How do I work out my taxable profits?
There are many steps to working out your taxable profits. We take you through the process.
Taxable profits are usually based on the profits shown by your business accounts, after they have been adjusted to comply with the tax rules. We explain how to prepare business accounts and how to make adjustments for tax purposes later in this section.
However since 6 April 2017 there are two situations where these calculations may not be necessary and this is due to the introduction of the trading allowance. The situations are:
(b) if you decide to claim a round sum amount equal to the trading allowance for your business expenses instead of the actual business expenses you have incurred in your basis period for the tax year, in which case the taxable profit is simply the excess of the total income over the trading allowance in that tax year.
However, you cannot create a loss if your trading income is less than the trading allowance.
This is explained in more detail in the section on the trading allowance below.
Your total income, which is also known as your gross income, is all your business income in the accounting period. This is sometimes also called turnover or sales. This information should form part of your day-to-day business records and so should be fairly easy to calculate. Most small businesses or hobby traders will record their income and expenses on a cash basis and so for most people, the gross income will be the amount of income received in the accounting period.
This is the period for which you will be charged tax in a particular tax year. Usually, for a continuing business this is the 12 month accounting period that ends in that tax year.
Normally accounts are prepared to the same date in each year (the accounting date), so you usually choose a date that is convenient for you. You can have any day in the year as your accounting date although from a tax point of view, the easiest date to choose is 5 April, but any date from 31 March to 5 April inclusive will be treated as 5 April to make things as easy for you as possible.
If you make up your accounts to 31 December each year, this is your accounting date and the 12 months to 31 December is your accounting period.
If you start your business on 1 July your first accounting period will be only 6 months long, and then subsequent accounting periods will be 12 months each.
Trevor makes up accounts to 31 October each year. His basis period for 2018/19 is the year ended 31 October 2018. This means that the tax Trevor will pay for the 2018/19 tax year is the tax on his taxable profits for the basis period 1 November 2017 – 31 October 2018.
For the first tax year, your basis period is always the period from the date you started trading until the following 5 April.
Remember that if your accounting date falls from 31 March to 5 April inclusive, this will be treated as 5 April for these purposes.
Gunther starts trading on 1 July 2018. His basis period for the 2018/19 tax year is the period from 1 July 2018 to 5 April 2019.
For the second tax year that you are self-employed you may fall into one of three different categories:
- If you have prepared a set of accounts for at least 12 months that end in that second tax year, then the basis period for that tax year is the 12 months ending on the accounting date.
George starts trading on 1 September 2017. He draws up accounts to 31 December 2018 and to the same date each year after that. The basis period for his first year (2017/18) is the period from 1 September 2017 to 5 April 2018. The basis period for his second year (2018/19 tax year) is the year from 1 January 2018 to 31 December 2018. The basis period for his third year is the year to 31 December 2019.
You will see that to arrive at these figures George will have to split the figures for his 16 month period of accounts. This is done on a strict time basis. For example, if George’s accounts for the 16 month period to 31 December show a profit of £16,000, then it is assumed he made a profit of £1,000 each month evenly over the period, so for the basis period from 1 September 2017 to 5 April 2018, he would be assumed to have profits of £7,000 – equivalent to profits for seven months.
- You may have no accounts that actually end in the tax year: if that is the case, the basis period is from 6 April to the following 5 April.
Alexander starts trading on 1 February 2017 and draws up accounts to 30 April 2018 and to the same date each year after that. The basis period for his first year (2016/17) is the period from 1 February 2017 to 5 April 2017. The basis period for his second year (2017/18) is the period from 6 April 2017 to 5 April 2018. The basis period for his third year is the twelve months to 30 April 2018.
- You may prepare a set of accounts that end in the tax year, but they are not at least 12 months long. In that case, the basis period is your first 12 months of trading.
Louis starts trading on 1 January 2017 and draws up accounts to 30 June 2017 and to the same date each year after that. The basis period for his first year (2016/17) is the period from 1 January 2017 to 5 April 2017.The basis period for his second year (2017/18) is from 1 January 2017 to 31 December 2017. The basis period for his third year is the year to 30 June 2018.
