Employed & Self Employed

Employed or Self Employed

The question as to whether someone is employed or self-employed is not as straightforward as it might at first appear. Many people assume they are free to choose, but HM Revenue & Customs is increasingly emphasising that this is not the case.

How do you decide?

Although there is no clear-cut answer to this question, HM Revenue & Customs has published a leaflet (IR56 Employed or Self Employed?), which sets out a series of questions to test the particular circumstances of any working relationship. These cover areas such as:

1. Ultimate control of the work
2. Profit element, and risk of loss
3. Provision of materials and equipment
4. Integration with the employer's business
5. The intention between the parties
6. Usual conditions in the industry

Note, however, these are matters of general employment law, and not specific tax legislation.

What are the practical differences?

Employees are taxed under the PAYE system and are subject to Class 1 National insurance (NI) contributions. If the worker is an employee, the employer also has to pay Class 1 NI over a limit set each year, the employee's NI rate reduces to 1%, but for employers, NI continues at the full rate, with no upper limit. The employer also assumes responsibility for paying Statutory Sick Pay and Statutory Maternity Pay.

Employees have rights under health and safety and employment laws, such as the rights to redundancy payments and not to be unfairly dismissed. Moreover, the range of social security benefits is greater for employees than for the self-employed.

Self-employed workers are taxed under self assessment, and are allowed more scope in claiming expenses. They also pay Class 2 and Class 4 NI contributions, the combined burden of which is lower than Class 1 NI. Their 'employers' are not subject to NI.

It is not surprising, therefore, that most bosses show a marked preference for self-employment status for their workers!

What if you are wrong?

It is the responsibility of the person making the payment to get it right. If you treat a worker as self-employed and he or she is subsequently ruled to be an employee, you could find that all the payments you have made will be treated as net payments, and you will have to pay the corresponding tax and employees' NI, as well as the employer's NI. You have no right in law to recover such items from your employees after the event. You may also have to pay interest and penalties for incorrect returns.

If you want to substantiate a classification of a worker as self employed, it is strongly recommended that you draw up and enforce a suitable contract. In line with the tests referred to above, you will need to give particular consideration to the following points:

1. One of the main requirements is that self employed workers bear some element of risk in the arrangement, which means you will have to avoid the 'hourly rate', in favour of a 'price for the job'. The main principle is that the price, scope, and timing of the work should be agreed, and evidenced in writing, before the job commences.

2. Within reason, the more freedom the worker has in the detail of the way the work is carried out the better. You must also make it clear that the worker will have to put right any faulty work at his or her own expense.

3. One of the strongest tests of self employment is the right to substitute a worker who is equally capable of carrying out the work.

4. All self-employed workers should hold public liability insurance.

Where practical, the worker should supply at least some of the important equipment or tools. Of course, the extent to which equipment is required depends upon the nature of the work.

What about the construction industry?

The construction industry is subject to exactly the same rules as any other type of industry. However, there are some special considerations.

Where the work entails use of heavy equipment or expensive plant, it is sometimes recommended that contractors hire the equipment to their subcontractors, who then include the cost within their 'price for the job'. Such arrangements may seem artificial, and there is the danger that with substantial hire costs being included in the pricing, the subcontractor's turnover may breach the VAT Threshold and force him or her to register for VAT. However, this is not necessarily a bad thing because VAT registration is often cited as further evidence of self employment.

With regard to pricing work, a competitive tender is best, but in practice it should not really matter who makes the first suggestion of an appropriate price.

Although there is a special scheme for taxing construction industry workers, the possession of a Subcontractors Tax Certificate in itself does not necessarily prove self-employment status
.
What about personal service companies?

These guidelines apply equally to the so called “IR35” rules to test whether a worker would be treated as an employee of the client, if it were not for the existence of an intermediate service company.

If you start working for yourself, you must register with HM Revenue & Customs within the first three full months of self employment. Otherwise you may be liable to a penalty of £100. You may register by telephone or by using the form incorporated in leaflet P/SE/1 (Thinking of working for yourself?).

Once you become self-employed, the tax rules are quite different from those that may have applied when you were an employee. Instead of tax (and national insurance) being deducted from your earnings at source, you must be prepared to receive a bill at some time in the future. This can be a nasty shock if you haven't put enough money aside.

