There are few certainties in life, but the late Benjamin Franklin named taxes as one of them. For most UK workers and businesses, that’s certainly true. No matter you do business, you’ll face certain tax obligations on any eligible taxable income.
As an employee, tax is generally calculated and deducted automatically as part of the payroll process. For self-employed people and limited businesses, tax is a more complex matter and requires manual calculations on your behalf.
Before you can pay any tax, you need to calculate how certain taxes apply to you and how much you owe. Most taxes, such as income tax and National Insurance, aren’t charged against the entirety of your income. Instead, they are based on a percentage of your taxable income.
Finding out what your taxable income is means first calculating taxable profit for your business. Once you know your taxable profit, you can then apply personal allowances and other reliefs to determine your personal tax liabilities.
Understanding how taxable profit and income works is therefore vital for self-employed people and owners of limited companies. This guide will walk you through calculating taxable profits and determining personal tax liabilities.
Please note: we’re focusing on personal taxes such as income tax rather than business-specific taxes like corporation tax for the purpose of this guide, though the concept of taxable profit remains relevant to both.
Understanding Taxable Profit
To work out taxable profit, you need to understand a few other concepts and terms that dictate how taxes will be applied to you or your business. The first is the difference between profits and income.
Profits refer to the trading profits of a business. This means the total earnings/sales of the business, minus any expenses giving “trading” profit. Taxable profits are calculated by taking the “trading” profit, deducting capital allowances and adding back disallowable expenses such as entertainment, depreciation, penalties among others .
Income is a broader term that refers to personal income from all sources, such as a salary from your limited business or income from self-employment, as well as other sources like investments or property.
Total income, also called gross income, is all of an individual’s income from all sources within a certain tax year. When reporting total income, you need to account for any deductions which are taken before you are paid, such as the Construction Industry Scheme (CIS), as failing to do so could see you being fined. Some forms of benefits and investments are subject to tax and must be included in any total income calculations.
Total income isn’t the value against which you’ll pay tax. Instead, you need to subtract any tax-free income, allowable expenses and allowances to result in a final taxable income that is used to determine personal taxes such as income tax and National Insurance contributions.
- Trading profits: the profits of a business before any adjustments.
- Taxable profits: specifically refers to the trading profits of your business after adjustments for disallowable transactions and allowances for capital allowance.
- Total income: also known as gross income, all of the income earned in a tax year including salaried income, sole trade profits, dividends, bank interest, etc.
- Taxable income: total income minus eligible deductions, reliefs and exemptions. Remember to also deduct your personal allowance.
Preparing Business Accounts To Determine Taxable Income
To work out taxable income, you’ll prepare your accounts for the period that applies to you. There are two ways of preparing accounts, either on an accrual or cash basis.
Accruals accounting counts income even if it has yet to be paid. As soon as you issue an invoice or receive a bill, it will count – even if the client is late in paying you or you delay paying the bill. Accounting in this format gives you far more insight and control over your total cash flow but also creates issues because you may have to pay tax before clients have paid their bills.
Cash basis accounting only counts income and expenses actually paid within the accounting period. It doesn’t matter if you’ve sent an invoice in that period – only that it has been paid. This system is generally preferred for small businesses as it is simpler to account for, though it is only available to specific types of businesses.
Preparing your accounts is a matter of using one of the above systems to record income and expenses across the tax year. You’ll need to add all forms of income together to get a total income figure, then subtract allowable expenses.
What are allowable expenses?
To determine your taxable income figure, you must deduct any allowable expenses from your total income. Allowable expenses must be spent solely for the benefit of the business and must be documented with receipts and evidence in case HMRC asks you to provide them.
Which expenses are classed as ‘allowable’ for your business will vary depending on the nature of your business and the specific purchases you’re making. In general, however, the following types of spending are usually allowable.
- Travel costs incurred for work purposes - this includes petrol, transport costs, hire vehicles etc.
- The costs associated with running an office, including phone and broadband bills.
- Purchasing stock or materials for resale
- Energy costs for powering and heating your business premises
- Rent on business premises
- Clothing and uniform costs (only for specific items such as health and safety clothing)
- Financial costs like banks and insurance charges and certain subscriptions
- Salaries and subcontractor fees
Following the process above when preparing accounts means a business’s accounts should look roughly like this:
Okay, so there’s trading profit – but we’re not done yet. There are other deductions you can still make to further reduce your tax liabilities. In addition to allowable expenses, certain ‘capital allowances’ are also available for you to claim. Like allowable expenses, these can be deducted from your trading profit – but they are unique in that capital allowances provide different levels of tax relief against assets purchased for use in a business over time.
Capital allowances are complex and worthy of further discussion, which we provide in our comprehensive Guide to Capital Allowances. For the purposes of understanding taxable profit, all you need to know is that capital allowances are worked out separately and then deducted from total income in addition to standard allowable expenses.
Remember our table further up? If the business in question spent £2000 on computer equipment that was eligible for 100% capital allowances in the same year, the final taxable income would be as follows:
The £15,200 figure in the example above is the final total taxable profit of the business itself. This would be used for a business tax calculation such as for corporation tax.
Taxable profit matters in different ways:
- It’s important for calculating corporation tax and other business-focused taxes
- Self-employed people pay tax based on taxable profits, not total income
- Taxable profits do not account for personal allowances and other personal benefit reliefs
If you’re self-employed or you operate multiple businesses, you need to go a step further to understand taxable profit and taxable income.
Taxable profit isn’t taxable income: working out income tax liabilities
Now that you know how to calculate taxable profits, what about taking things further and determining your total taxable income? This will help you work out income tax and National Insurance liabilities and speed up self-assessment.
When looking at income and not just profit, you need to use ‘adjusted net income’ to work out your tax.
What is adjusted net income?
Before you get a final taxable income figure to use for any personal tax, you’ll need your adjusted net income. This is your total income less certain tax reliefs such as pension contributions and gift aid.
Working out adjusted net income is a case of adding up all taxable income as we’ve discussed above. That means any income from self-employment, dividends, salaries, interest etc. This is your net income.
What if you run multiple businesses?
If you run more than one business, you’ll need to work out taxable profits for each individually. You’ll then need to add these together before subtracting any personal allowances or expenses. We’d advise keeping individual records for each business to avoid accidentally confusing income streams or expenses.
Subtracting the personal allowance
In the UK, income up to a certain threshold is tax-free. This is known as the personal allowance and is currently set at £12,570 except for specific circumstances.
For most people, you’ll subtract the personal allowance from your adjusted net income to determine your final tax liability. This final figure is the amount you’ll be taxed on, though which taxes impact you will depend on what the figure is.
Now that you know more about taxable profits and taxable income, you can probably see the value of a platform like Crunch. We offer a straightforward accountancy platform that allows self-employed people and small businesses to easily track income and expenditure, making the process of calculating profits and income simple and efficient. Save time and money by choosing Crunch – try it for free today.