This basis period starts just after the previous period ended and stops on your final day of trading.
You have been trading for many years making accounts to 31 October. You cease trading on 31 August 2018, which is in the 2018/19 tax year. Your accounts for the year to 31 October 2017 would form your basis period for the tax year 2017/18. Your final tax year of trading is 2018/19 and your basis period is the period from 1 November 2017 to 31 August 2018. Remember you can deduct any overlap relief that is still being carried forward when you cease trading.
A trading allowance has been introduced for the 2017/18 tax year onwards to exempt trading and/or miscellaneous income of up to £1,000 per tax year from income tax. The allowance can be used against any trading or miscellaneous income. This might include income from what is often known as the ‘sharing economy’ for example car sharing, or perhaps against income arising from hobby activities which are in the process of developing into a more commercial business.
You are entitled to claim the trading allowance if either:
(a) you use the cash basis of accounting, or
(b) you use the accruals basis of accounting but are eligible to use the cash basis.
In this section ONLY we will now refer to trading income to cover both trading and miscellaneous income.
If your total trading income in the basis period for the tax year is less than £1,000 then you have no taxable income from the activities. This means there is no need to prepare accounts and no need to include the income on your self assessment tax return. If this is your only source of taxable income there is no need to register for self assessment in these circumstances. But there may be circumstances where you may still want to register, even if you don’t have to, for example:
- Because you want to pay voluntary class 2 NI contributions.
- Because you want a record of your self employment for maternity allowance.
- Because you would like to claim tax-free childcare.
If the trading allowance is more than the trading income, no trading loss is created.
You should be able to calculate your total income in the basis period from your business records.
If your total trading income in the basis period for the tax year is more than £1,000 you can choose to deduct the trading allowance from the trading income instead of deducting your actual business expenses for the period. If you do this, the taxable profit from the activity will simply be the total income less the trading allowance. So if Sarah has total income of £1,700 from selling home-baking at local monthly farmers markets in 2018/19, and she decides to claim the trading allowance, her taxable profit from this is £700.
It would be beneficial to claim the trading allowance in this way if you do not have very high expenses related to the activity. It also means that you do not need to prepare any business accounts for tax purposes.
It will still be necessary to keep business records so you know what your income and expenses are to be able to work out whether or not you wish to claim the trading allowance.
If you have a taxable profit after claiming the trading allowance, you can find out how to report this to HMRC and how to pay tax on the profit in the section ‘How do I pay tax on self employed income?’. If you need to register for self assessment for the first time due to this income see the section ‘How do I register for tax and National Insurance?’
Please note that even if you do not have to report this income to HMRC you may still need to report it for some means tested benefits, such as universal credit.
If you claim the trading allowance and you are repaying your student loan, then the income used to calculate your student loan repayments will be the amount after the trading allowance has been deducted.
If you have more than one type of trading or miscellaneous income you can still only claim one trading allowance but you can choose how to allocate the allowance between your income sources. This is best illustrated by an example. But remember you can’t claim expenses when you claim the trading allowance, so the effect of this needs to be considered too. It may not be beneficial to claim the trading allowance at all.
Boris has recently started his own self-employed web design business. He also buys and sells items on an on-line auction website from time to time. During the 2017/18 tax year his income and expenses were as follows:
Web design business:
Income £2,400 Expenses £700
Online auction sales:
Income £1,100 Expenses £900
Boris can choose how to use the trading allowance. His options are:
Claim the allowance against the web design income. This would mean he has a taxable profit of £1,400 from this source. But his profit from the online auction sales is £1,100, as he cannot deduct the expenses of £900. So his total taxable profits are £2,500.
Claim the allowance against the online auction sales. This would mean his taxable profit from this source would be £100. His profit from the web design business is £2,400, as he cannot deduct expenses of £700. So his total taxable profits are £2,500.
Not claim the trading allowance at all. This would mean he has taxable profit of £1,700 from the web design business and £200 from online auction sales. SO his total taxable profit is £1,900.
It is best for Boris not to claim the trading allowance at all as this gives him the lower taxable profits overall.
