Self employed taxed on profits not drawings

We are often asked by self-employed clients to explain why their tax bills are high in proportion to the amount they withdraw from their business as “wages”.

In truth, the self-employed do not take a wage, this would imply that the cost of their “wages” is a deduction for tax purposes, and this is not the case. What happens is that self-employed traders draw down against the profits they have made, after any tax and NIC charges have been deducted.

On this basis, a thrifty self-employed person may find that their annual income tax bill is a significant amount if compared to their annual drawings from the business.

For example, if your profits are £75,000 this will create a tax and NIC bill of almost £23,000. This would leave after-taxed profits of £52,000. You now have a choice: to take less than £52,000 as drawings and retain the difference in your business, or, withdraw the £52,000. If you can manage on an annual draw of say £30,000 this would leave £22,000 in your business, but your tax bill would almost be as high as your drawings.

Of course, there is a third choice, you could draw more than your after-tax profits as drawings. Commercially, this is not a good idea especially if you have no retained profits to draw against, in effect you would be on a one-way road to insolvency.

However, if you have built up capital reserves over many years, and they are no longer required to finance future trading, or if you are winding down, it is perfectly fine to withdraw these funds. Drawing on retained profits from past years will not create additional income tax liabilities, the profits you are drawing against are already tax paid.

Planning for profit withdrawal is often overlooked by self-employed business owners. If you have never considered these issues before we could help you adopt a strategy that suits your goals.