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  2. 7 Tax Rules UK Freelancers Should Be Aware of in 2021

7 Tax Rules UK Freelancers Should Be Aware of in 2021

You’ve finally taken the plunge and decided to become a freelancer, like an estimated 4.75 million other people in the UK—great!

However, your enthusiasm can quickly disappear once you understand this means getting to grips with an entirely new set of tax rules.

When you work for a company, they handle all taxes under the PAYE scheme. As a freelancer, however, this burden falls back on you—so it’s crucial you understand what your tax obligations are.

This piece will examine the differences between being a sole trader versus a limited company, the basic rules that you need to be aware of (including tax, VAT, IR35, and National Insurance, and finally, we’ll look into the best way to calculate taxes as a freelancer.

Are You a Sole Trader or a Limited Company?

While freelancing might be a popular way of working in the modern world, the term ‘freelancer’ means nothing when it comes to taxes. Instead, all freelancers are either considered to be sole traders or limited companies, depending on how they’ve decided to structure their business.

This classification isn’t a mere technicality—it has a profound impact on how you pay your taxes and how much you need to pay in the first place.

Let’s examine the differences between sole traders and limited companies in more detail.

Sole Trader

As a sole trader, you are:

  • Not considered to be legally separate from your business
  • Personally liable for all your business’s activities (including any debts the business incurs)
  • Obliged to file Self-Assessment Tax Returns each year

As estimated 60% of all small businesses in the UK are run by sole traders. Unlike setting up a limited company, there’s no lengthy, admin-heavy set-up process.

But there are potential downsides to also be aware of. For instance, if your business fails, then you’ll be held personally liable.

Gary worked as a sole trader providing consultancy services to fast-growth tech companies. However, after a series of poor investments, he was left unable to pay his yearly tax bill to HMRC—so they were eventually forced to repossess his home.

Limited Company

If you form a limited company, however, then this means you will:

  • Create an entirely separate legal entity—even if you’re the director, you’ll still just be considered an employee.
  • Absolve yourself of personal liability. As a company director, however, you will still have to follow certain legal and statutory responsibilities.
  • Have to pay both personal Income Tax and Corporation Tax.

Laura decides to set up her events management business as its own limited company. She registers with HMRC and lists herself as the company’s director and sole employee. While this means she’s not held personally liable for any business debts incurred going forward, she does however have to pay both corporation tax on behalf of the business, as well as income tax for her individually.

For a quick and easy (albeit rough) estimate of your limited company’s tax obligations, consider taking a look at this online calculator.

Below, we’ll cover tax the following:

  1. Income Tax
  2. Tax on Dividends
  3. National Insurance Contributions (NIC)
  4. Corporation Tax
  5. Allowable Deductions
  6. VAT
  7. IR35

Whether you’re a sole trader or operate via a limited company, there are some basic rules that you need to stay on top of.

  1. Income Tax

Unlike Corporation Tax, it’s likely that both sole traders and limited company directors will pay income tax—after all, most directors choose a tax-efficient method of drawing both dividends and a PAYE-based income from their business.

Income Tax in England, Wales, and Northern Ireland

England, Wales, and Northern Ireland operate using a marginal tax-rate system for tax year 2021/22 using the following bands:

Income Band Tax Rate
£0 to £12,57 0%
£12,571 to £50,270 20%
£50,270 to £150,999 40%
More than £150,000 45%

From £0 to £12,570 you will not be taxed. This is also known as your ‘personal allowance.’ You won’t be taxed on this.

Note:

Your tax-free personal allowance actually decreases by £1 every £2 you earn over £100,000, if your total taxable income is over £125,140, you will have no personal allowance available

From £12,571 to £50,270 you will be taxed at 20%. However, it’s worth noting that you only pay taxes on any earnings that exceed £12,570.

If Jagmeet earns £15,000 per year, then he would only pay 20% taxes on £2,430 worth of your income—the first £12,570 is tax-free.

From £50,270 to £150,999 you will be taxed at 40%.

Again, you only pay this 40% rate on all income that exceeds £50,000.

Louisa earns £60,000 per year, meaning she has to pay:

20% on all income from £12,571 to £50,279 = £37,708 x 0.2 = £7,541.60

40% on all income from £50,270 - £60,000 = £10,000 x 0.4 = £3,892

Total: £11,433.60

And you pay an additional 45% of tax on all earnings exceeding £150,000.

