Business Taxation — SQE1 FLK1 Business Law and Practice

Your client expects her business to make about £60,000 this year. She needs £30,000 to live on. The other £30,000 she wants to leave in the business, to fund expansion. So here is the question she asks you. Does she pay tax on money she never takes out? As a sole trader, yes. All of it. Every pound of profit, drawn or not.

Through a company, the answer changes completely, and that is what this episode is about. Business Taxation, the fourteenth topic in Business Law and Practice. Six taxes, one organising question: who is the taxpayer, and on what. Get that right and the computations follow. Get it wrong and no amount of arithmetic saves you. Keep your client in mind. We are coming back for her.

Here is the route. Income Tax first, because it catches the most people. Then dividends, then Corporation Tax. Then Capital Gains Tax, then VAT, then Inheritance Tax and Business Relief. Then how a partnership and an LLP are taxed, then employees, then sole traders. And last, the planning question your client actually asked, and where avoidance stops being legal.

Start with the taxpayer, because that is what the examiners test. Individuals pay Income Tax on income and Capital Gains Tax on gains. Companies pay Corporation Tax, and they pay it on both. A company never pays Capital Gains Tax. Its chargeable gains go into the Corporation Tax computation alongside its trading profits. Partnerships pay nothing at all. They file a return, but the tax belongs to the partners.

Three answers, three regimes. That distinction decides more marks than any rate you can memorise.

Income Tax first. The tax year runs from 6 April to 5 April, and everything is measured inside it. Sole traders pay it on business profits, partners on their share, employees on salary, and individuals on investment income, dividends, savings and property.

Four figures for 2025/26. The personal allowance is £12,570. Nothing is taxed below it. Then the basic rate, 20%, from £12,571 to £50,270. The higher rate, 40%, from £50,271 to £125,140. The additional rate, 45%, above that. Learn the shape, not just the numbers.

Two smaller allowances to hold. A dividend allowance of £500. And a trading income allowance of £1,000, below which a sole trader need not report at all.

Now the trap the papers love. The personal allowance is not fixed. It falls by £1 for every £2 of adjusted net income above £100,000, so it is gone entirely at £125,140. Do the arithmetic on that slice. Each extra pound is taxed at 40% and costs you 50p of allowance, which is then taxed at 40% as well. An effective rate of 60%.

Dividends now, and they have rates of their own. After the £500 allowance, a basic rate taxpayer pays 8.75%. A higher rate taxpayer pays 33.75%. An additional rate taxpayer pays 39.35%. Notice that none of those is 20%, or 40%, or 45%. Dividends are never taxed at the rates that apply to earnings.

Here is where candidates slip under pressure. The company has already paid Corporation Tax on the profits the dividend comes out of. That is not a credit. It does not reduce the shareholder's bill by a penny. The dividend comes out of post-tax profits and is taxed again in her hands.

Run one through. Salary of £36,000, dividend of £5,000, in the same tax year. The personal allowance goes against the salary first, leaving £23,430 of salary in the basic rate band. There is room left in that band, so the dividend falls inside it. Take off the £500 allowance, and £4,500 is taxable at 8.75%. That is £393.75. Not nothing, and not 20%.

Corporation Tax. Two rates, and a band in between. Profits up to £50,000 are charged at the small profits rate of 19%. Profits over £250,000 are charged at the main rate of 25%. Between those two limits the main rate applies with marginal relief, which tapers the effective rate up from 19% towards 25%. The slice in between bears an effective 26.5%.

One warning about those limits. They are shared, not given to each company separately. Companies are associated where one controls the other, or both are under common control, and the limits are divided by the number of associated companies plus one. Two associated companies, and each has limits of £25,000 and £125,000.

Deadlines, briefly. Corporation Tax is payable nine months and one day after the accounting period ends, or by instalments if profits exceed £1.5 million, and the return is due within twelve months.

Then company losses, and this one earns marks. A trading loss can be set against total profits of the same accounting period and, on the same claim, carried back against total profits of the previous twelve months. That is s 37 of the Corporation Tax Act 2010. Now the point. For Corporation Tax, total profits means income and chargeable gains together.

So a trading loss can be relieved against a capital gain. Carry forward is narrower. Losses made on or after 1 April 2017 go forward against total profits, under s 45A. Older losses fall under s 45 and reach only later profits of the same trade.

Capital Gains Tax. Individuals pay it on chargeable gains. Companies do not, and that is a favourite. Try it. A company sells a factory at a profit. Which tax? Corporation Tax, on the chargeable gain, inside the ordinary computation. Partners are individuals, so partners pay Capital Gains Tax on their share of a partnership gain. The firm itself pays nothing.

