Isabellas Tax Liability - Essay Example

Isabella’s Tax Liability

Froggy Recruitment Income Statement

For the Period Ended June 30, 2015

Gross Profit85,010

Add

Rental Income 8,501

Total Income93,511

Less

Depreciation 6,801

Wages and Salaries 8,501

Rent and other expenses17,002

Utility costs10,201

Printing and stationery 4,251

Motoring expenses 5,95152,707

Net Income40,804

Taxable Income

Net Profit40,804

Add back

Interest on late tax payment 500

Legal fees 3,000

Gifts 3,100

Lease premium (2% × 60,000 × 17 years)20,40027,000

67,804

Less

Capital allowances

Motor car (18% × 80% × 20,000)2,880

Desktop PC and accessories (18% × 4,000) 720

3,600

National Insurance Contribution (9% × 40,804) 3,672 7,272

60,532

Less tax free income10,600

Taxable income49,932

Tax Liability

Basic Rate on Taxable income (20% × 31,785) 6,357

Higher Rate on taxable income (40% × 16,942) 6,777

Higher rate on interest income (40% × 4000) 1,600

Higher rate on Dividend Income (32.5% × 9,000) 2,925

Total tax liability17,659

Tax Relief (Pension Payment – 20% × 5,000) 1,000

Net Tax Liability16,659

Report on the Calculations

Membership fees to professional bodies are only allowable if incurred for trade purposes. Since the business is a sole proprietorship, there is therefore a need to subscribe to a professional body for the purposes of running the agency (IRS b). Membership fees to the professional body would therefore be allowable. There is therefore no need to adjust the income for this amount. Interest on late payment of tax is a non-operating expense (HR Revenue and Customs b). That is because it is not incurred wholly for trade purposes. Since it is a penalty for defaulting, it cannot be allowable, as that would mean the state helps the taxpayer pay the penalty (Shashay, and Clukey, 2014). It is therefore added back to the net income. We therefore add back the £500 amount to the net income. Legal fees in relation of the 5-year lease of the office are not an allowable expense. That is because it is a capital expenditure. Under tax rules, any expense in connection to the first letting of a building for a duration of over one year is a capital expense (Feeley &Driscoll, P.C.). The legal fees are only deductible if the lease is for one year or less (HM Revenue and Customs a). We therefore add back the £3,100 to net income. Generally, expenses on gifts that carry a conspicuous advertisement for a trader are allowable against tax. However, if the gift plus the cost of any other gift to the same person within the same financial period exceeds £50, then the gift would be disallowable (HR Revenue and Customs c). In Isabella’s case, she gives fleece jackets to her top 50 customers. The total cost of these gifts is £3,100. That means the cost of the gift per person is £62. It exceeds the limit of £50 and therefore is not allowable for tax purposes (IRS a). It is therefore added back to the net income. The business receives £60,000 as lease premiums. The business also leases a car for three months. However, since all car expenses relate to business use, they are allowable against tax. Therefore, there is no need for further adjustments for the car lease. There needs to be a provision for this amount in the adjustment of income for tax purposes. For leases exceeding one year but less than 50 years, the lease premium is taxable. The amount of the premium to be taxed is at the rate of 2% for every year after the first year (HR Revenue and Customs d). Since the lease is for eighteen years, the number of years after the first year is therefore 17 years. Multiplying 2% by 17 years and by £60,000 gives £20,400. That is the portion of the premium that forms income for taxation purposes. We add this amount back to the net income.

Capital allowance is a deductible expense. Items liable for capital allowance fall in three pools; main pool at the rate of 18%, special rate pool at 8% and single asset pools at the rate of 18% or 8%. The car would fall under the main rate pool. Therefore, its capital allowance would be 18% × 80% × £20,000. That equals £2,880. The multiplication by 80% is because the usage of the car for business is 80% and for personal use 20%. The desktop PC and accessories also fall under the main pool. The tax-deductible capital allowance would therefore be 18% of their value. Multiplying £4,000 by 18% gives £720. Adding the capital allowance amounts gives £3,600. We subtract this amount from the net income since capital allowances are tax-deductible. National insurance contributions are allowable expenses. A sole proprietor qualifies for both class 2 and class 4 of national insurance. Class 2 includes those with profits of more than £5,965 in a year. Class 4 includes those with profits exceeding £8,060 in a year (Tax Aid, 2016). Since the profits are £40,804, they are more than £8,060 in a year and therefore the appropriate class for use would be class 4. The amount of National insurance contribution for class 4 is 9% of the profit. 9% of net profit is £3,672. We subtract this amount from the net income since national insurance is allowable.

After adjusting for the tax-allowable and taxable expenses, the adjusted net income comes to £60,533. To get the taxable income, we subtract the tax-free income of £10,600 from the adjusted income (Cameron, 2015). The new value for taxable value is £49,933. We then multiply the first £31,785 of this amount by 20% giving £6,357. Tax on the remaining £18,142 is at the rate of 40%, which gives us £7,259. Where the taxable income is more than £31,785, the taxpayer falls under the higher rate tax bracket. In this case, the higher rate is applicable in determining tax interest and dividends. We therefore multiple the interest received by the higher rate of 40%, which amounts to £1,600. The tax rate on the dividends is 32.5%. The resulting tax is £2,925. Adding together the tax on net income, interest and dividends gives £17,659. However, there is some tax relief due to the contributions to personal pension. The tax relief is 20% of the contributions to the pension (20% × 5,000). We subtract the resulting £1,000 from the total tax amount of £17,659. The resulting tax liability is £16,659.

