Turning income into taxable profit

Assembling the number

Everything in this module has been building one figure: your taxable profit. This is the number that income tax and National Insurance are both calculated from, and getting it right is most of the work of a tax return.

Business income (turnover)                    £48,000
Less allowable expenses                       -£6,000
                                            ----------
TAXABLE PROFIT                                £42,000

Income tax is charged on this, after your personal allowance
Class 4 National Insurance is charged on this, above its own threshold

Turnover is not what reached your bank

Two adjustments catch people out.

First, most sole traders use the cash basis, where income counts when you are paid and expenses count when you pay them. That is the simple, default position for smaller businesses and it does match your bank account closely.

Second, some businesses use traditional accruals accounting, where income counts when you invoice and expenses when you are billed, regardless of when the money moves. An invoice raised in March but paid in May belongs to the March tax year on this basis.

Whichever you use, be consistent, and know which one you are on. Mixing the two produces a profit figure that is simply wrong.

What happens to the profit next

Your profit is not taxed in one lump at one rate. Your personal allowance comes off first, then the remainder is taxed in bands, each slice at its own rate.

The interactive example below builds this band by band, so you can see exactly which part of your profit is taxed at which rate. Drag the slider to your own figure and watch the bands change.

The bit HMRC does not spell out

Your profit is not the same as your drawings. Money you take out of the business for yourself is not an expense and does not reduce your profit by a penny. A sole trader and their business are the same legal person, so paying yourself is simply moving your own money between pockets.

This trips up almost everyone who has previously been employed, where the salary is the number that gets taxed. Here, you are taxed on what the business made, whether you took it out or left it in. A trader who reinvests everything still owes tax on the full profit.

If your profit is a loss

Expenses exceeding income produces a loss, and a loss has value. It can generally be carried forward and set against future profits of the same trade, reducing a later year's tax. Record it properly on the return even in a year when nothing is owed, because an unrecorded loss is one you cannot use later.

Common mistakes

• Treating drawings as an expense. They are not, and this is the single most common conceptual error.
• Mixing cash basis and accruals. Pick one and apply it consistently.
• Assuming one rate applies to everything. Income is taxed in slices, not at a single rate on the whole amount.
• Ignoring a loss year. Report it, so you can use it against future profit.