Taxation in business - Income Tax

Learning Outcomes

This article covers the income tax treatment of business owners and partners, including:

• Who is chargeable to income tax in business and how partnerships are assessed on partners’ shares
• The components of taxable income (NSNDI, savings, dividends) and their ordering for rate application
• The calculation sequence: total income, allowable reliefs, personal allowance, component rates, and deduction of tax at source
• Computing taxable trading profits from chargeable receipts, deductible expenditure, and capital allowances
• Common reliefs and exemptions and the choice and timing of trading loss reliefs (carry across/back, early years, carry forward, terminal loss)
• Opening year, current year, and final year assessment bases for sole traders and new/retiring partners, and identification/relief of overlap profits
• Applying the personal savings allowance and dividend allowance as nil-rate bands in the charging order
• Self-assessment reporting obligations, payments on account, key deadlines, and consequences of non-compliance
• Core anti-avoidance rules (including GAAR), the “double reasonableness” test, and associated penalties

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, with a focus on the following syllabus points:

• 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
• Self-assessment, payments on account, time limits for claims and penalties

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.

1. Who is chargeable to income tax when a partnership makes business profits?
2. What is the purpose of the personal allowance and at what level of income is it reduced?
3. Which reliefs are commonly available for trading losses for sole traders?
4. 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. A partnership itself does not pay income tax; each individual partner is assessed on their share. Corporate partners are not charged to income tax; companies pay corporation tax on their profits.

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. Income is grouped into components because different rates and ordering rules apply.

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.

Key Term: NSNDI (non-savings, non-dividend income)
All taxable income other than savings and dividend income (eg trading, employment and rental income).

Where relevant, small “trading” and “property” allowances may apply. These permit up to £1,000 of gross trading or property receipts per tax year to be treated as having a nil tax charge. If gross receipts exceed £1,000, the taxpayer can elect to deduct the allowance instead of actual expenses where advantageous.

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 to identify the profit assessable in each tax year.

For sole traders, special rules apply in opening and closing years when the accounting period and tax year do not align neatly:

• Opening year: assess profits from commencement to the following 5 April.
• Second year: assess profits for the 12‑month accounting period ending in that tax year.
• Third and subsequent years: assess profits for the 12‑month accounting period ending in the tax year (current year basis).
• Final year: assess profits from the end of the last period already assessed to cessation, deducting any overlap profit.

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.

Key Term: overlap profit
Profit charged twice to income tax in the opening years because of the interaction of accounting periods and the tax year; relieved on cessation or change of accounting date.

How to calculate business income tax

The income tax calculation for business profits proceeds in a defined order. Follow the steps carefully to avoid misapplying allowances and rate bands.

1. Calculate total income, including trading profits and all other taxable sources, for the tax year.
2. Deduct allowable reliefs to arrive at net income.
3. Deduct the personal allowance and any other statutory allowances to determine taxable income.
4. Separate taxable income into components (NSNDI, savings, dividends). Apply the statutory rates in the correct order (bottom slice NSNDI, then savings, then dividends), taking account of nil-rate allowances for savings and dividends.
5. Combine the tax at each rate to arrive at total liability, then deduct any tax paid at source.

Key Term: total income
Aggregate gross income from each source for the tax year before any reliefs or allowances.

Key Term: allowable reliefs
Deductions from total income before personal allowances, such as interest on qualifying loans (eg to buy a partnership share), certain pension contributions and Gift Aid. Reliefs may be subject to caps or conditions.

Key Term: net income
Total income after deduction of allowable reliefs, but before deduction of personal allowances.

Allowable reliefs and personal allowances

Allowable reliefs include certain interest payments on qualifying loans (eg to buy a partnership share or to invest in a close trading company) and contributions to pension schemes or Gift Aid donations. Relief for non‑deductible interest on qualifying loans is generally subject to an annual cap (the greater of £50,000 or 25% of adjusted total income).

The personal allowance is set by statute and may be reduced or eliminated for those with higher income. It is not carried forward if unused.