If the trading allowance is not relevant to you then you will need to prepare a set of accounts for your business and then make tax adjustments for business expenses that are not allowable and for capital allowances.
You need to prepare accounts so you can work out what profits or losses you have made from your self-employment. You do this from your business records. Your accounts should show all of the income and expenses from your business for the period of the accounts. After that you can decide whether the expenses are allowable for tax purposes or not.
Historically, this was the usual way that accounts were prepared in the UK. In general terms this means that all income earned and all expenses incurred during the accounting period are included in the accounts, whether they are paid or not.
For example, if you invoice a customer on 31 December 2017 and draw up accounts to 31 December 2017, this invoice would be included, whether the customer had paid it or not.
Similarly, if you paid your annual insurance bill on 1 July 2017 to cover the period from 1 July 2017 to 30 June 2018, you would only include half of the cost in the accounts to 31 December 2017 even though you had paid the full amount; the other half would be included in the accounts for the following year.
Whereas the accruals basis looks at income earned and expenses incurred, the cash basis looks at income actually received and expenses actually paid in the accounting period.
If you meet certain criteria, you can choose to use the cash basis instead of the accruals basis.
You can read about more about this on our page 'what is the cash basis?'.
Below is an example of what a typical profit and loss account may look like, but if your accounts look slightly different to this that is fine as long as you have included all the income (sales) less any business expenses (costs) so you can calculate your business profit.
Profit and loss account for the year ended 5 April 2018
Tax year 2017/18
|Sales (turnover or income)||15,000|
|Less cost of sales:|
|Less other expenses|
|Travel – mileage||400|
|Working at home||120|
|Net taxable profit||6,505|
I have prepared my accounts and decided which expenses are not allowable. What do I do next?
You take the profit per your accounts (£6,505 in the above example) and add to it any business expenses that are not allowable for tax purposes. This is because you may incur expenses that reduce your profit in your accounts but which HMRC do not allow you to deduct for tax purposes. You must therefore add them back in so that you pay tax on them.
Bernard’s accounts for the year to 31 March 2018 show a profit of £17,300. The accounts include all of his motoring expenses of £12,000, but Bernard estimates that only 60% of these costs are actually business costs.
|Profit per accounts||£17,300|
|Add: private motoring expenses||£4,800 (ie 40% of £12,000)|
Some expenditure will be treated as capital expenditure rather than a trading expense. An item will generally be a capital expense rather than a trading expense if it is an item you need for your business and it is likely to have an enduring benefit. There are some exceptions to this.
If you are using the accruals basis you cannot deduct capital expenditure from your trading profits. Instead you may be able to claim a capital allowance for that expenditure.
Once calculated, capital allowances are treated as a trading expense and are deducted from the adjusted profits as noted above. You should note that deduction of capital allowances may create a loss for tax purposes or increase a loss.
Continuing the example of Bernard from above: Bernard bought a new machine in January 2018 for £2,500. That will qualify for 100% capital allowances (annual investment allowance).
Bernard’s taxable profits become:
|Adjusted profits (from above)||
|Less: capital allowances||£2,500|
See our capital allowances page for more information on calculating capital allowances.
Once you have calculated the taxable profits in this way you will need to work out which tax year the profits will be taxed in by following the basis period rules explained above.
The tax system operates so that overall all business profits are only taxed once but, as you can see from the examples above, sometimes at the start of a business profits are taxed more than once. These profits that are taxed twice are called overlap profits.
Consider the Louis example above.
In year 1 (2016/17) he is taxed on the profits from 1 January 2017 to 5 April 2017.
In year 2 (2017/18) he is taxed on the profits from 1 January 2017 to 31 December 2017.
In year 3 (2018/19) he is taxed on the profits from 1 July 2017 to 30 June 2018.
You will see that in year 2 he is taxed on the profits from 1 January 2017 to 5 April 2017 that were already taxed in year 1.
In year 3 he is taxed on the profits from 1 July 2017 to 31 December 2017 that were already taxed in year 2.