The annual exempt amount for 2025/26 is £3,000 for an individual and £1,500 for trustees, and it cannot be carried forward. It belongs to its year. If there are no gains for it to cover, it goes.

Rates for 2025/26. Residential property, 18% at basic rate and 24% at higher or additional rate. Other chargeable assets, the same two figures. Then Business Asset Disposal Relief, formerly Entrepreneurs' Relief, 14% in 2025/26 and rising to 18% for disposals on or after 6 April 2026, on a £1 million lifetime limit.

What qualifies? Selling all or part of a business, selling assets after it has ceased, or shares in your personal company. Personal company means 5% of the ordinary share capital and votes, officer or employee, and a trading company. All three, throughout the two years before the disposal.

Capital losses have their own rhythm. Current year losses must be set against that year's gains in full, even where that wastes the exemption. Losses brought forward are kinder. They come off only so far as they reduce the gains down to the annual exempt amount. Notify a loss to HMRC within four years of the end of its tax year.

VAT. Registration becomes compulsory once taxable turnover exceeds £90,000 in any period of 12 months. You may register voluntarily below that, and start-ups often do. Deregistration is possible if turnover falls below £88,000.

Four categories, and the difference between the last two matters. Standard rate, 20%, most goods and services. Reduced rate, 5%, home energy and some mobility aids. Zero rate, 0%, food, books, children's clothes, most exports. And exempt, which covers education, health, insurance and some financial services.

Zero rated is taxable at nothing. Exempt is outside the system, and an exempt supplier cannot recover input VAT.

Output tax is the VAT you charge on your sales. Input tax is the VAT you pay on your purchases. You hand HMRC the difference. So try this. A firm charges £10,000 of output tax and pays £20,000 of input tax in the same period. Does it write a cheque, or receive one? It receives one. Input exceeds output, so it reclaims £10,000 and pays nothing for that period.

Returns are usually quarterly, due one month and seven days after the period end. Making Tax Digital now requires most businesses to keep digital records and file through compatible software.

Inheritance Tax. Charged on transfers of value, lifetime gifts and transfers on death. The rate on death is 40%. The nil rate band is £325,000, frozen until 5 April 2031, and a residence nil rate band adds up to £175,000 where a main residence passes to direct descendants.

The relief that matters for a business client is Business Relief, once called Business Property Relief. 100% on an interest in a trading business, including a share in a trading partnership, and on shares in an unquoted trading company. 50% on a controlling shareholding in a quoted trading company. And 50% on land, buildings, machinery or plant owned personally but used for the business of a partnership you belong to, or a company you control.

Take a hard case. A partner dies owning a one third interest in a trading partnership worth £300,000, and the office the firm trades from, worth £700,000. She had owned both for more than two years. The partnership interest? 100% relieved. The office, owned personally but used for the firm's business? 50%, so £350,000 of it. Charging the firm rent changes nothing.

Two conditions gate all of this. The business must be trading, not wholly or mainly making or holding investments. And the transferor must have owned the property for at least two years before the death or gift. That is s 106 of the Inheritance Tax Act 1984. Six months in a new partnership, and there is no relief at all, however genuine the trade.

Partnerships now, and the LLP with them. A partnership is not a separate tax entity: it files a return and pays nothing. Each partner is taxed individually on their share, income profits to Income Tax and capital gains to Capital Gains Tax. A partner's share of a trading loss can go against their other income of the year, their capital gains of the year, or their income of the previous year.

An LLP with only individual members is transparent in the same way. Its members pay Income Tax on their profit share and Class 4 National Insurance. But an LLP with corporate members is taxed as a company for the corporate members' share. Two regimes inside one firm.

Employees next. An employer deducts Income Tax and National Insurance from salary through the Pay As You Earn system and pays it to HMRC. Real Time Information means reporting on or before each payday. Benefits in kind are taxable too, from company cars to loans below market rates, though trivial benefits up to £50 are exempt.

The 2025/26 numbers changed, so know them. An employee pays Class 1 at nothing up to £12,570, 8% from £12,570 to £50,270, and 2% above. An employer pays 15% on everything above a secondary threshold of £5,000, up from 13.8% and £9,100 on 6 April 2025. The self-employed pay Class 4 at 6% and 2% on the same bands, and compulsory Class 2 was abolished from 6 April 2024.

Sole traders. Income Tax on business profits, plus Class 4 National Insurance on the same profits, and a trading income allowance of £1,000 below which there is nothing to report. Losses go against other income of the same or the previous year, forward against future trading income, or as terminal loss relief in the final year. Early years relief reaches back three years.

