How Part-Time Businesses
Are Taxed

Some important differences to be aware of

MANY PEOPLE start out with a ‘part-time’ business. They may have a full time job and start a business on the side; they may see a ‘part-time’ business as an easier way to make the transition to self-employment; they may already have an existing business in a different field; they may even be turning their hobby into a business.

Recent years have also seen the growth of the ‘online’ business, which is often run from home on a part-time basis. So, what are the tax issues that you need to consider when you start a little ‘something on the side’?

What’s the Difference?
As far as the tax system is concerned, there are very few differences between a part-time business and a full-time one. The major differences come in the areas of loss relief and National Insurance and we will look at these a little later. As far as calculating profits and tax deductions is concerned, there is really very little difference.

Do You Have a Business?
The first step, however, is to determine whether you actually have a business in the first place. Although a hobby or other activity can evolve into a business, it can be difficult to tell exactly when this happens. Some old case law gives us six tests to indicate when a business exists:

• The activity is a ‘serious undertaking earnestly pursued’ or a ‘serious occupation’.
• The activity is ‘an occupation or function actively pursued with reasonable or recognisable continuity’.
• The activity has ‘a certain measure of substance as measured by the value of supplies made’.
• The activity is ‘conducted in a regular manner and on sound and recognised business principles’.
• The activity is ‘predominantly concerned with the making of supplies to consumers’.
• The goods or services supplied ‘are of a kind which, subject to differences in detail, are commonly made by those who seek to profit by them’.

Where some or all of the above tests are met, you probably have a business. The language of the tests is a bit ‘legalese’ though, so what do they actually mean?

To me, the tests can be summed up by saying that something which you do on a regular basis, in an organised manner, with the intention of realising a profit, is a business.

If you do have a business, it will usually be a trade, but there are some important exceptions to this. For example, a supply of services may sometimes be a profession rather than a trade (although there is very little difference in the tax treatment); property rental businesses have their own special rules; and, whilst it can be a business, investing on the stock market will almost never be regarded as a trade.

For the rest of this article, I will assume that your part-time business is a trade. Before I move on though, I should point out that, just because you do not have a business, this does not mean that any profits or gains you make are not taxable. Although there are many exemptions which can apply (like selling your house or car), any time you make money on something, there is a good chance that it is taxable!

Why Does It Matter?
The good thing about having a business, as opposed to some sort of casual, windfall, income, is the fact that you can claim deductions against your business income. The principles here are the same as for any full-time business and hence, as well as your direct business costs, you will be able to claim all the usual things like premises costs, motor expenses, travel and subsistence, legal and professional fees, etc, etc: as long as the costs are incurred for the purposes of the business.

For the part-time business owner, the only ‘business premises’ they have will often be their own home. This means that they are entitled to claim a proportion of all their household running costs, including: mortgage interest, council tax, insurance, repairs, gas, electricity and other utilities. (See the April 2009 issue of Business Tax Saver for more details on claiming a deduction for ‘use of home’.)

But Size Doesn’t Matter
It doesn’t matter if it only takes you an hour a week to run your business: as long as you have a business, you are entitled to claim tax deductions under the same rules as everyone else.

One thing you should bear in mind, though, is that it naturally follows that, if your business is only part-time, you will generally only be able to claim a lower level of expenses than a full-time business, particularly when it comes to things like motor expenses and ‘use of home’.

For example, a ‘use of home’ claim equal to 25% of your household running costs might be appropriate for a full-time business, but would be hard to justify if you only spend five hours a week on your business!

Each case has to be decided on its own merits, but the key thing to remember is that you need to restrict your claims to something which is reasonable under the circumstances.

Loss Relief
Where a part-time trading business gives rise to losses, the general rule is that these can be set off against the proprietor’s other income or capital gains for the same tax year or the previous one.

This is another advantage of having a business rather than casual income and it means that many part-time traders are able to claim repayments of tax paid under PAYE on employment income, or else reduce the tax due under self-assessment on other sources of income.

There are, however, two areas of difficulty in claiming loss relief for part-time businesses.

The first problem is that, when it comes to part-time businesses, HM Revenue and Customs (‘HMRC’) have a tendency to want to ‘have their cake and eat it’. If the business makes a profit, HMRC will want to tax it, if it makes a loss, they may claim that it is actually just a hobby and thus deny any loss relief.

When a loss arises, therefore, it is important to be able to point to the six tests which we looked at earlier and to show that your business meets at least some of them. Most importantly, however, you need to be able to show that you are in business with the intention of making a profit: you cannot claim relief for a loss unless you were trying to make a profit.

There are many ways to demonstrate your intention to make a profit and the facts of the case will often speak for themselves. One of the best defences is to have a business plan which shows not only that you hope to make a profit, but also how!

The other problem for part-timers is that loss relief is restricted to a maximum of just £25,000 in each tax year where you spend an average of less than ten hours per week working in the business. This covers both part-time sole traders and part-time business partners and the £25,000 limit applies to the total losses from all your part-time businesses.

This rule was brought in a few years ago as an anti-avoidance measure aimed at investment partnerships but, sadly, it also catches many genuine part-time businesses. The second best way to get around it is to make sure that you work at least ten hours per week in the business. If you are close to this threshold, it may be worth keeping time records to demonstrate that you are working more than the required minimum number of hours.

The best way to avoid this rule though is to make a profit!

National Insurance for Part-Timers
The downside to having a business is that you will generally have to pay National Insurance. There are some important exceptions to be aware of though. You don’t usually have to pay National Insurance if:

• You are over state retirement age at the beginning of the tax year
• You are under 16 at the end of the tax year
• Your business is not a trade or profession

You can also apply for exemption from National Insurance if your annual business profits are less than the ‘small earnings exception’ (currently £5,075, rising to £5,315 for 2011/12).

If you have more than one trading business, either as a sole trader or as a partner, you will only pay one Class 2 National Insurance contribution of £2.40 per week (£2.50 from April 2011) and your total profits will simply be added together to calculate your Class 4 liability.

The real complication comes when you have both employment and self-employment income and each of them amount to more than the National Insurance ‘primary threshold’ (currently £5,715, increasing to £7,225 for 2011/12). In this situation, you will be liable for Class 1 National Insurance on your employment income and both Class 2 and Class 4 on your self-employment profits.

Where your total income from both sources amounts to more than the upper earnings limit (currently £43,875, reducing to £42,475 for 2011/12), you may effectively ‘overpay’ National Insurance – i.e. you may pay more than you are required to by law.

The trouble is that you cannot simply reduce the amount that you pay: you will either have to put in a claim for exemption or make a repayment claim later.

The calculations involved in this scenario are some of the most complex that I have seen in my career, so I will not repeat them here. As a quick guide though, I can say that a repayment may be due to anyone with part-time business profits over the primary threshold and total combined employment and self-employment income of more than around £50,000.