As I mentioned in my previous blog post, if you are self employed (also known as “sole trader” in the UK), you have more tax benefits than you would have as an employee. One of these major tax benefits is that you can deduct certain expenses from your gross annual income, hence reducing the total amount of tax that you have to pay (good news!). To give you an example, a friend of mine, let’s call him Oliver, recently became self employed and founded a new startup. Oliver spent around £1,000 on advertising expenses for his business, but he didn’t realise that these costs were deductible for tax purposes, and so he didn’t bother to keep the receipts for these expenses. At year-end, Oliver asked me to help him with his tax return, and I found out that he could have saved a lot of tax dollars on these expenses if he had kept track of them and saved the receipts. Similarly, I have tons of self employed friends, who often ask me what they can and cannot deduct from their business income when they file their tax returns. Therefore, I have decided to write this blog post to explain it once and for all.
Firstly, let’s get the tax terminology straight:
Allowable expense – an expense that you can deduct from your gross business income for the tax year1 (we will get to what falls into this category in a minute).
Taxable profit – the net income that your total income tax will be calculated on, AFTER deducting all of your allowable expenses.
Income tax – self employed individuals pay personal income tax. The income tax is calculated based on various bands, where the tax rate applied increases gradually for the higher income levels. Currently, there is a personal allowance of £11,000 (may change each year), where income earned up to this limit is tax-free. You can find all of the current income tax rates here.
1BEWARE: the UK tax year is not the same as the calendar year. The tax year ends by 5th April (i.e. tax year 2016/17 is from 6 April 2016 till 5 April 2017). Therefore, the total income and expenses that you report in your tax return should ONLY pertain to the relevant tax year period.
– Total annual business income you earned is £60,000 pre-tax (well done!)
– Total allowable expenses for the year is £10,000
£60,000 – £10,000 = £50,000 Taxable Profit
£50,000 – £11,000 (Personal Allowance) = £39,000
(£43,000-£11,000) (Basic Rate Band) x 20% = £6,400
(£39,000-£32,000) (Higher Rate Band) x 40% = £2,800
£6,400 + £2,800 = £9,200 Income Tax
Therefore, total income tax you have to pay for the year is £9,200. Your after-tax net income is therefore £50,000 – £9,200 = £40,800, which is not bad at all.
Now that you have a basic understanding of how personal income tax is calculated, let’s get to the juicy part: how should you report your expenses in your tax return. As a general rule, expenses incurred solely for business purposes will most likely be an allowable expense that is deductible for tax purposes. Therefore, unless your business is a sailing tour service, I would say that buying a yacht would not earn you any tax deductions (even if your accountants are magicians or worked for Enron). In general, allowable expenses are deducted from gross income so that the net income based on which your income tax is calculated will truly reflect how much you have earned from being self employed after paying for your business expenses.
In general, there are two types of tax treatments for business expenses: 1) claim the expense as an allowable expense OR 2) claim capital allowances on the capital expenditure as an asset2. The first type of treatment is most commonly used for recurring expenses that your business benefits from for a short period of time. For example, rent expense for your office would be a recurring expense, as they only cover rental of the office for the month. However for capital allowances, they are usually claimed for an expense that generates benefits for the business for a longer period of time. For instance, a printer purchased for your business will usually be used for more than 2 years; therefore its benefit lasts for a longer period of time. This is why the expense is treated as an “asset”, and each year a capital allowance amount is deducted from the total asset value to amortise it throughout its useful life. I will explain in another blog post about capital allowance in more detail. For now, let’s focus on the allowable expenses. At the end, I will also explain how to actually claim these allowance expense deductions in your tax return, so stay tuned.
2Note: capital allowances can only be claimed if you use the traditional accounting method for your business, where in you accrue for expenses to be paid in the future. If you use cash basis accounting, where you only account for expenses as they are paid, then you generally cannot claim capital allowances, except for car costs, which I will explain further below. This makes sense, because under the traditional accounting method, you are accounting for future events, therefore you can deduct the cost of purchasing a product/service throughout the period it will be used for.
1. Office, property and equipment
If you use traditional accounting for your business, you can claim capital allowances on office equipment (i.e. computer, printer, etc.) that you will use for a longer period of time, provided that they relate to your business. In general, you can claim allowable expenses for the following types of office-related costs:
- Phone/mobile, fax, internet bills
- Postage, stationery
- Printer ink and cartridges
- Computer software (if used for a longer period of time, you can claim capital allowance)
- Software license renewal fees
Rent, power and insurance (if the property is SOLELY used as your office. This means that you use the space only for work, so your mom’s garage won’t qualify.)
- Co-working space fees
- Utility bills
- Property insurance
- Repairs and maintenance costs
You can also claim allowable expenses for alteration costs to install or replace equipment (or you can claim capital allowance on this). However, you CANNOT claim expenses for the costs related to buying an office property (i.e. mortgage).
