More Profit – Less Tax

As we all know, the whole point of going into business is to make a profit. Why then would anyone want to put additional expenses through the business? Surely this defeats the purpose of having a trade?

This is true, but only up to a point. The problem is that profit = taxes. Yes we want to make money, but how do we maximise personal wealth whilst minimising tax charges and keep on the right side of the law?

The solution? Turn your ordinary, everyday expenditure into bona-fide business expenses. It really is that simple!

In an ideal world we would charge every penny we spend against the business and pay no taxes at all, but this is obviously unrealistic. The Taxman may be a lot of things, but he isn’t a fool. After all, if you consistently show losses on your tax returns while living the highlife then he’s going to smell a rat. Before you can say ‘Lester Piggott’ he’s going to start making a few enquiries

Business v Private

In reality for most owner-managers is that the line between their private and business lives is so blurred that you can’t always tell where one ends and the other begins. With some things it’s more obvious than others, like the company car for example, which clearly has both business and personal uses. Others though are not so straightforward. For example, how many people take work home with them? If the accounts are done on the kitchen table, is the cost of heating and lighting that room business or private? What about telephone calls, or using the internet for research? How many people pick up bits and pieces for the office along with the groceries? Does that make it a business trip? And that newspaper you read every morning with the business section…

The list could go on, but the point is clear: there are times when what we naturally think of as household expenses will also have a work-related element to them. These can in part or in whole be quite legitimately charged against profit.

The Rules

But don’t be fooled into thinking you can take liberties with the tax rules. There are clear principles that have to be followed for the expense claim to be considered ‘legitimate’ by HMRC. The first of these is that for an unincorporated business the costs charged have to be ‘wholly and exclusively for the purposes of the trade’. This basically means that any non-trade element is disallowed. This commonly comes in the form of an ‘add-back’ for tax purposes ie an adjustment made in the computations to mop up any private element, typically done on a percentage basis and often calculated after negotiation with the Inspector.

The second rule to consider here is that the expense must be a ‘business’ expense in the truest sense of the word. What we mean is that the expenditure was incurred because of your business and not merely that there was some incidental business element to it. This is the ‘duality of purpose’ rule which was interpreted very strictly in a court ruling which stated that a barristers dark clothing was not allowable for tax purposes because it served another purpose: simple function of clothing. Fortunately the Inspector is rarely as strict as this in his interpretation but it must be borne in mind that this is a long-established principle that he can turn to if pushed too hard.

The third point is an extension of the ‘wholly and exclusively’ rule and is applicable to employees, which of course includes company directors, and this is that the claimed expenditure must be ‘wholly, exclusively and necessarily incurred in the performance of the duties of the employment’. Basically if it’s not necessary for the employee to incur the expense then it can’t be claimed.

This may at first glance look like a killer blow for anyone wanting to make a more inventive claim. Fortunately for us however a company director’s prime duty, as enshrined in company law, is to act in the best interest of the shareholders ie to make a profit on their behalf. Therefore any expenditure incurred to this end is a legitimate expense of the company. It will need to be demonstrated that this is the case should the Taxman make a challenge, but the point can be argued. Incur the expense for the business, even if there is a private element, and it can properly be claimed.

The question many people will be asking at this stage is whether the amount saved in tax will be worth the extra hassle of making the claim, particularly for those of us who aren’t over keen on paperwork. Well, imagine you can turn £50 per month into business expenses. That’s £600 per year, and at a tax rate of 21% will save your company £126 in corporation tax. And that’s not all, because you have just saved the company the equivalent in salary costs for you of £600 net of tax. The tax and NI bill on the gross equivalent could be £417 for you and another £130 for the company, making £673 saved all together. Now it starts to look like a good proposition!

For an unincorporated business it’s much simpler to work out the savings. If you’re paying tax at 40%, then with the Class 4 NI supplement of 1% to consider the overall saving is £246. This may not look particularly attractive when compared with the limited company savings, but as we will see later on it’s far easier to charge expenses against profit as a sole trader or partner than as a company director which gives you a greater scope for making a claim. The second point to bear in mind here is that for an unincorporated trader business and personal tax are one and the same. This means that every penny of tax saved has a direct effect on the income available to you.

What we are looking at here then is recognising those expenses that are by nature personal but have a legitimate business element that can be claimed against tax.

And remember, the Taxman doesn’t have all the answers. His job is to make sure you’re not underpaying your taxes, and he has a big book of rules to help him. But there are also rules in place to see that he plays fair, and there are people looking over his shoulder make sure he’s not wasting time chasing small amounts of tax. At the end of the day tax law is full of grey areas and as we have seen it’s not always possible to demonstrate clearly where ‘business’ begins and ‘personal’ ends, and if it’s uneconomic to pursue an argument then he will try to reach a compromise.

So, take advantage of these uncertainties and tip the balance a little more in your favour.

There are two golden rules to follow here:

Number One – get the documentation right and the argument will be half way won before you even start; and

Number Two – don’t be intimidated into backing down without a fight!