Learning Outcomes
After studying this article, you will be able to:
- Identify who is liable to pay income tax in a business context.
- Distinguish different types of taxable income relevant to business owners and partners.
- Apply the sequence of steps required to calculate business income tax liability for sole traders and partnerships.
- Recognize common reliefs and exemptions.
- Explain how anti-avoidance rules and penalties operate in the context of business income tax for the SQE2 assessment.
SQE2 Syllabus
For SQE2, you are required to understand the income tax treatment of business owners, including sole traders and partners, and the processes for calculating and reporting income tax. In your revision, focus on:
- The categories of persons (and entities) chargeable to income tax in business contexts
- The structure of the UK personal income tax year and relevant thresholds
- Income tax liability for trading and non-trading income
- The calculation of taxable profit for unincorporated businesses
- Reliefs for trading losses and allowable reliefs
- The order and rates at which different components of income are taxed
- Personal allowances and other statutory allowances
- Core anti-avoidance provisions and consequences for non-compliance
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Who is chargeable to income tax when a partnership makes business profits?
- What is the purpose of the personal allowance and at what level of income is it reduced?
- Which reliefs are commonly available for trading losses for sole traders?
- Name two steps in the calculation of income tax on business profits.
Introduction
Income tax is a core consideration for individuals operating or investing in sole traderships and partnerships. Your understanding of how trading income is taxed, what counts as taxable income, and the sequence of calculation is tested throughout SQE2. This article sets out the requirements and practical implications.
Persons liable to income tax
The main chargeable persons for business income tax are individuals (including sole traders), individual partners in a partnership, personal representatives, and trustees.
Key Term: chargeable person
An individual or entity liable to pay income tax on business profits, such as sole traders, individual partners, trustees, or personal representatives.
What types of income are taxed?
Business income encompasses trading profits, partnership profits, employment income, rental income and certain investment income such as interest or dividends. The type of business and structure determines which person is taxed.
Key Term: trading profit
Profits made from trading, ie, carrying on a business of providing goods or services. The basis for income tax charges for sole traders and partnerships.
Structure and tax year
The income tax year runs from 6 April to 5 April. Individuals and partners pay tax on income earned in this period. For businesses, the accounting period may differ from the tax year, requiring appropriate adjustments.
Key Term: tax year
The period running from 6 April in one year to 5 April in the next, used to assess UK income tax liability.
How to calculate business income tax
The income tax calculation for business profits proceeds in a defined order:
- Calculate total income, including trading profits and all other taxable sources, for the tax year.
- Deduct allowable reliefs to arrive at net income.
- Deduct the personal allowance and statutory allowances to determine taxable income.
- Apply the statutory income tax rates to each relevant source or “slice” of income.
- Combine the tax at each rate to arrive at total liability, deducting tax paid at source.
Allowable reliefs and personal allowances
Allowable reliefs include certain interest payments (on qualifying loans) and contributions to pension schemes. The personal allowance is set by statute each year and may be reduced or eliminated for those with higher income.
Key Term: personal allowance
The amount of income each individual may earn in a tax year before any income tax is due, subject to an income cap where it is reduced.
Worked Example 1.1
A sole trader earns business profits of £32,000 in the tax year 2023/24. She pays £2,000 interest on a qualifying loan. Her only other income is bank interest of £400. The personal allowance is £12,570.
What is her taxable income, and how much income tax is due before considering the rate bands?
Answer:
Step 1 – Total income: £32,000 (trading) + £400 (interest) = £32,400
Step 2 – Less allowable reliefs: £32,400 – £2,000 (loan interest) = £30,400
Step 3 – Less personal allowance: £30,400 – £12,570 = £17,830 taxable income
The £17,830 is then subject to the relevant rates (e.g., 20% basic rate for non-savings income).
Types and “slices” of business income
Different income sources are taxed at different rates and bands, and in a defined order:
- Non-savings, non-dividend income (trading, employment, rental)
- Savings income (interest)
- Dividend income
Applying the correct order is essential to ensure the personal allowance, savings allowance, and dividend allowance are set off properly.
Worked Example 1.2
A partner’s total taxable income after reliefs and allowances is £45,000, of which £42,000 is trading profit and £3,000 is bank interest. The basic rate band covers £37,700.
What rates apply?
Answer:
The first £37,700 (basic rate band) of income, starting with non-savings (trading), is taxed at 20%. Any income above this band (here, £7,300) is taxed at 40%. Savings income (bank interest) also uses the remaining part of the basic rate band.
Reliefs for trading losses
If a sole trader or partner makes a trading loss, there are several main reliefs:
- Carrying the loss forward to offset against future trading income from the same business.
- Carrying the loss back one year and setting it against income of the previous year.
- Early years/new business relief (for losses in the opening years, offset against prior income, subject to specific conditions).
- Terminal loss relief (if ceasing trade).
Worked Example 1.3
A sole trader begins a new business and in the first tax year has a trading loss of £7,000. She was previously employed with a salary of £25,000 in the previous year.
What options are available for loss relief?
Answer:
She may claim early years loss relief and set the loss against the previous year’s employment income, potentially resulting in a tax refund. Alternatively, she may carry the loss forward for set-off against future trading profits of the same business.
Taxation of partnerships
A partnership does not pay tax itself. Instead, individual partners are taxed on their share of the partnership's income. Each partner's share is treated as if received directly as a sole trader, allowing for deduction of personal allowances and reliefs before applying income tax rates and bands.
Anti-avoidance rules and penalties
There are rules to counter abusive arrangements intended to reduce income tax liability, known as the general anti-abuse rule (GAAR). HMRC can impose penalties and demand adjusted payment of tax if arrangements are found to be “abusive”.
Key Term: anti-avoidance rule
A statutory measure allowing HMRC to counteract arrangements whose main purpose is to obtain a tax advantage, including GAAR for “abusive” avoidance.
Revision Tip
Focus on the precise calculation sequence: total income, allowable reliefs, personal allowance, apply bands and rates, deduct tax already paid to arrive at the final liability. Traders must also consider the impact of loss reliefs and anti-avoidance provisions.
Key Point Checklist
This article has covered the following key knowledge points:
- Calculation of income tax for sole traders and partnerships is on the individual's share of trading profits, not at business level.
- The tax year for income tax is 6 April–5 April; accounting periods may differ.
- Steps: calculate total income, deduct reliefs, deduct personal allowance, apply statutory bands/rates, calculate tax liability.
- Allowable reliefs include qualifying loan interest; personal allowance is reduced at higher incomes.
- Trading losses can be set against other income or carried forward, subject to statutory rules.
- Partnerships do not pay tax directly; partners pay tax on their profit share.
- Anti-avoidance rules apply to abusive schemes; penalties and tax adjustments can be enforced.
Key Terms and Concepts
- chargeable person
- trading profit
- tax year
- personal allowance
- anti-avoidance rule