Self-employed: The cash basis can reduce your tax bill
Taxable profits are required to be calculated using Generally Accepted Accounting Principles (GAAP). This means the accounts are prepared on an 'accruals' basis by reference to the work performed in an accounting year not the cash received for that work in a tax year.
However, small eligible businesses with turnover of less than £150,000 can elect to use the simpler cash basis to work out taxable profits. An election is made by ticking a cash basis box on the tax return for the year and subsequent years.
The cash basis option is only available for the self-employed and individuals in a partnership. You can stay in the scheme until business turnover exceeds £300,000.
Cash basis probably won’t suit you if you:
- want to claim interest or bank charges of more than £500 as an expense
- run a business that’s more complex, e.g. you have high levels of stock
- need to get finance for your business - a bank could ask to see accounts drawn up using traditional accounting to see what you owe and are due before agreeing a loan
- have losses that you want to offset against other taxable income (‘sideways loss relief’)
Cash basis probably will suit you if you:
- pay interest on personal borrowings. The borrowing doesn't need to be for business reasons - so if you pay any interest, including a mortgage on your home, you can claim up to £500 as a business expense.
- want simpler accounts without the need to account for yearend stocks, debtors and creditors
- want to delay tax payments if yearend debtors, work in progress and stocks exceed creditors
- want to delay tax payments by not paying tax on income not received in the accounting year
- have simpler tax affairs as there is no need to make adjustments for capital allowances for plant and machinery, as capital expenditure (apart from cars) will simply be relieved as and when it is incurred, just like any other revenue expense
A good example of an industry that is ideal for the cash basis is associate dentists. Associate dentists are normally self-employed to preserve their superannuation pension, are paid a month in arrears and have little or no yearend creditors.
Example of a self-employed associate dentists using cash accounting
Darren starts as a self-employed associate dentist in 2017-2018. He prepares accrual accounts and has profits of £60,000. He has no other income and calculates total Income Tax and National Insurance contributions of £16,460.
Darren decides to use the cash basis accounting scheme. He can exclude the £5,000 he was paid for services he performed before his yearend that was paid to him after his year end. He has no year end creditors to exclude. He has a overdraft on his bank account and he can include the first £500 interest he has paid on this overdraft in the tax year as tax deductable expenditure.
Darren has profits of £54,500 using the cash basis accounting scheme and has Income Tax and National Insurance contributions due to £14,150. He saves £2,310 in tax payments by using the cash basis scheme.
Darren's payments on account for January 2019 and July 2019 now fall from £8,157 using the accrual scheme, to £7,002 using the cash basis scheme. This allows Darren to pay less to HMRC and keep more of his income.
A further benefit to Darren is as a parent. As Darren and his partner now both have incomes of less that £60,000. This reduces Darren’s “High Income Child Benefit Charge” from 100% of child benefit withdrawn, to 45% of child benefit withdrawn.
By using the cash accounting scheme, Darren pays less tax to HMRC and his family keep more of their Child Benefit.