If you file a self assessment tax return online, you have until 31 January to get it done. Or, you risk a fine.
This means it's time to find out how much money you made last year. And how much of it HMRC is going to take away from you in taxes. Which involves getting to grips with your business profits, your gross income and - gasp - using these figures to calculate your taxable income.
Big words. Right? Intimidating, even scary terms. But don't worry. We've got you covered. In this post, we'll explain what profit, gross income and taxable income are. We'll also show you how to calculate them, so you can crunch the numbers and complete your self assessment tax return like a pro.
Which profits do I pay tax on?
Whether self-employment is your main source of income or just a side hustle, you'll need to pay tax on your business profits. Luckily, you don't have to pay tax on all your profits, but only on part of them (whew!).
In the UK, you pay tax on your gross profits less any allowable expenses. These are also known as adjusted profits.
But let's back up a bit.
What are gross profits?
Gross profit is all the revenue you (and your business) have generated during a given tax year, less the cost of goods sold. So, if you're a bookseller, your gross profit is the sum you get when you subtract total sales from your books' wholesale price. In other words, it's what you've charged your customers less what you paid for your stock.
What is turnover?
Some taxpayers don't know what is turnover and how it affects your business. Turnover is the net sales generated by the business. In the above example, this would be the amount of sales for the books.
Calculating gross profits: Example
Let's say you bought £150,000 worth of books in 2016/17. Business was really good, and you managed to sell everything. Your sales for the year totalled £250,000.
Your gross profit would be £250,000 less £150,000. So, £100,000.
However, you won't pay tax on the full £100,000. In addition to the cost of goods sold, HMRC also lets you deduct other expenses, called allowable expenses. These further reduce the amount of profits you pay tax on.
How do I calculate my taxable profits?
To calculate your taxable profits, you'll need to deduct allowable expenses from your gross profit.
As a rule, you can deduct an expense only if you incurred it "wholly and exclusively" for business purposes. So, if you have a consulting business, you can deduct the cost of professional indemnity insurance, which covers legal costs if a client sues you for malpractice.
On the other hand, you can't deduct the cost of your suits. This is because you might also wear them outside working hours, for instance, to attend a wedding.
However, you can sometimes deduct a portion of your expenses, even though you also use the item for personal reasons. In order to do this, you must be able to show HMRC that you use a "definite proportion" wholly and exclusively for business reasons.
Mileage is a prime example of this kind of expense. You can usually deduct business mileage even though you also use your car for personal journeys. This is because you can usually identify a specific amount of miles you've racked up wholly and exclusively for business purposes, for example, to travel to and from client meetings.
How do I calculate my profit margin?
As you're calculating your profits, it's worth taking the opportunity to find out your profit margin. While you won't need this for tax purposes, your profit margin is a measure of how profitable your business is. This helps you assess your business performance and make adjustments so it runs more efficiently.
So what's a profit margin? It's your profit expressed as a percentage. This table sets out the three main types of profit margin and explains how you can calculate them using a simple formula.
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Examples:
Let's use our previous example, in which you made £250,000 selling books you bought for £150,000.
Gross profit margin
Your gross profit margin would be £100,000 divided by £250,000 and multiplied by 100 to get a percentage. In other words, 40 percent.
Operational profit margin
Let's say you deduct a further £70,000 in business expenses such as utilities, shop rental costs, and wages.
Your operational profit margin would be £30,000 divided by £250,000 and multiplied by 100 to get a percentage. In other words, 12 percent.
Net profit margin
To get your net profit margin, you'd need to find out your net profit first. This is your gross profit, less operational expenses, less tax and national insurance contributions.
The tax bands for 2016/17 were:
0 percent for the first £11,000
20 percent for income between £11,001 and £43,000
40 percent for income between £43,001 and £150,000
This means you'd pay 0 percent on the first £11,000 and 20 percent on the remaining £19,000. So, £3,800. You'd also pay National Insurance at the following rates:
Your net profit margin would be £30,000 minus (£3,800 + £145.60 + £2,700) divided by £250,000 and multiplied by 100 to give a percentage. So, your net profit margin would be 9.34 percent.
