Small business sector
Small businesses, or more accurately micro-businesses, which are defined as employing up to nine people, make up a huge proportion of the client base for small and medium sized accountancy firms. Parliamentary research in November 2016 found there were 5.498 million private sector businesses in the UK, of which 5.254 million were micro-businesses.
These micro-businesses account for 19% of turnover and 32% of employment in the UK. Since the year 2000 the number of private businesses in the UK has increased by 3% on average each year, but the proportion of these businesses which employ people has fallen from 32% to 24% over that period. This is due to the number of one-person businesses (those with no employees) increasing at a faster rate than growth in the business population as a whole.
This article focuses on four areas of advice accountants can help micro-businesses with in their day to day operations. There will be other issues a business may need help with, such as the sale of the business or retirement of the owner, when specialist advice on capital gains tax reliefs and inheritance tax planning will be relevant.
Businesses who are also employers often need help with running a payroll, and this applies equally to one-person companies as larger concerns. Where the business employs more than just the owner/ director, it will need to understand the employer obligations to pay the national minimum wage (NMW) and to provide access to a work place pension (auto-enrolment). Accountants may wish to help their clients with these additional areas of administration.
The first tax-relevant decision a person has to make concerning their business is the type of trading vehicle to trade through. This boils down to:
- a limited company which pays corporation tax;
- an unincorporated business (sole trader or partnership), which pays income tax and national insurance contributions(NIC) on the profits; or
- a limited liability partnership (LLP), which has some of the advantages and the reporting requirements of a company but is generally subject to income tax and NIC like an unincorporated business.
The current rate of corporation tax (19%) is lower than all the rates of income tax which apply to profits of an unincorporated business (20%, 40%, 45%), and in most cases the trader will also pay national insurance (NIC) at 12% or 2%, on those same profits. Although a comparison of these tax rates appears to favour incorporation of a business, the full end-to-end tax burden should be considered, including the cost of extracting funds from the company.
Each method of funds extraction chosen, eg: salary, dividend, rent, interest, pension contribution or other benefit in kind, will trigger a different tax charge. The needs of the business owners may change over their lifetime, and the tax rules change from year to years, so an annual reappraisal of the methods used for fund extraction would be appropriate.
The decision to incorporate, or operate as an unincorporated business, should consider the requirements of the owners and the expected growth of the business over several years. The structure of the business can be changed from unincorporated to a company, and there are tax reliefs to encourage this, but the tax relief for the reverse: disincorporation is very limited.
It is possible to operate a business in a form which combines individuals and companies in a mixed partnership, but there are anti-avoidance rules to prevent the tax rules being manipulated by using such structures.
The owner of a micro-business needs an accounting system which will provide meaningful information on a timely basis, and produce accounting reports in an acceptable format for submission to HMRC and Companies House (for LLPs and companies). Accountants play a key role in helping their clients set up and operate accounting systems which work for each individual business.
The flexibility of accounting software to record transactions and report using accruals accounting (under UK GAAP rules), or a version of the cash basis, is important. Most unincorporated trading businesses can start to use the cash basis if their annual turnover is no more than £150,000. The business can then carry on using the cash basis until its annual turnover reaches £300,000.
LLPs, although not incorporated, are barred from using the cash basis, as are businesses which use profit averaging rules, or the herd basis for livestock farmers. Individual landlords were not permitted to use the case basis for periods before 2017/18. However, the law is to be changed with retrospective effect from 6 April 2017, to make a property version of the cash basis the default option for individual landlords of residential property, where the annual turnover is no more than £150,000. The landlord will be able to opt out of the cash basis and use accruals accounting instead.
Where a micro-business is required to, or opts to use GAAP accounting, it can choose to use a financial reporting standard tailored for micro-entities: FRS 105. This standard replaces the Financial Reporting Standard for Small Enterprises (FRSSE) for accounting periods for accounting periods beginning on and after 1 January 2016. The business is not forced to prepared its financial statements under FRS 105 rules, it can use to apply another accounting standard.
Employment status issues
Where an individual provides their personal services to another business, both parties to the arrangement need to be clear whether it is a contract for services (self-employment), or a contract of service (employment). If the arrangement amounts to an employment the engager must deduct tax and NIC under PAYE. This is generally the more expensive option for both parties.
The fuzzy line between employment and self-employment has encouraged micro-businesses to operate through the wrapper of a company or partnership, to avoid their customer (the engager), having to pay employers’ NIC and operate PAYE. Such personal service businesses must consider whether the IR35 rules apply to each contract they perform.
From 6 April 2017, where personal service contracts are performed for public sector bodies, such as the NHS or BBC, the end-client (the public sector body) must decide whether the IR35 rules apply. This decision must then be communicated down the engagement chain, so the fee-payer understands that it must deduct tax under PAYE from the amount invoiced by the worker’s company.
VAT is a deceptively simple tax with only three tax rates applicable to supplies made in the UK: 0%, 5% and 20%. However, there are two other circumstances in which no VAT should be charged, when the transaction is:
- outside the scope of VAT; or
- exempt from VAT.
Exempt sales are not the same as zero rated sales, and the differences must be clearly understood to avoid penalties arising for VAT-related errors. For example, exempt sales don’t count towards the turnover test to determine whether the business must register for VAT, but zero-rated sales do form part of that turnover. The ability to reclaim VAT on purchases can be affected by the proportion of exempt sales a business makes, and this can lead to partial exemption problems.
Many disputes with HMRC arise from the business not registering with HMRC at the right time, as this series of articles discussed.
When a transaction involves land or buildings the VAT implications must be considered carefully because any of the five ways to charge (or not charge) VAT can apply. A key decision with regard to property is to know whether and when the owner should exercise their option to tax the property (i.e. to apply VAT at the standard rate), as has been explored in this series of articles.
Small businesses can take advantage of three schemes to simplify their VAT recording and reporting:
- Flat rate scheme for small businesses
- Annual accounting
- Cash accounting
There are also sector-related VAT schemes such as; the flat rate for farmers, the tour operators margin scheme (TOMs), and the universal margin scheme.
When trading across international borders the trader must understand the place of supply rules, which are different for services and goods. The VAT treatment depends on whether the customer is a business (business to business: B2B supplies), or a non-business (business to customer: B2C supplies).
Where services supplied to non-business customer in another EU country are of a digital nature, broadcasting, or telecoms, the VAT MOSS rules apply. In this case the turnover test is irrelevant, as the UK business will have to register to use VAT MOSS reporting even where the volume of sales is very small.
The future of tax compliance is certainly digital, as HMRC push forward with the Making Tax Digital (MTD) project. Although the start of this project has been delayed for the small businesses, VAT registered businesses are on track to start reporting under MTD from April 2019. Those businesses will be the first to be required to keep digital accounting records, and to use accounting software to submit reports to HMRC on a quarterly basis.
Many changes will need to be made to the tax system to allow accounting data to reported digitally with minimum human intervention. It is inevitable that the tax rules will have to be simplified, and this will create winners and losers as concessionary treatments, and specialist allowances, are abolished.
Some accounting rules will have to be changed or amended to fit with the digital agenda. We have already seen this with the expansion of cash accounting. The finance reporting standards FRS 102 and FRS 105 may well be adapted further in the future.
About Rebecca Cave
Consulting tax editor for Accountingweb.co.uk. I also co-author several annual tax books for Bloomsbury Professional and write newsletters for other publishers.