benefits such as Universal Credit and the state pension. If an organisation employs staff, it must ensure that both employers' and employees' NICs are paid. Self-employed people have a separate contribution structure. The amounts involved can be significant and the different tax structures and advantages of one system over another can be a factor in helping business owners decide whether to set up their business as a sole trader/partnership or limited company.

There are four classes of NICs:

Class 1 contributions Class 1 NICs apply to employed people and are paid by both the employer and the employee. They are calculated as a percentage of gross pay. It is the responsibility of the employer to pay both contributions, deducting the employees' contributions from their salaries through the PAYE scheme.

From 6 April 2022, the rate of Class 1 contributions paid by employees and employers increased by 1.25%.

Class 2 contributions Class 2 NICs are paid by self-employed people, whether sole traders or partners, whose annual earnings are above the lower profits limit. From April to June 2022, the lower profits limit is £9,880. For the remainder of the 2022/23 tax year it is £12,570. In 2022/23, Class 2 NICs are set at a flat rate of £3.15 per week.

Provided that their annual earnings are above the small profits threshold (£6,725 in 2022/23), self-employed people will receive National Insurance credits that will count towards their entitlement to state benefits, even if they are not paying Class 2 NICs.

Self-employed people whose annual earnings are below the small profits threshold can choose to pay Class 2 NICs voluntarily to protect their entitlement to state benefits.

Exemptions from paying Class 2 NICs can be made for individual weeks if someone who is self-employed is unable to work due to illness or other forms of incapacity. Class 3 contributions Class 3 NICs are voluntary contributions, set at £15.85 per week in 2022/23. They allow self-employed people to protect their right to contributory benefits even if they are not liable to NICs under Class 1 or 2, or have not paid enough contributions in the past to qualify for state benefits.

Class 4 contributions Class 4 NICs are payable by the self-employed. In 2022/23, they are set at 10.25% of profits over the lower profits limit and up to £50,270, and 3.25% of profits above this upper level. Class 4 NICs are paid to HMRC at the same time as income tax. Class 4 contributions do not count towards state benefits.

Value Added Tax (VAT) VAT is a tax on most goods and services, and is paid at each stage of the production and distribution chain. Some goods and services, such as insurance and education, are VAT-exempt. If a business expects to turn over more than £85,000 a year (and the business does not exclusively sell goods or services that are exempt from VAT), the business is required to register with HMRC. The compulsory VAT registration threshold is usually raised in April each year.

There are several different rates of VAT, as follows:

The standard rate (20%). This covers all goods and services that are not exempt, zero- or reduced-rated.
The reduced rate (5%). This is charged on certain goods and services, for example domestic fuel and power, children's car seats and nicotine patches. The renovation and conversion of certain buildings is also subject to the reduced rate.
The zero rate (0%). This applies to specified categories of goods, including children's clothes, food (exclusions apply including restaurant meals and catering supplies), books and newspapers. The advantage of goods being zero-rated is that they are still included in taxable turnover, so input tax can be recovered.
Temporary zero rate for energy-saving materials. From April 2022 to April 2027, the installation of certain types of energy-saving materials is zero-rated for VAT in England, Wales and Scotland.

If turnover is lower than the legal threshold for registration, a business may register voluntarily for VAT.

Hints and tips

Tax-related records must be well organised and payments should be kept up to date and made on time.
It is advisable to talk to an accountant in order to fully understand any business or personal tax obligations.
Slips and paper records of sales, purchases and wages should be retained and kept safe for up to five years in case they are needed for a tax inspection.

Contact Ashored for help and support with your taxes.