What taxes do I need to pay as a contractor

Making the decision to work as a contractor rather than an employee can be daunting, and knowing when and how to pay the relevant taxes can be of particular concern. How much you pay and how regularly will be determined by how you establish yourself – either a sole trader or a limited company. 

Whichever option you choose, you’ll be taxed via the self-assessment system each year, and you’ll pay income tax and National Insurance Contributions on your business profits. There are, however, several other tax obligations you’ll need to be aware of.

## Taxes you may need to pay as a sole trader 

Being a sole trader means you run your business by yourself, and your business assets and liabilities aren’t differentiated from your ones. It is the simplest business structure and can be a good way to get started as a contractor. 

## Income tax

As a sole trader, completing your annual self-assessment will be the biggest job regarding taxes. This will tell you how much income tax you need to pay. All UK citizens are entitled to a tax-free personal allowance of £12,570. You’ll then pay the basic income tax rate of 20% on income up to £50,270, the higher income tax rate of 40% on income between £50,271 and £150,000, and the additional income tax rate of 45% on income over £150,000.

An online self-assessment must be submitted by 31 January each year. 

## Payment on account

It’s also worth being aware of the payment on account system enforced by HMRC, as this can be a shock for some contractors, especially in the first year of trading. In essence, payments on account are advance payments for the tax you will likely owe for the current tax year. They must be paid in two instalments every year - on 31 January and 31 July – with each payment equal to half the amount of tax you owe for the previous tax year. This means your first self-assessment payment may be significantly higher than expected.

## National insurance

As a sole trader, you’ll also need to make National Insurance Contributions (NICs). Your earnings will determine the amount paid. This will include Class 2 NICs – which are £3.15 per week – if your profits are above £6,725, and Class 4 NICs, which HMRC will work out during the self-assessment process.

## VAT

Another tax obligation to be aware of as a sole trader is VAT. If your business has a turnover of more than £85,000 over 12 months, you must also register for Value Added Tax (VAT). If this is the case, you’ll need to add VAT to all your bills, and you’ll be able to reclaim the VAT you pay on business costs.

## Capital Gains Tax

Capital Gains Tax is applied to the profit you make if you dispose of business assets – whether selling, transferring, or even giving them away as a gift - and is relative to your income. It is payable on most business assets, such as land and buildings, fixtures and fittings, and shares. You don’t usually need to pay it on gifts to your husband, wife, civil partner or a charity.

## Taxes you may need to pay as a limited company

Operating as a limited company can be the most tax-efficient route for many contractors, but it does come with more admin and more obligations regarding your financial reporting. Individual situations will vary, but here are some taxes you may need to pay.

## Income tax 

As with the sole trader route, you must submit an annual self-assessment as a limited company director to determine your income tax. Rates and allowances will be the same as for a sole trader.

## National insurance 

As a limited company director, you’ll also have to pay National Insurance, but in this situation, you’ll be classed as an employee for tax purposes. This means you’ll pay National Insurance on annual income from salary and bonuses over £11,908. 

## VAT

Again, if you have an annual turnover of £85,000 or more, you must register for VAT as a limited company, although many choose to do so even if they are below this level. Most contractors register for the Flat Rate VAT Scheme, which means you charge the standard 20% but then repay at a lower rate, dependent on your business type. Another benefit is the 1% discount you get during your first year in the scheme. However, the difference you keep is considered profit and will be subject to Corporation Tax.

## Corporation tax 

Limited companies must pay corporation tax on any profit they make directly from their business or the sale of assets. Be aware that as of 1 April 2023, there is no longer a single Corporation Tax rate. The primary rate for non-ring fence profits has increased to 25% for profits above £250,000, while the small profit rate for companies with £50,000 or less stays at 19%.

Companies with profits between £50,000 and £250,000 will pay tax at the main rate, reduced by a marginal relief. You can use the Marginal Relief calculator to determine how much you can claim.

## Dividend tax 

As a limited company director, it may be tax efficient to draw money from your dividends – that is, your shares in the company – in combination with taking a salary. Using this method means you’ll benefit from the tax-free dividend allowance of £2,000. Above £2,000, you will pay the following rates of tax on dividend income:

· 8.75% on income within the basic-rate tax band (£12,571 to £50,270) · 33.75% on income within the higher-rate tax band (£50,271and £150,000) · 39.35% on income within the additional rate tax band (above £150,000)

## Keeping track of your taxes and accounting 

Whether you operate as a sole trader or a limited company, maintaining clear, accurate and accessible financial records will ensure you pay the correct tax at the right time. At a basic level, you’ll need to keep a record of receipts and invoices, but you’ll likely need to do a whole lot more than that. Accounting software can be a huge time-saver here, making it easy to manage your finances and simplifying tasks such as completing and submitting VAT returns. Tools such as AccountsPortal enable the automatic submission of VAT reports to HMRC. Software will also provide a space to manage your customer and supplier information, generate quotes, view your financial reports and even accept online payments, all of which will help ensure you have all the information you need in one place to manage your taxes efficiently.