What is gross income?
Your adjusted business profits aren't the only thing you pay tax on. HMRC will also want a cut of your other earnings. For this reason, you can't calculate your adjusted business profits and stop there. You'll also need to calculate your total gross income. You can then apply any allowable deductions in order to arrive at your total taxable income.
But let's not get ahead of ourselves.
Your gross income is all the money you earned during the financial year. It includes:
Your adjusted business profits, which we've just tackled above
If you work full time or part time, your salary, including any benefits (for example, a company car)
Any other income, such as income from a rental property or interest on your savings and investments
Any benefits you claim from the state
How do I calculate my gross income?
To calculate your gross income, you'll need to add up all the income you earned in a given tax year. So, if you're calculating your gross income for the 2016/17 tax year, you'll have to include any income you earned between 6 April 2016 and 5 April 2017. This sounds simple, but it can be tricky.
Here's how to go about it.
Step 1: Work out your adjusted business profits As we explained above, you'll first need to deduct the cost of goods sold from your total revenue to find your gross profit. Then, apply allowable deductions to your gross profit using the "wholly and exclusively" rule.
Step 2: Work out your total gross salary These are the total wages you earned during the tax year, including any benefits in kind. You'll find this on:
Your P60 form. Your employer should give you a P60 form at the end of each tax year. If you hold down more than one job, you should get a P60 form for each job.
If you left your job, for example, because you've decided to go self-employed full-time, your employer should have given you a P45 form.
Both P60 and P45 forms are a legal requirement. If your employer hasn't given you one, make sure you ask for it. Aside from calculating your gross income, you'll also need the forms for other reasons, for example, if you want to get a mortgage.
For benefits in kind, such as a company car, your employer should give you a P11D form. This will tell you the taxable value of any benefits you've received.
Step 3: Add up other income If you:
Earn income from a rental property
Have an interest-bearing savings account
Have an interest-bearing investment
Earn income from another source, for example from a trust or a pension
You'll need to include them in your gross income calculation.
In the case of interest-bearing savings or investments, your bank or investment advisor should provide you with an end-of-year annual interest statement. This will show you how much interest you earned during the tax year.
The following are tax-free, so you don't need to include them in your gross income calculation:
The interest you earn on an ISA (individual savings account) if you haven't exceeded the annual threshold. In 2016/17, this was £15,240. In 2017/18, it's £20,000.
The interest you earn on your pension contributions, as long as you and your employer haven't contributed more than £40,000 in the current tax year. (You can, however, carry forward any unused portion of your annual allowance from the last 3 tax years).
Withdrawals from an insurance policy or investment bond if they're less than 5% of the amount you originally invested.
You've calculated your taxable profits and added them to your other earnings to get your total gross income. Great. This means you're in the final stretch. Now, you just have to find out what your taxable income is.
Put simply, your taxable income is the amount of income that's used to calculate how much tax you owe. In the US, this is known as the adjusted gross income. However, in the UK, it's called the adjusted net income.
How do I calculate my adjusted net income?
To calculate your adjusted net income, deduct the following from your gross income:
Any tax and national insurance contributions you've already paid, for example, because they were automatically deducted from your part-time or full-time salary.
Trade losses and other allowable expenses (if you haven't deducted them already). If you're employed, you may also be able to deduct certain expenses, such as business mileage. To do this, your employer must not have reimbursed you.
Charitable donations you've made through Gift Aid or Payroll Giving. Here, you can deduct your donation plus an extra 25 percent. In other words, you can deduct £1.25 for every £1 you donate.
Your personal allowance. In 2016/17, this was £11,000. It's £11,500 in 2017/18. You don't get a personal allowance if your taxable income is £123,000 or more.
That's it. You've arrived at your adjusted net income. This is the figure you'll use to calculate your tax bill and work out national insurance contributions.
