Remember – It’s not your money (yet)!
Contractors often fall into the trap of thinking that all of the money in their business account is theirs. As inviting and as attractive as those big numbers might look on the screen, not all of it belongs to you.
The best way to think of the company’s bank balance as just that – belonging to the company! That should help you to remember that your company has certain obligations to fulfil. Yes, I know, it is inevitable but I am going to say it – your company needs to pay tax.
Firstly, if you are VAT registered, then whatever you collect (on behalf of HMRC) in VAT will need to be given back every quarter (give or take a few adjustments). So, while the money does come into your current account, it does not belong to you. If you spend it, then you will simply have to pay it back later. My advice would be to set up a separate account that you transfer all of the VAT you collect straight into. That way you are likely to see a little bonus every quarter rather than a big bill.
Make sure you stay in everyone’s good books…
Then there is the issue of Corporation Tax, which you need to pay, calculated as a percentage of the profits your company makes. If it is at all possible, you should try and work out how much profit your company is creating throughout the year. That will enable you to draw down the amount you are entitled to rather than, in effect, going overdrawn. Technically, if you take too much from your company, then you need to pay that amount back within nine months of your year end. If you fail to comply, then additional Corporation Tax will need to be paid on the outstanding amount. And no one wants to pay more tax than they have to, do they?
And it gets worse… before its gets better
If the amount that you have overdrawn is more than £10,000, you will have to pay interest on it or be liable for a taxable P11D benefit in kind. Horrible eh?
Here is where your accountant should be helping you out!
Conversely, to the ‘taking out too much’ scenario, if you do not take out enough you could actually be wasting the tax-free allowance that is available through the basic rate tax band. So there is a balance to be found and the reality is that it is actually quite easy to follow. Here is my simple overview:
1) Put aside what you collect in VAT in a separate account, ready to be given back each quarter (and look forward to getting a little bit of that back yourself)
2) Work out what your profit is and the Corporation Tax rate (currently 20%), then put aside that money as well.
3) Make sure that you take out, at least, the Basic Rate Income Tax Band (applicable to you) but no more than what remains after your previous calculations.
Then you can take ‘your’ money and spend it on whatever you please (providing it keeps you in the good books at home), and still leave ‘your company’ able to pay its obligation to the Tax Man and keep you in his good books too.