Basis period reform for the self employed: explained

Significant changes to the basis period reform for the self employed may mean a larger tax bill.

For the self employed, time is very precious and most of it will be spent running your business. With such a busy schedule, it can be difficult to keep up to date with complex and ever-changing tax rules.

However, it is vital to be aware of the latest reform in respect of basis periods for the self employed. It means that more tax may be due on income from self employment or a partnership in the next five tax years starting in the current year (2023/24).

Basis period reform

The government have recently moved away from the accounting year system to a tax year system. This means you will have to pay tax on the profits earned in the tax year, rather than in the accounting year. Under the new system, more than 12 months worth of profit could potentially be taxed in a single tax year.

Self employed individuals/partners who are using a business accounting year end other than 31 March or 5 April will feel the impact of this basis period reform.

If you do not have a 31 March or 5 April accounting date for your sole trader or partnership business, an additional amount of trading profit is taxable in 2023/24. This amount is called ‘transition profit’ and will run from the end of your usual accounting date up to 5 April 2024.

Transition profit – case study

For example, Julie is a self employed architect, and she has a 31 December 2023 accounting year end.

All of the profits she earns for the period 1 January 2024 to 5 April 2024 will be considered transition profits. These are taxed in addition to her normal annual profits (i.e. from 1 January 2023 to 31 December 2023).

This transition profit will be automatically spread over the next five years to 2027/28, with 20% of transition profits taxed in each of the tax years.

Choose to be taxed sooner

It is possible to choose to be taxed sooner on these transitional profits. You could choose to be taxed on more than 20% of the transition profits in 2023/24 (up to the full catch up element) with the balance spread over the remaining years. This  may make your payments in the years to come more manageable.

If you are thinking about taking this route, it is important to weigh up your current circumstances with future projections. Is your income likely to increase in the next few years? Will that push you into the higher rate of tax? Will you be helping yourself in the long run by making these payments now?

What may be impacted

Two key areas of taxation which are impacted by this change are the personal allowance and the personal savings allowance.

The personal allowance is reduced where taxable income is over £100,000. Therefore, any transition profits that push your total income over that threshold will result in a reduction of your personal allowance. When your income is over £125,140, all of the personal allowance is lost.

With the personal savings allowance, there is no tax payable on the first £1,000 of savings for a basic rate taxpayer. This is reduced to £500 for a higher rate taxpayer and zero for additional rate taxpayers. If your transition profits push your total income into a higher tax band, your personal savings allowance will be either reduced or lost completely.

Another area to look out for is how the basis period reform may impact any student or postgraduate loan deductions for the self employed. These deductions are typically calculated on total income, and unless current rules are modified, this will include transition profits.

Please note that the impact of the changes on some parts of the tax code is, as yet, unclear but further guidance is awaited from HMRC.

Plan ahead

For those who are self employed, you have the remainder of the tax year to consider the costs and prepare for what is likely to be a larger tax bill come January 2025.

There are a number of strategic moves you can put in place to manage your taxable income such as pension planning, making gift aid payments, transferring assets between spouses and employing family members in your business.

Speaking to a professional tax adviser can help you to assess your situation and navigate this new legislation. If you’d like to reach out to discuss your plans, please do contact the Progeny Tax team today.