Just set up a business? Be prepared for your income tax obligations.

Avoiding the Preliminary Tax Pitfall

A common oversight among people who move from PAYE employment to paying income tax on a self-assessed basis is to fail to take account of their preliminary tax obligations. All sole traders, self-employed individuals and individuals operating a business through a partnership will be paying their income tax on a self-assessed basis. Consequently they are liable to pay preliminary tax.

As many of you will be aware, self-assessed taxpayers are required to file their income tax returns and pay their income tax liability by the 31^st October in the year following the year of assessment. For example, a self-assessed taxpayer must file their income tax return for 2015 and pay the balance of their income tax liability for 2015 by 31^st October 2016.

In addition to this, the self-assessed taxpayer must make a preliminary tax payment for the current year on this date. This means that when the taxpayer files their return and pays the balance of their tax liability for 2015 by 31^st October 2016. They must also make a preliminary tax payment (or payment on account) for 2016.

The preliminary tax payment must amount to:

• 100% of the tax payable for the preceding year, or
• 90% of the tax payable for the current year, or
• 105% of the tax payable for the pre-preceding year (only available to taxpayers that pay by direct debit).

This means that on 31^st October 2016 a self-assessed taxpayer’s preliminary tax payment must amount to:

• 100% of the tax payable for 2015, or
• 90% of the tax payable for 2016, or
• 105% of the tax payable for 2014 (subject to the condition above).

The taxpayer is free to choose the most beneficial method of calculation. Once one of the conditions above is satisfied they will not be liable to interest for underpayment of preliminary tax.

For an ongoing business with a level of profit that is stable from year to year this system should present no difficulties. Let’s say a self-assessed taxpayer had an income tax liability of €2,650 in 2014 and €3,000 in 2015. And for both years preliminary tax was paid based on 100% of the preceding year. In that case their tax payment due on 31^st October 2016 would look like this:

Income tax liability for 2015                                                          €3,000

Less Preliminary tax paid for 2015                                             (€2,650)

Net Income tax due for 2015                                                            €350

Preliminary tax due for 2016                                                         €3,000

Total payment due on 31^st October 2016                                 €3,350

However, for an individual new to self-assessment, or a self-assessed taxpayer with a significant increase in their profit from one year to the next, this system can cause significant cash flow difficulties particularly if they are not aware in advance of their preliminary tax obligations.

Take for example, an individual who started a business in January 2015 having previously been a PAYE employee. This person will file their first income tax return, for 2015, on 31^st October 2016. Similarly to the previous scenario, let’s say their income tax liability for 2015 is €3,000. And the most tax efficient way of calculating their preliminary tax for 2016 is 100% of their liability for 2015. In this case their total payment due on 31^st October 2016 would be as follows:

Income tax liability for 2015                                                          €3,000

Preliminary tax paid for 2015                                                       (       Nil)

Net Income tax due for 2015                                                        €3,000

Preliminary tax due for 2016                                                         €3,000

Total payment due on 31^st October 2016                                 €6,000

Effectively, their income tax payment for 2015 is doubled in order to cover the preliminary tax due for 2016, and this could present significant cash flow problems for this fledgling business.

Unfortunately this problem cannot be eliminated. There are a few steps an individual new to paying income tax as a self-assessed taxpayer can do to combat this:

1. Put aside an appropriate amount each month from the start to cover the income tax and preliminary tax obligations. This amount will be based on the level of profit of the business on a monthly basis.
2. Prepare, or have prepared, your income tax return as early as possible after the year of assessment. This will give you the exact amount due and leave you with the remaining months up to 31^st October to put aside the remaining funds to meet your liability.

These suggestions may seem simple but if new self-assessed taxpayers are aware of this potential problem and adhere to these guidelines then they should not find themselves with a tax bill they cannot meet on 31^st October.