Which brings us back to your client. As a sole trader she is taxed on the whole £60,000 as it arises. Drawings are not an expense. The £30,000 she leaves in the business is taxed exactly like the £30,000 she takes. Through a company, the company pays Corporation Tax on the £60,000, and what is left inside bears nothing further until she takes it out.

Put numbers on it. On £50,000 of profit a sole trader pays £7,486 of Income Tax and £2,245.80 of Class 4, about £9,731.80. A company pays 19%, or £9,500.

One last distinction, and it is not a technicality. Avoidance is the legal use of tax rules to reduce a bill: an Individual Savings Account, a pension contribution, an allowance properly claimed. Evasion is illegal: undeclared income, false deductions. HMRC can still challenge an abusive scheme under the General Anti-Abuse Rule. The first is your job. The second is a crime.

A word on how SQE1 tests this. You will not be asked to recall a section number. And from the January 2027 sitting, where a question needs a monetary value for an exemption, a relief, a rate or a threshold, the question gives you the figure. So revise the method, not the numbers.

This topic has no famous cases, so the pegs are provisions. If you keep only three, keep these. s 37 of the Corporation Tax Act 2010, because total profits means income and gains, so a trading loss can eat a chargeable gain. s 106 of the Inheritance Tax Act 1984, the two year ownership condition, which kills Business Relief on its own. And s 105 of the same Act, which gives the personally owned building 50%, not 100%.

Five traps. One: the personal allowance taper. Between £100,000 and £125,140 the effective rate is 60%, not 40%, and a question that dangles a bonus at that level is testing exactly that. Two: partnership capital gains are allocated by capital sharing ratios, not income sharing ratios. The deed usually gives different figures for each, and the wrong one is always on offer.

Three: Business Relief. The business must be trading, not wholly or mainly making or holding investments, and the two year ownership condition is absolute. And the building you own personally and let to your own firm gets 50%, not 100%. Rent makes no difference. What the section asks is whether the property was used for the business.

Four: for Corporation Tax, do not confine a trading loss to trading profits. Total profits includes chargeable gains. Five: avoidance and evasion are not the same word said twice. Avoidance is lawful. Evasion is a crime. And an abusive avoidance scheme can still be attacked under the General Anti-Abuse Rule.

Quick check, and it is your client's own question. Her business will make about £60,000 a year. She needs £30,000 to live on and wants to leave the rest in to fund expansion. She is choosing between a sole trade and a company in which she would be the only shareholder and director. How does the choice affect the tax on the profits she does not draw?

Three candidate answers. One: retained profit is taxed under neither structure until she draws it. Two: sole trader and company owner are alike, both taxed on the whole profit as it arises. Three: a sole trader is taxed on the whole profit, while a company's retained profit bears only Corporation Tax. Pause here if you want a moment.

The answer is three. A sole trader is taxed on the profits of the trade as they arise, whether or not any part is drawn out. Drawings are not a deductible expense. So the whole £60,000 bears Income Tax and Class 4 National Insurance, even though she takes only £30,000.

A company is a separate taxable person. It pays Corporation Tax on the £60,000, and what is left inside bears nothing more until she takes it out. She is charged only on what she extracts, as salary or at the dividend rates.

Why the others fail. One says retained profit escapes tax until it is drawn. For a sole trader it does not: retained profit is taxed exactly as drawn profit. Two says the structures are alike. They are not, because the owner of a company is not taxed on profits left inside it.

Five things to take away. One: who the taxpayer is decides everything. Individuals pay Income Tax and Capital Gains Tax, companies pay Corporation Tax on income and gains alike, partnerships pay nothing. Two: dividends carry their own rates, and the Corporation Tax the company paid is no credit against them.

Three: Corporation Tax is 19% up to £50,000 and 25% above £250,000, with marginal relief between, and the limits are shared with associated companies. Four: the annual exempt amount is £3,000, and partnership gains follow the capital sharing ratio. Five: VAT registration bites at £90,000, and Business Relief gives 100% on a trading partnership interest but 50% on the building you own yourself.

And your client? If she wants to build the business up, the company keeps the retained profit out of her own tax return. If she wants every pound in her hand, the advantage shrinks. That is the conversation, and it starts with who the taxpayer is. Next time, Corporate Insolvency.

Practise this topic with exam-style questions at sqe1prep.co.uk. This episode is for education and exam revision only, not legal advice, and we are not affiliated with or endorsed by the SRA or Kaplan.