No matter what business structure you choose to operate your business through the ultimate aim must be to make a profit so that you can pay yourself something out of the business to live on. How you do that depends on your business structure – sole trader or limited company. Before we move onto explaining how to pay yourself let’s take a look at the reality of being self employed.
Ditch the monthly payslip
Moving into the world of self employment means ditching the usual weekly or monthly PAYE (pay as you earn system of taxation with your employer sorting out the administration of the system and payment of taxes due) payslip showing how much you’ve earned after deductions with the net amount popping into your bank account on a regular basis.
Instead, you are responsible for self assessing the amount of tax that you must pay on all of your income which will include the profits from your self employment, dividends or salary. To be able to self assess your tax bill you will need to know the tax laws that apply or to appoint someone who can do this on your behalf such as an accountant or tax advisor. Ignorance of the rules or laws is no excuse and HMRC do not generally accept a lack of knowledge as a valid reason for not completing tax returns, completing them incorrectly or not fulfilling your legal responsibilities.
HMRC’s stance will be that you should have known or you should hire someone who does.
How much is yours and how much belongs to HMRC?
In practice this means that alongside all of the tasks and financial management associated with running your business, from day one you need to take responsibility for knowing two key figures:
- how much you need to set aside for your tax bill
- how much you can take out from your business to pay yourself
There is no getting around this – it is the reality of being self employed.
The first thing to do is to set a recurring task (weekly or monthly depending on your needs) to work out how much money in the business is yours and how much belongs to HMRC. Put this recurring task into your diary system.
If you are using an accounting system this should have a dashboard which will show you this information. However, it’s still worth understanding the mechanics behind the calculation.
To work out your business finances follow a basic rule of thumb being:
Tax due on profits (amount to set aside to pay future tax bills)
Money you can take out of the business
Your tax bill is based upon your profit (income less costs) and the amount left after setting aside what you’d need to pay in tax is what you can take out of the business. This is your earnings (also known as wages, drawings or if taken from a limited company your salary and dividends) from the business.
If you don’t follow this simple process then you could end up taking more out of the business than you should have done and not having enough set aside to settle your tax liabilities. HMRC will take a very dim view and in all likelihood this will result in them taking action to recover the tax due, even if it’s tax owed by your company.
It could be that you cannot live on your earnings. In reality that means that the business is not successful enough or generating enough profit to meet your outgoings and you need to take action. The right action is to look for other income sources or lower your outgoings, or a combination of the two. The action to avoid is to live off the money that you need to set aside for tax. That’s the equivalent of borrowing money from HMRC – it will not end well. HMRC will want their tax money paid. They will not accept any protests from you that you needed the money to live on and you haven’t got anything left.
Tip – As a self employed person it is absolutely essential to get into the mindset that your earnings are profit AFTER tax – not all the money that you get is yours!
How can you legally take money out of your business?
Once you’ve established how much you can pay yourself you need to formally take this out of the business so that the amount can be represented correctly in your accounting records.
The rules for doing this are different depending on your business structure:
The other payment to you – out of pocket expenses
As well as Drawings for sole traders or salary and dividends for a Limited Company there is one other payment that could be made to a business owner and that is for Expenses.
Wherever possible any business costs should be paid directly from the company business bank account using the payment card associated with that account. That’s just good accounting practice and will avoid issues later.
However there may be some things that you just have to pay for on behalf of your business (“out of your own pocket”) as well as certain expenses which the business will owe you such as business mileage and use of home as office.
Unless you are using an accounting system which has an expenses claim function, a good protocol to follow for such items is to complete an expenses claim at the end of each month.
List all of the expenses that you need refunding from the business bank account. Total up the expenses to be reimbursed from the business and pay this amount from the business bank account to your personal bank account giving the transactions the description of “Expenses”.
When you enter your expenses into your accounting system, or explain the transaction on your bank statement you do need to allocate the total amount to each cost heading from your expenses claim form.
This whole process is something that you may have followed if you’d been employed and you had to claim back expenses from your employer for trips made and such like.
It is good practice to have the necessary back up to support the amounts on your expenses claim such as receipts, a mileage log* or your use of home as office calculation.
*A mileage log is simply a list of business journeys made in your own car showing the date, destination, mileage and reason for the trip.
Do not include expenses that have already been paid for via the business bank account – this would just be double counting the amount.
- Being self employed means abiding by certain formalities when it comes to extracting money from the company
- For this you need to do your accounting as you go
- Extract money from the business only via one of the allowed ways; salary, dividends and expenses reimbursement for limited companies or Drawings and expenses reimbursement for sole traders
- Set up a monthly direct debit for any salary paid to yourself from the Limited Company but avoid setting up a regular direct debit for dividends
- To make things simpler avoid paying for personal items through the company business bank account
- Make each payment separately avoiding lumping them together even if it is easier
- Doing things properly will avoid issues later