Implications of Accounting Dates

The choice of an accounting year-end is very important for a sole proprietor. That is because it determines the timing for taxing profits as well as when the tax on the profits becomes due. The accounting date would therefore have an impact on the cash flow of the business. One may choose any date between 6th April and 5th April of the following year. The nature of the business and trade usually has a huge bearing on the choice of the accounting dates (Liang, 2012). To decide on the appropriate date, one has to consider the timing of tax payments, profits as well as other business factors. One could choose a date that is early in the tax year or late in the tax year. An earlier accounting date would result in an overlap of profits. Since there is a longer period between when the business earns profits and when it pays taxes on the profits, some profits in the first year may end up with double tax. The overlap profits would then be carried over until the business ceases. The disadvantage is that although at cessation the business will get back the overlap profits in terms of reliefs, their value may not be the same. That is because of inflation, which would reduce the value of the amount of profits carried forward (Liang, 2012). On the other hand, when a business chooses an earlier accounting date, it pays its taxes earlier. By paying earlier, it reduces the overlap profits. However, since it pays taxes earlier, it may have some cash flow issues. That is because the payment of tax may come at a time when the business does not have ready cash to make the payment. The earlier date also causes problems for business planning as well as tax planning. In a seasonal business, the accounting date should be such that the timing of the tax payment is when the business is enjoying its high season. At such a time, there will be ready cash to make the tax payment without having a great effect on cash flow (Liang, 2012). If a business determines that its profit are rising, then having an earlier date would be appropriate. However, if the profits are falling, then the business should have a later accounting date. Although simple to implement, an earlier date such as March 31 has its disadvantages to a business. It has increased risks of tax default and hence penalties as the business may have difficulties paying taxes in time. Such a date also causes overlap profit, which is worth less at cessation. It also causes planning challenges for the business. It would therefore seem that a later date such as April 5th would seem a better date due to the flexibilities it offers a business.

Tax-Efficient Savings

There are several ways one can save without incurring tax liability or incurring minimal tax liability. Among the options for tax-efficient savings include individual savings accounts (ISA), pension contributions and tax-efficient investments. Individual savings accounts can be of two kinds. There is the cash individual saving account and the stocks and shares savings account (HR Revenue and Customs d). The interest from the cash individual savings account does not attract tax. There are also no tax liabilities on income or capital gains from investment in stocks and shares individual savings accounts. There are limits on the amount one can put into an individual savings account. For a stocks and shares individual savings account, the maximum amount is £15,240 (HR Revenue and Customs d). However, one can invest in a combination of the cash ISA and stocks and shares ISA. The combination would comprise of £10,240 in a Cash ISA and £5,000 in the Stocks and Shares ISA. There is also the option of saving for a minor. The Junior ISA limit is £3,720. At the end of the tax year, which runs from 6th April to 5th April, the ISAs do not close. The money stays in the ISA account on a tax-free basis until you decide to withdraw it. Cash ISAs can include several assets such as savings in bank and saving society accounts as well as some national savings and investment products. The stocks and shares ISA include corporate bonds, shares in companies, government bonds as well as unit trusts and investment funds. One can also buy a life insurance individual savings account. Such an ISA pays out at the death of the insured (HR Revenue and Customs d). When it pays out, the dependents of the deceased do not have to pay tax, as the payment is tax-free.

Pension contributions are another efficient way of making savings in view of taxation. Contributions to pensions attract a tax relief of 20% for basic rate taxpayers. For higher rate taxpayers, the tax relief could be an extra 20% or even up to 30% of their contributions. That provides a tax saving way of making savings for the future. Tax efficient investments include venture capital trusts and enterprise investment schemes (The Money Advice Service (GB)). Although these have a higher risk, they provide higher income as well as capital and tax reliefs. For maximum tax benefits, one must hold a venture capital trust for at least five years. The income tax relief on venture capital trusts is 30%. One can put up to £200,000 into a venture capital trust in a year with the entire amount receiving tax relief. Any dividends or capital gains from venture capital trusts are tax-free. One can invest in three types of venture capital trusts. They include the limited life, generalist and specialist. Enterprise investment schemes have better tax reliefs than venture capital trusts. The tax relief on the initial investment for enterprise investment schemes is 30%. An investor may invest from £500 to £1,000,000. That means they could possibly do away with their tax liability for a year. One could also possibly defer capital gains from another investment by reinvesting into an enterprise investment scheme. The enterprise investment scheme enjoys income that is capital gain tax-free as long as the sale of shares is after three years (The Money Advice Service (GB)). For an individual wishing to enjoy tax-free income, the individual savings account would be more appropriate. That is because it involves no capital gains on income from the ISAs. The interest from these accounts is also tax free and therefore offers an efficient way to save.