M5: Trading Income

Question 1

What are the key features of a sole trader structure and how is it taxed?

Answer 1

A sole trader is an individual who exclusively owns and operates a business under the trader’s personal name or uses a different ‘business name’. They may or may not have employees

Taxation:
- The sole trader is personally liable for the tax liability (income tax).
- The sole trader will calculate the tax-adjusted trading profits of the business and include this figure as trading income (a type of non-savings income) within the income tax computation.

Question 2

What are the key features of a partnership structure and how is it taxed?

Answer 2

A partnership is formed when multiple individuals carry on a business together with the intention of making a profit. This relationship can be implied or explicitly agreed upon. Partnerships can operate under the names of the partners or use a distinct ‘business name’.

Taxation:
* Partnerships do not have their own tax liability, but they must file tax returns.
* Each partner is individually taxed on their share of the partnerships tax-adjusted trading profit, treated as trading income (a type of non-savings income) within each partners income tax computation.

Question 3

What are the key features of a company structure and how is it taxed?

Answer 3

A company is a business entity incorporated under the Companies Act in the UK which has a separate legal identity, distinct from its members (shareholders) and directors. It therefore continues to exist irrespective of changes in ownership or management.

Taxation:
* Companies have their own tax liability and pay corporation tax instead of income tax.
* A company will pay corporation tax on its taxable total profits which will be disclosed on the
corporation tax return.

Question 4

What are “unincorporated businesses”?

Answer 4

Partnerships and Sole Traders.

Question 5

How do we determine if an individual is employed or self-employed?

(Indicators of employment & self-employment?)

Answer 5

1. A Contract of Service: Typically indicative of employment; or
2. A Contract for Services: Typically indicative of self-employment.

Question 6

What are the indicators of employment?

Answer 6

• Control over manner of performing work
• Remuneration without risk
• Contract defines scope of work but not
  conclusive
• Employer provides tools
• Regular defined hours
• Employer obliged to provide future work
• Payment during illness/holiday
• Payment regardless of the success of tasks performed
• Integral part of the organisation

Question 7

What are the indicators of self-employment?

Answer 7

• Freedom to achieve objectives and delegate
  duties
• Bears losses but keeps profits
• Contract defines scope of work
• Responsible for own tools
• Freedom to decide work timing and location
• No expectation of recurrence or obligation
• Makes own arrangements for illness and
  holiday
• Payment dependant on completion of task
  and can be withheld until task completed
  satisfactory
• More than one client, not integral to any of
  the client’s businesses

Question 8

What are the different rights between an individual who is employed, self-employed or a worker?

Answer 8

1. Employees have protection against unfair dismissal, a right to receive redundancy payments, right to the national minimum wage, paid holiday and sickness pay.  
2. Self-employed individuals have none of these rights. 
3. Workers have limited employment rights, including holiday pay, paid rest breaks and the national minimum wage. 

Question 9

What is a trade and why is it important?

Answer 9

‘Trade’ encompasses trades, professions and vocations.

To determine the correct tax treatment it is vital to distinguish between trading activities (resulting in taxable profits) and non- trading activities (generating investment income or capital gains).

Question 10

What are the main badges of trade?

(aka tests of if someone is conducting trade or hobby)

Answer 10

1. The Subject Matter: Certain types of assets are held for investment (the value growing over time and / or rental income being generated e.g. property), while others are acquired with the intent of reselling for a profit (e.g. toilet rolls).
2. Length of Ownership: Trading assets are typically held for shorter durations than those acquired for personal use or investment.
3. Frequency of Transactions: Repeated, similar transactions over time suggest trading, but one- off transactions can also be trades.
4. Supplementary Work: Modifying assets into a more marketable condition or making efforts to attract purchasers indicate trading.
5. Reason for Sale: Sales motivated by emergencies or immediate cash needs are less likely to qualify as trades.
6. Motive: Transactions undertaken to realise a profit indicate a trade, but many investments are also purchased with profit in mind.

Question 11

What is the trading allowance?

Answer 11

There is a trading allowance of £1,000 for individuals.

When trading income before expenses (gross
income) is below this figure, no declaration of the trading income is required and the income does not
give rise to a tax liability.