What profits do HM Revenue & Customs tax?

The starting point for the calculation of taxable profits is your profit and loss account. In calculating taxable profits you are entitled to claim deductions from your business income in respect of any expenses incurred for the purposes of trade (with a few minor exceptions).
When you buy equipment or motor vehicles, you will be entitled to deduct a proportion of the cost each year you own them and use them in your business.
If you take stock for your own use, the disposal should be shown in the accounts at market value, and not at original cost. It may be possible to avoid this by arguing that such items never actually formed part of your stock and showing the original purchase as private expenditure (drawings).
Tax is payable on the whole of the profits of a trade, and so payments for your own 'wages' (drawings) are not deductible. However, if your spouse works in the business, the wages are an allowable deduction, provided they are actually paid and are a reasonable reward for what is done.

How does HM Revenue & Customs allocate profit to tax years?

The aim of the system is that over the lifetime of your business the profits will be taxed in full, once, and once only. But to make the system fair, there are certain complications you will have to cope with.

The general rule is that the tax for a particular tax year is based on the profits of the twelve months to your accounting date in that tax year. For example, the tax for 2005/06 could be based on accounts for a year ending on various dates ranging from 6 April 2005 to 5 April 2006. This demonstrates that you get more time for the tax to be worked out if your accounts end early in the tax year, which is why 30 April is such a popular year-end for self-employed people.

How is the tax collected?

Tax returns covering income for the year ending 5 April 2006 have to be submitted to HM Revenue & Customs by 31 January 2007 (the 'filing date'). The return will include a self assessment of your liability to income tax and capital gains tax. If you don't want to work out your own liability, you must send the tax return back by 30 September 2006. There are automatic penalties for late filing of tax returns.

Payment of tax

Payments on account of income tax and Class 4 NIC will be due on 31 January 2006 and 31 July 2006. These interim payments will be based on one half of the total liability (less any tax deducted at source) for 2004/05. You will have the right to reduce payments on account if you believe the income tax for 2005/06 will be lower.

The balance of income tax for 2005/06 is due on 31 January 2007 (along with the first interim payment for 2005/06 and any capital gains tax for 2005/06). Interest and surcharges will be levied for late payment.

Opening years

In the first tax year of your business, the tax payable is based on the profit arising between the starting date and the following 5 April. This is taken as the appropriate fraction of the profit shown in your first set of accounts. Say you start on 1 June 2005 and your first accounts run to 30 June 2006 with a profit of £13,000, then tax will be worked out (to the nearest month) on the profits of the following periods:

2005/06 1 June 2005 to 5 April 2006 - 10/13 x £13,000 i.e. £10,000
2006/07 1 July 2005 to 30 June 2006 - 12/13 x £13,000 i.e. £12,000

You can see that the profit from 1 July 2005 to 5 April 2006 (9 months) has been taxed twice. The 'overlap' profit of £9,000 will be available for deduction when the business comes to an end, or (at least in part) if you change your accounting date to one nearer 5 April.

Change of accounting date

If you decide to change your accounting date from 30 June 2007 to 31 December 2007 and the accounts for the 18 months ending 31 December 2006 show a profit of £27,000, the taxable profit for 2007/08 will be worked out as follows:

Cessation

If you then cease trading on 31 August 2009 , and your final accounts for the eight months ending on that date show a profit of £11,000, the taxable profit for 2009/10 will be:

What about national insurance?

The self-employed are subject to a two-tier system of national insurance contributions. Class 2 contributions are at a flat rate of £2.10 per week, payable against a quarterly bill or by direct debit from your bank account, if earnings exceed £4,345 per annum.

Profits between £4,895 and £32,760 are subject to Class 4 contributions at a rate of 8%. Profits in excess of £32,760 are liable to Class 4 contributions at the rate of 1% without any upper limit. Class 4 contributions are collected by HM Revenue & Customs and are payable at the same time as the instalments of income tax.

Save for your tax

It is essential that you make proper provision to ensure the availability of funds to pay income tax and Class 4 national insurance. Interest on unpaid tax is chargeable by HM Revenue & Customs, and is not deductible from business profits.

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