Will I pay 40% tax on my business income?

A new client recently asked us if the income from her new business would be taxed at 40%.

She explained that to make ends meet she had started a part time internet business selling cup cakes on line.

She also worked full time and was paid £21,000 which was taxed under PAYE.

(Details slightly changed to protect client’s confidentiality)

Taxed on profit not income

The first thing we explained is that she would be taxed on the profits from her business – not income.

Profits = Income less costs

Income, also known as turnover or sales, is the money received from what she sold.

Costs are those amounts that she would spend which were “wholly and exclusively” incurred for her business.

In her case it was things like the ingredients for the cakes, postage, packaging material, her web site, advertising, accountancy and so on.

Don’t forget the personal allowance

The next thing to explain was that she would be taxed on the total of her taxable income less any personal allowance that she was entitled to receive.

In her case as she had no other income such as interest on savings or rent, the total taxable amount would be the profits plus her salary.

From this her personal allowance of £8,105* would be deducted and then she would be taxed at 20% on the first £34,370 and at 40% on anything else up to £150,000 when the tax rate increased to 50%.

Of course she had already paid a large amount of tax on her salary and this would be deducted from any tax due.

Sole Trader or Limited Company

This of course  assumed that she operated her business as a sole trader and not a limited company.

In addition we pointed out that she may have to pay Class 2 and Class 4 National Insurance on the profits from her business although she may be entitled to an exemption from Class 2 National Insurance if her profit from the business was small (less than £5,315 for the period from 6 April 2011 to 5 April 2012).

Final Tip – Check contract of employment

We did suggest that she may also want to check her contract of employment as some contracts specifically forbid employees to be operating a business whilst employed.

There would be no point in jeopardising her main source of income if the contract prevented her from operating her new venture.

As it turned out her contract did not prevent her running her business and in fact she sells some of her cup cakes at work.

So will she pay 40% tax?

As usual there is no straight yes or no answer to that question ….

The rate of tax that is paid depends on her total taxable income which includes the profit, and not income, from her business.

Note – for taxable income over £100,000 the personal allowance starts to decrease.