Key Term: personal allowance
The amount of income each individual may earn in a tax year before any income tax is due (commonly £12,570 in recent tax years), subject to an income limit 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.

Key Term: personal savings allowance (PSA)
A nil-rate band that taxes the first part of savings interest at 0%. Basic rate taxpayers usually receive up to £1,000; higher rate taxpayers up to £500; additional rate taxpayers have no PSA.

Key Term: dividend allowance
A nil-rate band for dividend income taxed at 0% up to the statutory amount for the tax year. The allowance reduces the rate on the first slice of dividends to 0%, but does not reduce taxable income.

Savings income may also benefit from the starting rate for savings (0%) where taxable NSNDI plus the PSA falls below the starting rate limit. Dividend and savings allowances are nil-rate bands: they do not reduce taxable income at Step 3; they reduce the charge at Step 4 on the first slices of savings and dividend income.

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.

Applying savings and dividend allowances

Once NSNDI has been charged, tax is calculated on savings income next, then dividend income. For savings:

• Deduct the PSA first (taxed at 0%).
• Any remaining savings income is charged at savings rates (starting rate 0%, then 20%, 40%, 45% depending on where it falls once the PSA is added to taxable NSNDI).

For dividends:

• Deduct the dividend allowance first (taxed at 0%).
• Charge the remaining dividend income at dividend rates (ordinary, upper, additional) based on the combined position of taxable NSNDI and savings.

Worked Example 1.3

A sole trader has taxable NSNDI of £28,000 after reliefs/allowances and savings interest of £1,600. There are no dividends.

How is the savings income taxed? Assume the PSA for a basic rate taxpayer.

Answer:
NSNDI is within the basic rate band, so the taxpayer is a basic rate taxpayer for PSA purposes.
PSA applies first: £1,000 at 0% = £0.
Remaining savings income: £600.
NSNDI plus PSA = £28,000 + £1,000 = £29,000 (below the basic rate threshold), so the £600 falls within the basic rate band and is taxed at 20% = £120.

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 across the current tax year and/or back one year against general income.
• Early years/new business relief (for losses in the opening years, set against income of the prior three tax years, taking later years first).
• Terminal loss relief (if ceasing trade, set against profits of the same trade in the final year and up to three prior years, taking later years first).
• Carry-forward relief on incorporation (losses carried forward to set against income received from the company, eg dividends or directors’ fees).

Each partner in a partnership claims reliefs for their own share of the partnership loss. The same loss cannot be relieved twice.

Key Term: start-up loss relief/early trade losses relief
Losses in the first four tax years of trading may be set against any income in the three tax years before the loss, taking later years first.

Key Term: carry forward relief
Loss carried forward and set against future profits of the same trade; claimed within statutory time limits and available until fully used.

Key Term: terminal loss relief
Relief for a loss in the final 12 months of trade, set against trading profits of the same trade in the final year and the three preceding tax years (later years first).

Worked Example 1.4

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 £7,000 against the previous year’s employment income, potentially resulting in a tax repayment (taking later years first if she claims more than one prior year). Alternatively, she may carry the loss forward for set-off against future trading profits of the same business. She could also consider carry across/back one year if she has other general income in the loss year or the preceding year.

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 deduction of personal allowances and reliefs before applying income tax rates and bands.

Profit sharing is governed by agreement. In the absence of an agreement, income profits and losses are shared equally (Partnership Act 1890, s 24(1)). The agreement may provide for salaries or interest on capital to be paid out of profits before division. Partners’ drawings (withdrawals on account of profits) should be managed to avoid excessive withdrawals that may later need repayment.

When partnership membership changes:

• A new partner is assessed under opening year rules for their first two tax years, while existing partners remain on the current year basis.
• A retiring partner is assessed under the final year rule, with overlap profit deducted.

Worked Example 1.5

A new partner joins an existing firm part way through the year. The partnership prepares accounts to 30 April and shares profits equally. The profits are £90,000 for year to 30 April 2024. The new partner joined on 1 May 2023.

