The answer to this question depends, in the first instance, on the business structure you select.
If you run your business as a sole trader, or in partnership with another person, you are deemed to be self-employed. Partnerships also include Limited Liability Partnerships where the partners’ personal assets are protected from business risks.
The alternative to the above self-employed options is to incorporate your business, to be a limited company. In this case the company legally owns the business and you are an employee of the company, and in most cases, a shareholder too.
Sole traders and partners
As defined above, tax payers in this group are self-employed and subject to self-assessment for income tax purposes. Profits of your business, adjusted for tax purposes, are included in your annual self-assessment tax return and provide the basis (together with any other income you earn) of your half yearly income tax payments under self-assessment.
Additionally, there are National Insurance considerations. Presently, you will pay Class 2 and Class 4 contributions and these are collected with your income tax payments. Class 2 is a fixed weekly amount, and Class 4 contributions are graduated, based on the amount of profit you make. The government is to phase out Class 2 contributions shortly and adjust Class 4 contributions to provide for basic State benefits such as the State Pension.
Companies do not pay income tax, instead, they are subject to corporation tax.
Corporation tax is based on a fixed percentage of adjusted profits plus any chargeable capital gains the company makes.
Directors are treated as employees by the company. Any salary taken is taxed under the PAYE system and forms part of the allowable costs of the company. The amount of any income tax or National Insurance due will depend on the amount of salary taken.
Directors, who are also shareholders, may also choose to take part of their remuneration as a dividend. This is a distribution of taxed profits by the company and so no further tax consequences apply to the company. Dividends received by shareholders are subject to personal tax if they exceed £5,000 in a tax year. The rate of tax payable depends where the dividends sit in the tax payer’s basic, higher or additional rate income tax bands.
As you can see, business structure determines tax treatment, and the selection of the most appropriate structure is of paramount importance, both to ensure you minimise taxes due and protect your personal assets.