If the gross trading income exceeds £1,000, the taxpayer can either deduct £1,000 from the gross income amount or elect to deduct the actual expenses if that produces a lower taxable amount.

e.g. trading income = 5k, expenses = £800. Allowance = 1k

Either deduct 1k from 5k = 4k taxable or 5k - £800 = 4.2k taxable.

Question 12

What are the main differences between the profits of a business per its accounts and for tax purposes?

Answer 12

Unincorporated businesses are taxed on the profits of a trade - which are the profits calculated for accounting purposes, adjusted as required by the tax law.

Where accounting and tax rules differ,
adjustments to the accounting profit are needed.

Question 13

When adjustments are being made to the accounting profit, are we increasing or decreasing profits?

Answer 13

If its income:
- If its taxable - no adjustment
- If its not taxable - deduct from profit

If its expenses:
- If its an allowed deductible - no adjustment
- If its not allowed - add back

Question 14

When should accounting profits be adjusted for tax?

Answer 14

There are three reasons why the accounting profits may need adjusting:

1. Amounts which relate to capital should be removed (deduct income and add back expenses).
2. Amounts which are taxable or deductible elsewhere in the computation (i.e. not treated as trading income or a trading deduction) should be adjusted.
3. Where there are specific rules in the legislation or case law.

Question 15

What is capital and how is this treated under trading income?

Answer 15

Capital expenditure is defined by case law as “ bringing into existence an asset or advantage for the
enduring benefit of a trade”.

Capital items should not be included in the taxable trading profit for a business.

Question 16

What are common capital adjustments that need to be made to the profits?

Answer 16

1. Depreciation
2. Losses / gains on disposal of non-current assets – not inventory
3. Professional fees related to capital transactions (this rule applies even if the transaction never
   actually takes place)
4. Goodwill written off
5. Initial repairs to assets purchased in a run-down condition

Question 17

What types of income and expenses are dealt with elsewhere in the income tax computation, separate from trading income?

Answer 17

The key items of income that are taxable (but not as trading income) are:
1. Rental income (i.e. property income)
2. Interest income
3. Dividend income

These items should be deducted from trading income and will be taxed under another heading in the tax computation.

Expenses:
1. Charitable donations by Gift Aid
2. Contributions to a personal pension scheme

These items should be added back to trading income and relief will be given elsewhere in the income tax computation.

Question 18

What are the specific rules for restricting deductions?

Answer 18

See adjusting profits sheet for full. Adjustments are necessary to the accounting profit because not all expenses are eligible for tax relief.

Business entertainment and gifts:
- Generally, no deduction is permitted for expenses associated with business entertainment or gifts,
even if they are related to the trade.
However, there are exceptions which allow a deduction for specific types of entertainment and gifts:
- Entertainment or gifts where it is the trader’s usual trade to provide these and they are
provided as advertising to the public e.g. a restaurant giving a free meal to a restaurant critic
or a bakery giving free samples of donuts to customers.
- Entertainment or gifts provided to employees which is not incidental to that provided to others.
- Gifts (other than food, drink, tobacco or a gift voucher) with a conspicuous advert for the trader
(limited to cost of no more than £50 per recipient per accounting period).
- Gifts to a charity.

Leased Cars:
- 15% of the lease cost is disallowed for leased cars with CO₂ emissions of over 50g/km.

Bad and Doubtful Debts:
- Specific bad debts written off are deductible, bad debts recovered are taxable.
- Movements in specific provisions (calculated in accordance with accounting standards) are
deductible/taxable and there is no need to make an adjustment to accounting profit.
- Movements in general provisions (not calculated in accordance with accounting standards) are not
deductible/taxable so must be adjusted for.

Other rules restricting deductions:
- Accrued, unpaid remuneration after 9 months from the end of the period to which it relates is
not deductible.
- NICs for employees are deductible, Class 2 and 4 NIC’s for a sole-trader or partner are not.
- Most tax penalties and interest on late payments are not deductible for unincorporated
businesses.
- Criminal and crime-related payments are not deductible.

Question 19

What does ‘for the purposes of the trade’ mean?

(and what’s the 2 components of the rule to determine this?)

Answer 19

No deduction is allowed for expenses not incurred wholly and exclusively for the purposes of the
trade.