What profits are assessed on the new partner in their first two tax years?

Answer:
First tax year (2023/24): opening year basis – assess 11 months’ share to 5 April 2024 (the proportion of the accounting year falling in the tax year).
Second tax year (2024/25): current year basis – assess full 12 months to 30 April 2024.
Overlap may arise on the months taxed in both years, relieved on cessation or change of accounting date.

Collection and payment (self‑assessment)

Some income tax is deducted at source (eg employment income under PAYE). Tax not deducted at source must be reported via self‑assessment.

Key Term: tax return
A self‑assessment form submitted to HMRC annually where tax has not been fully collected at source; it reports income and the taxpayer’s calculation of liability.

Key dates:

• Notification duty: tell HMRC of chargeability within six months of the end of the tax year.
• Filing deadlines: 31 October (paper) or 31 January (online) following the end of the tax year.
• Payments on account: two instalments, generally half of the previous year’s net self‑assessment liability, due by 31 January in the tax year and 31 July after the tax year, with any balancing payment by the following 31 January.

Key Term: payments on account
Two interim payments towards the current year’s income tax bill based on the previous year’s net self‑assessment liability, followed by a balancing payment.

Penalties include interest on late payment, fixed penalties for late filing or non‑payment, and penalties for inadequate records. Appeals go to the First‑tier Tribunal (Tax).

Worked Example 1.6

A taxpayer’s self‑assessment liability for 2023/24 was £24,000, of which £10,000 was deducted at source. In 2024/25, their self‑assessment liability is £30,000.

What are the payments on account and when are they due?

Answer:
Payments on account for 2024/25 are based on the prior year’s net self‑assessment liability: £24,000 – £10,000 = £14,000.
Two instalments of £7,000 are due: 31 January 2025 and 31 July 2025.
The balancing payment for 2024/25 is £30,000 – £14,000 = £16,000, due by 31 January 2026 (with credit for any amounts deducted at source in 2024/25).

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 counteractions 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.

The GAAR applies across major taxes (including income tax) and uses a “double reasonableness” test: an arrangement is abusive if it cannot reasonably be regarded as a reasonable course of action in relation to relevant tax provisions. GAAR itself does not levy a standalone penalty; however, failure to pay adjusted tax leads to ordinary interest and penalties. HMRC may also challenge arrangements under specific anti‑avoidance provisions or by applying purposive statutory interpretation principles.

Revision Tip

Focus on the precise calculation sequence: total income, allowable reliefs, personal allowance, apply bands and rates in the correct order (NSNDI, savings, dividends), and deduct tax already paid to arrive at the final liability. Apply PSA and the dividend allowance as nil-rate bands only at the charging stage. Traders must also consider opening/final year rules, the impact and timing of loss relief claims, and the consequences of non‑compliance under self‑assessment.

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 and create overlap profits in opening years.
• Steps: calculate total income, deduct allowable reliefs, deduct personal allowance, apply statutory bands/rates in the correct order, calculate tax liability.
• Allowable reliefs include qualifying loan interest; personal allowance is reduced at higher incomes.
• Savings and dividend allowances operate as nil-rate bands; savings may benefit from the starting rate depending on NSNDI.
• Trading losses can be set against other income or carried forward, subject to statutory rules and time limits; terminal loss relief applies on cessation.
• Partnerships do not pay tax directly; partners pay tax on their profit share. Default income profit sharing is equal absent agreement.
• Collection is via deduction at source and/or self‑assessment; know filing/payment deadlines and payments on account.
• Anti-avoidance rules apply to abusive schemes; HMRC can counteract and enforce adjusted tax with interest and penalties.

Key Terms and Concepts

• chargeable person
• trading profit
• NSNDI (non-savings, non-dividend income)
• total income
• allowable reliefs
• net income
• tax year
• personal allowance
• personal savings allowance (PSA)
• dividend allowance
• overlap profit
• tax return
• payments on account
• start-up loss relief/early trade losses relief
• carry forward relief
• terminal loss relief
• anti-avoidance rule