Income Tax in Scotland

The rules are slightly different in Scotland, where the bands are as follows:

£12,570 - £14,667: 19% (Starter Rate)

£14,668 - £25,296: 20% (Scottish Basic Rate)

£25,297 - £43,662: 21% (Intermediate Rate)

£43,663 - £150,000: 41% (Higher Rate)

£150,000+ : 46% (Top Rate)

  1. Tax on Dividends

If you operate a limited company—and own shares in it—then you can also pay yourself via dividends (e.g. a share of the company’s profits).

Just as with income tax, you have an annual tax-free dividends allowance of £2,000. Beyond this, you pay progressively more tax.

This is based on your total taxable income, which is: personal income + dividends - Personal Allowance).

If your total taxable income is in the Basic Rate (£12,570 - £50,270), then you pay 7.5%.

Note:

You will always have £2,000 dividend allowance, even if your income is over the personal allowance

If it’s in the Higher Rate (£50,270 - £149,999), you have to pay 32.5%.

And if you’re in the Additional Rate (£150,000+), you have to pay 38.1%.

Felipe draws £3,000 worth of dividends each year, on top of a personal salary of £29,500. This makes a total income of £32,500.

However, given that he has a Personal Allowance of £12,500, his total taxable income is £20,000 (£32,500 - 12,500).

Felipe therefore has to pay:

  • 20% tax on £17,000 worth of wages
  • No tax on £2,000 worth of dividends (due to the dividend allowance)
  • 7.5% tax on £1,000 of dividends

Note: if you receive over £10,000 worth of dividends per year, you will need to fill in a Self Assessment tax return.

  1. National Insurance Contributions (NIC)

Paying National Insurance Contributions (NIC) ensures that you qualify for a range of benefits, including a State Pension, Maternity Allowance, Jobseeker’s Allowance, and more.

So let’s dig into who pays what, and in which circumstances.

A Recap of NIC system

  • Class 1 contributions are payable on earnings from employment
  • Class 2 and 4 are payable on the profits gained from self-employment
  • Class 3 contributions are voluntary payments

When you’re self-employed, you usually pay 2 types, or classes, of National Insurance.

  • Class 2 if your profits are £6,515 or more a year
  • Class 4 if your profits are £9,569 or more a year

If you’re… a Sole Trader

You pay Class 2 NICs when your income exceeds £6,515 per year.

At this amount, you contribute £3.05 per week to NIC.

When your income sits between £9,569 and £50,270, you’ll qualify for Class 4 NICs, which means you have to contribute 9% of your profits to NIC, as well as having to pay an extra 2% on all profits exceeding £50,270.

If you’re… Running a Limited Company

If you are both the director and employee of your limited company, then you will pay Employees’ NICs (Class 1 Contributions) and Employer’s NICs (Class 2 contributions).

Employees’ NICs or Class 1 National Insurance Rates

An employee’s Class 1 National Insurance is made up of contributions from the following sources:

  • deducted from their pay (employee’s National Insurance)
  • paid by their employer (employer’s National Insurance)

The amounts deducted and paid depend on:

  • the employee’s National Insurance category letter
  • how much of the employee’s earnings falls within each band
Income Level / Category letter £120 to £184 per week (£520 to £797 a month) £184.01 to £967 per week (£797.01 to £4,189 a month) Over £967 per week (£4,189 a month)
A 0% 12% 2%
B 0% 5.85% 2%
C N/A N/A N/A
H 0% 12% 2%
J 0% 2% 2%
M 0% 12% 2%
Z 0% 2% 2%

If you’re in category A and you report your earnings as £1,000 in a week you’ll pay:

Nothing on the first £184

12% (£93.96) on your earnings between £184.01 and £967

2% (£0.66) on the remaining earnings above £967

This means your National Insurance payment will be £94.62 for the week.

13.8% of all earnings above £169 per week.

Earnings above the primary threshold up to and including upper earnings limit 12%

Balance of earnings above upper earnings limit 2%

Employer’s National Insurance Contribution Rate

This table shows how much employers pay towards employees’ National Insurance for the 2021 to 2022 tax year.

Income Level / Category letter £120 to £170 per week (£520 to £737 a month) £170.01 to £967 per week (737.01 to £4,189 a month) Over £967 per week (£4,189 a month)
A 0% 13.8% 13.8%
B 0% 13.8% 13.8%
C 0% 13.8% 13.8%
H 0% 0% 13.8%
J 0% 13.8% 13.8%
M 0% 0% 13.8%
Z 0% 0% 13.8%
  1. Corporation Tax

UK Budget 2021

Here's what small medium businesses should know on the UK budget.

If you operate through a limited company, you’ll need to pay Corporation Tax—this is on top of any income tax you pay if you receive a monthly salary, as well as any tax you pay on dividends that you’re paid.

