2 Sole trader
Whether you’re providing a product or a service, the simplest option available to you at the beginning of your small business journey is as a ‘sole trader’.
Many freelancers start off as sole traders because it is an easy structure to set up and the administration required is minimal. As a sole trader you are classed as self-employed and can choose a trading name. But you will also have to complete self-assessment tax returns to declare your trading income and expenses for HMRC.
When you start out as a sole trader you will need to:
- let HMRC know you are self-employed
- register for self-assessment tax returns as a sole trader.
Registering is an easy process and the UK government website provides step by step guidance. You can find this guidance in the Further research section at the end of this week.
Williams (no date) explains that ‘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’.
In order to complete your self-assessment tax returns, you’ll need to keep good records of all your income and expenditure. It is important to keep receipts for expenditure as you are allowed to deduct some of these costs when calculating your taxable profit.
Box 1 Worked example (using figures from the 2020/21 tax year)
Lauren is a dressmaker. She works on a freelance basis for a range of clients and has an annual income of £20,000. She is registered with HMRC as a sole trader.
Her allowable expenses for the year come to £5000. These include advertising and marketing for her business, and the cost of stationery, travel and raw materials, such as fabric.
This means that only the remaining £15,000 counts towards income on which tax might be due – this is known as taxable profit.
If Lauren had any other sources of income, such as interest from savings, she would need to add them to her taxable profit total. In this example, she doesn’t.
In the UK, everyone has a personal allowance, i.e. income that isn’t taxable. In the tax year 2020/21 that is set at £12,500, but it is subject to change by the government.
So, once Lauren’s personal allowance is deducted, she will only pay income tax on the remaining sum of £2,500.
As her taxable income is under £50,000, she will pay tax at the basic rate, which in 2020/21 is 20%.
So, Lauren’s final tax bill will be for 20% of £2,500 = £500.
One important thing about being a sole trader is that you are personally liable for your business’s debts, including any loans that you have taken out to start up your creative idea. Williams (no date) advises:
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’s debts.
You are also liable if your client suffers losses because you deliver late or make a mistake, or if your product causes injury or damage. That is why taking out appropriate insurance is important, and you’ll explore that in more detail at the end of this week.
Sole traders must pay their tax bill by 31 January following the end of the tax year. In order to ensure you have enough money to pay your tax and national insurance bill (you’ll learn about national insurance in Section 5) each year, a good rule of thumb is to save 25% of your earnings into a separate bank or building society account.
If self-assessment fills you with dread, you are certainly not alone! Many sole traders employ accountants to compile their tax returns. You will still need to keep good records of your income and expenditure, and all your receipts, but you can pay someone else to sort them out for you. Remember though, if you give your accountant a bag of tatty receipts to make sense of, they might charge you more than if your incomings and outgoings were all recorded neatly in a spreadsheet!
Activity 2 Who do you know?
Spend a few minutes thinking about the people you know – family, friends, teachers, lecturers, alumni from your college or university, friends of friends, and so on. Are any of them self-employed? Ask around – you might be surprised at what you discover.
Once you have identified someone who is self-employed, find out if they are a sole trader and, if so, why they chose that option. Ask them about their experiences with keeping financial records and paying tax through self-assessment.
There may also be informal online forums in your sector where you could ask your questions and share challenges. Spend some time exploring those, either through an internet search engine or your favourite social media platforms.
Talking to others about their experiences can often give you an insight that may be helpful for your own decision making. It also helps you feel less isolated when planning your freelance future.
If you think that becoming a sole trader is not right for you, you could consider another option, also common amongst freelancers – that is, forming a limited company.