On the other hand, if you work from home, only part of the costs of your property is deductible. These costs include:
- Utilities (heating, electricity)
- Council tax
- Mortgage interest or Rent
There are two ways to determine how to portion the costs of your home office: 1) based on the amount of space that you use for self employed work (i.e. there are 4 rooms in the house, you use 1 room as your office, so you can pro-rate your costs by ¼ of total amount. You can also use square footage to approximate the percentage of total costs you can deduct.) OR 2) using the “simplified expense” method, calculate how many hours you work from home each month, then apply the flat rate applicable to the total number of hours you worked from home to calculate how much expense you can claim.
2. Car and travel expenses
For any vehicle and travel expenses, the general rule is that expenses related to business travel purposes are allowable expenses. You can claim allowable expenses for the following items if the car is only used for business:
- Vehicle insurance
- Repairs and servicing of car
- Fuel costs
- Hire charges
- Vehicle licence fees
- Breakdown cover
- Train, bus, air and taxi fares
- Meals on overnight business trips
You CANNOT claim the following expenses:
- Non-business driving/travel costs
- Travel between home and work
You may also calculate your car expenses using a flat rate applied to mileage used for business travel (the “simplified expenses” method). For the first 10,000 miles, apply flat rate of 45p/mile. For miles after 10,000 miles, apply 25p/mile. This method allows you to not have to calculate all individual costs associated with buying and operating a vehicle. Also, if you use the car for both personal and work purposes, this allows you to divide up the car costs by the portion that only relates to business use. However, if you use the “simplified expenses” method, you cannot also claim the same car expenses as allowable expenses.
Under both traditional and cash basis accounting methods, you can claim the cost of buying a vehicle as a capital allowance, as long as you are not also claiming the car expense as simplified expenses.
You can claim allowance expenses for the following items:
- Protective clothing needed for work
- Costumes for entertainers (dust off that clown costume!)
The general rule is that you can only claim expenses for clothing that is required for your self employed work, so you cannot claim everyday clothing costs.
4. Staff Expenses
If your business is running well and you have hired some additional staff, the following expenses are deductible:
- Employee salaries
- Employee benefits
- Agency fees
- Subcontractor fees
- Employer’s National Insurance costs
On a side note, you CANNOT claim deductions for carers or domestic helper costs.
5. Product Costs:
Similar to a corporation, you can claim certain expenses directly related to the products that you sell:
- Goods for resale (inventory)
- Raw materials
- Direct production costs
6. Legal and Financial Costs:
You can claim certain costs associated with legal, financial, and other professional services that you have received for your business:
- Fees for accountants, solicitors, surveyors and architects for your business
- Insurance policy premiums for business insurance
However, you CANNOT claim the following expenses:
- Legal costs of buying property or equipment (but you can claim these expenses as capital allowance if you use traditional accounting)
- Fines/penalties from breaking the law (obviously)
For bank and financial charges, you can claim:
- Bank, overdraft and credit card charges
- Interest on business loans
- Hire purchase interest
- Leasing payments
- Alternative finance payments
You CANNOT claim a tax deduction for loan repayments, overdrafts, or finance arrangements.
*Note: if you use cash basis accounting, you can only claim up to £500 of interest and bank charges.
Also, if you use traditional accounting, you can claim for revenue that you won’t ever receive (called “bad debt”). Let’s say you sold your latest product release on credit to your best mate’s brother’s Tupperware business that went bankrupt the day after, you can at least not get taxed on this forsaken revenue. However, you can only deduct/write off this debt if you are certain that they won’t ever be recovered from the customer in the future. You CANNOT claim for debt not related to revenue, or debt related to disposal of assets.
7. Marketing, Entertainment, and Subscriptions
There are certain expenses related to the promotion of your business that can be deducted for tax purposes:
- Advertising costs: such as fees paid for Google ads, Facebook ads, etc.
- Free samples
- Website costs: such as web design agency costs, freelancer web designer costs, etc.
You can also claim allowable expenses for subscriptions to trade/professional journals, and trade body/professional organisation membership fees that relate to your business.
You CANNOT claim for costs on entertaining clients and suppliers, and event hospitality. Also, you CANNOT have tax deductions for payments to political parties and gym memberships.
There you have it, a comprehensive list of all expenses that you can and cannot deduct for tax purposes if you are self employed!
How to Claim Allowable Expenses
Now to actually claim these expenses as allowable expenses, make sure that you keep records (i.e. receipts, bank statements) as proof of the costs. Then, add up all of your allowable expenses for the tax year and input the total amount on your self-assessment tax return. You don’t need to send in any proof of the expenses when you submit your tax return. However, the HMRC may ask in the future to see the records in order to substantiate the expenses, so make sure that your records are accurate, because the fines and consequences for falsifying tax returns are substantial! Especially if you become the leader of a country one day, you will be asked to disclose all of your past tax returns (even if you consistently refuse to do it…).