This rule has two components:
* Expenses must be incurred wholly for the purposes of the trade, meaning they should have no
other primary purpose or a dual purpose; and
* The expenses must genuinely relate to the trade and be incurred by the trader in that capacity.

Question 20

What are the rules allowing deductions?

Answer 20

The tax law specifically allows deductions for:
* Allowable expenditure incurred within the 7 years prior to the commencement of trade – these
expenses are treated as if incurred on the first day of trading.

• Incidental costs of obtaining loan finance (e.g. fees and commission).
• Payments for restrictive undertakings to employees/ex-employees.
• Salary of employees temporarily seconded to charities and educational establishments.
• Cost of providing counselling and retraining for employees whose jobs have ceased.
• Statutory redundancy and other ex-gratia redundancy payments made for the benefit of the
  ongoing trade.
• Costs of obtaining patents, designs or trademarks for the purposes of the trade.
• Pension contributions paid on behalf of employees.

Question 21

What other common items might be included within the accounting profit or loss and what is the tax treatment?

Answer 21

Allowable / deductible:
* Interest payments if they are wholly and exclusively for the purposes of the trade. Hire
purchase interest (not capital payments) for assets used in the trade.
* Advertising expenses are generally allowable unless capital in nature or can be considered
as entertaining (e.g. some types of sponsorship could be considered entertaining).
* Charitable donations to local charities or charities from which employees likely to
benefit.
* Legal expenses in the normal course of trading (excluding those relating to capital
transactions) e.g. debt collection, normal tax fees, renewal of a short lease (<50years),
defending title to assets and maintaining existing trading rights.
* Staff welfare expenses (provided they are not capital) are generally allowable e.g. provision
of a sports facility to keep staff happy with the expectation of this leading to better business
performance.
* Repairs – Genuine repairs (to maintain the standard of asset) which may include replacing
individual parts of an asset (again provided there is no improvement). Improvements due to
advances in technology are generally allowable.
* Business rates
* Fines for breaking the law – payments of employee fines are allowable for the trader and
taxed on the employee.
* Contractual penalties – for example, if a builder pays a penalty for each day a project is late,
the cost of the penalty is allowable.

Not allowable / non-deductible:
* Charitable donations to national or international charities. For donations within the gift aid
rules tax relief will be given elsewhere in the computation.
* Political donations
* Repairs – Improvements to an asset which are capital (enhance asset performance).
Replacement of the entire asset is generally capital (not allowable), replacement of parts
generally revenue (allowable) unless involving improvement.
* Inventory for personal use by the sole trader / partner – add back market value (not cost).
* Fines for breaking the law – if the fine applies to the sole trader / partner.
* Appropriations of profit (drawings) – the sole trader / partners are taxable on every pound
of profit – rather than wait until the end of a year to draw out profits, regular payments may be
made from the unincorporated business to the individual sole trader / partners – these
payments (or drawings) are to be added back if included in the calculation of profit per the
accounts.

Question 22

How do we know which trading profits to include in the tax return for a particular period?

Answer 22

We know which trading profits because if the accounting date is March 31, April 1,2,3,4,5 then it requires the trading profits of one accounting period.

If the date is anything other than those then it requires >1 accounting period where we will require the tax-adjusted trading profits of more than
one accounting period to be time apportioned to the relevant tax years.

Question 23

What impact does the choice of accounting date have on a business owner?

Answer 23

Accounting dates earlier in the tax year give more time to complete accounts and prepare a
tax return, however a date later in the year gives less time and may involve the preparation of the tax
return using estimated figures.

Tax deadline is Oct 31 for paper submission or Jan 31 for online for HMRC.

Question 24

Are there any specific rules to follow in the first year of trade?

Answer 24

The tax-adjusted trading profits from the date of commencement to the end of the first tax year are
calculated and included as trading income for the first tax year.

This may involve a time apportionment
process, depending on the accounting date chosen by the trader.

Question 25

Are there any specific rules to follow in the final year of trade?

Answer 25

The tax-adjusted trading profits from the start of the final tax year to the last day of trading are
calculated and included as trading income for the final tax year.

This may involve a time
apportionment process, depending on the accounting date.