The Corporation Tax rate currently stands at 19% of all taxable profits. In other words, once you’ve taken your annual profits, reduced allowable deductions (such as staff salaries and travel costs), you then pay 19% of the figure that’s remaining.

However, the recent budget announced that from April 1st 2023 onwards, the rates will be as follows:

Companies with a turnover between £0 - 50,000: 19%

Companies with a turnover between £50,000 - 250,000: 25%, though this will be decreased according to marginal relief. In other words, if your turnover is around £60,000, then you will pay less than a company whose turnover hovers around £200,000.

Companies with a turnover that exceeds £250,00: 25%

Annabelle runs a limited company where she pays herself both a regular monthly income and dividends. In total, her salary amount to £42,500, so she pays 20% tax on £30,000 (as the first £12,500 is tax-free). Therefore, she pays £6,000 worth of personal income tax.

However, the business records annual profits of £70,000 after deducting all allowable expenses. Therefore, as well as paying £6,000 personally, Annabelle’s business must also pay 70,000 x 0.19 = £13,300.

  1. Allowable Deductions

We briefly touched on these above. In short, the government wants to incentivise business, so it makes certain purchases tax-exempt. This applies to both sole traders and limited companies.

These include:

  • Travel expenses
  • Cost of new machinery
  • Staff salaries
  • Professional services (e.g. accounting, legal, and banking costs)
  • Insurance
  • Utilities (e.g. internet, electricity, rent)
  • Office supplies

For more information on what qualifies, check out the dedicated HMRC page.

Annabelle’s company had recorded total annual profits of £150,000. However, this figure was reduced once her accountant deducted:

  • Her salary (£42,500)
  • Travel expenses (£7,500)
  • Utilities (£20,000)
  • Professional services costs (£10,000)

In total, this meant that her business was liable to pay 19% Corporation Tax on a total of £70,000.

  1. VAT

Whether you’re a sole trader or a limited company, there’s one key rule to be aware of:

VAT is payable if your annual turnover exceeds £85,000. There are also different VAT rules for different e-commerce businesses. Don’t fear, we know it can get complicated. Our accountants are specialised in e-commerce accounting and can help you figure it out. Drop us a message.

While you can voluntarily choose to pay VAT even if you're under that threshold, there’s no reason to do this. After all, why charge customers more than they need to pay?

Once you do reach £85,000 per year, however, then you must charge 20% VAT rate on all invoices. To register, head to GOV.UK. Companies can then claim back this VAT if their purchases were business-related.

For the first time in his career, Martin has brought in over £85,000 as a freelance copywriter. He therefore registers for VAT with HMRC, notifies his clients accordingly, and makes sure to charge 20% VAT on all invoices. Every three months, he submits his limited company’s VAT return.

His clients now have to pay increased fees as a result. That said, they can then claim this VAT back when they submit their own VAT Return.

  1. IR35

This controversial bill, due to come into effect on the 6th of April, 2021, means that freelancers may now be liable to pay increased tax. The government essentially wants to ensure that all freelancers who are in effect working as employees for companies (i.e. via contracting) pay roughly the same tax as full-time employees.

However, there are significant grey areas as to what constitutes this type of ‘off-payroll’ work. For more information on what does and doesn’t qualify, check out this useful HMRC fact-sheet.

John, a software engineer, has been working exclusively for one company for the past three years. However, they’ve technically employed him as an outside contractor—meaning they haven’t had to pay Employer's NIC of 13.8%.

From now on, however, he will be considered a full-time employee under the new IR35 regulations.

The Single Best Way To Calculate Taxes as a Freelancer

We hope that we’ve shed some light on how freelancers (both sole traders and limited companies) can calculate their taxes.

However, one thing’s clear: the UK’s tax system is incredibly complex.

There are hundreds—if not thousands—of loopholes, exceptions, regulations, and sub-regulations. Staying on top of the UK’s tax legislation is hard enough for experienced accountants, let alone if you’re a busy freelance entrepreneur trying to run your own business.

Fortunately, there’s a solution: OSOME.

You’ll work with your own, personal Chartered Accountant to guide you through your tax obligations. They’ll track all filing requirements and deadlines, suggest any relevant tax exemptions, and prepare bookkeeping reports on your behalf.

If you’re a freelancer, you’ll know that companies are willing to pay for genuine expertise. Usually you’re the expert that people seek out. When it comes to your accounting duties, however, there’s no shame in admitting that you’re far from an expert—even if you do try to regularly keep up-to-date with the latest industry changes.

So why spend unnecessary time, effort, and sanity picking your way through complex tax legislation? Book a demo with OSOME today and take a sneak peek into what life looks like once you ditch the headache of tax-related admin.

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