If we assume that Louis’s taxable profits for the 6 month period to 30 June 2017 were £6,000 and his profits for the year to 30 June 2018 were £18,000, then his taxable profits and overlap profits would be as follows:
|Tax year||Taxable profits||Overlap profits|
|2016/17||£3,000 (3 months)||nil|
|2017/18||£15,000 (12 months being 6 months to 30 June 2017 plus 6 months to 31 Decembre 2017)||£3,000 (3 months to 5 April 2017)|
|2018/19||£18,000 (12 months to 30 June 2018)||£9,000 (6 months)|
Total overlap profits are £12,000.
As you should only be taxed once on income, you can use these overlap profits at a later date to reduce the tax you pay.
You can use overlap profits either when you cease to trade or if you change your accounting date to a date closer to the end of the tax year, that is 5 April. See below for an explanation of how each of these works.
You will need to keep a note of the amount of overlap profit you have and what number of months it relates to. You carry your overlap profit forward on your tax return until you are able to use it.
It is possible to change your accounting date for tax purposes but you will need to explain to HM Revenue & Customs (HMRC) in your tax return why the change is necessary. They may not accept your explanation in which case you will have to keep your existing date.
However if you have a reasonable argument it is likely to be accepted. For example, you have two businesses and you want the same accounting date for each. You cannot just keep changing the date each year to suit yourself.
If you want the change to be temporary – you can ignore it for tax purposes. Otherwise if you have:
- Made up accounts to a date different from that used for your tax in the previous year; or
- You intend to draw up a set of accounts for more than 12 months so that no accounting date falls into the current tax year; or
- If you changed your accounting date last year but this was not accepted by HMRC and you are using the same date again
You will be treated as having changed your accounting date.
Changing your accounting date will mean that you will have a new basis period for your taxable profits. See the section below for how this is calculated.
If you change your accounting date you will need to work out your new basis period using the following rules:
- If your new accounting date in 2018/19 is more than 12 months after the end of your basis period for the previous year (2017/18), your new basis period will be from the end of that basis period to your new accounting date.
Susan has a basis period in 2017/18 that ended on 30 June 2017. She decides her new accounting date will be 30 September 2018. Her basis period for 2018/19 is the 15 months from 1 July 2017 to 30 September 2018. At this time she can use overlap relief equivalent to 3 months of profits to reduce the tax she has to pay for the tax year 2018/19. If she was carrying forward overlap profits of £4,000 that equated to 4 months profits, then she would use overlap profits of £3,000 now and still carry forward £1,000.
- If your accounting date in 2018/19 is less than 12 months after the end of your basis period for the previous year to 2017/18 your new basis period will be 12 months ending on the new accounting date.
Tom has a basis period for 2017/18 that ended on 30 September 2017. His new accounting date is 30 June 2018. His basis period for 2018/19 will be the 12 months to 30 June 2018. He is creating a further 3 months of overlap profits that will be carried forward.
If you have changed accounting date and your basis period is more than 12 months, you can use your overlap profits to reduce the basis period to 12 months – see the example Susan above.
Further example on use of overlap profit
You have unused overlap profit of £6,000 which came about because 6 months of profits overlapped when you started your business. You then change your accounting date and your new basis period for 2018/19 is 15 months. You can only be taxed on 12 months profits.
You have 6 months overlap relief available and you need to reduce the 15-month basis period to 12 months so you use 3 months of your relief up.
Overlap relief used
3/6 x £6,000 = £3,000
Your profits for 2018/19, which are based on a 15-month basis period will be reduced by £3,000 and you still have 3 months overlap profits to carry forward.
If you wish to find more information on change of accounting date, you can look on the GOV.UK website.
How do I get relief for overlap profits when I cease trading?
Any previously unrelieved overlap profits are deducted from your profits in the last tax year.
Louis is carrying forward overlap profits of £12,000. He makes up his last set of accounts for the year to 30 June 2018 that show a profit of £28,000.
Louis ceased trading on 30 June 2018,that is in the tax year 2018/19. If he had not ceased trading he would have been assessed to tax on profits of £28,000. But he can deduct his overlap profits from his taxable profits for the year to 30 June 2018 because he has ceased trading. His assessable profits for 2018/19 become £16,000 (£28,000 less overlap profits of £12,000).