Am I taxed on my drawings
A client who is a sole trader recently asked the question ‘if I take funds out of the business for myself personally (known as drawings) will this increase my tax liability? The answer to this question is no, which surprised him.
As a sole trader the business is effectively you and any money in the business bank account is yours. Indeed, some sole traders don’t have a separate business bank account, although we strongly recommend to client’s that they do. Tax liabilities for sole traders are based on the profits the business makes, and as money withdrawn from the bank for private use doesn’t count as a business expense then drawings don’t affect the profit.
This may sound a little confusing and maybe the best way to illustrate the principal is with an example. Let’s say John sets up in business as a sole trader and trades for just one year and then decides to cease the business, the starting bank balance is nil and he makes sales of £50,000 and has costs of £30,000. The profit will therefore be £20,000 and once all customers have paid their invoices and the business has paid all its costs there will also be £20,000 left in the bank.
John will be assessed for tax on the £20,000 profit which will be included on his Self Assessment Tax Return. If he has no other income his personal allowance will be deducted and income tax will be due on the balance. He will also incur some National Insurance liabilities.
John then withdraws the £20,000 from the business bank account for him personally. If he is then taxed on this he will have been assessed on it twice, once as profit and once as drawings which even HMRC would agree would be unfair. To avoid this, sole traders’ are only taxed on their business profit and not the cash they withdraw.
The rules are very different for limited companies and I will cover this in a later article.