UK Tax Accounting
By Student’s Name
Question one: Key Structural question and its significance
This chapter majors on the issues that influence the structure of small business taxation in the United Kingdom. It discusses the implications of taxation strategy on the employed and self-employed people, incorporated and unincorporated businesses, labor income and capital income, and employees’ wages and receipts of businesses. Small businesses form a large part of the economy because they are widely spread all over the country (De Rugy, 2005). This is a clear indication that the influence of taxation structure on small businesses would have great impact on the economy of the country, as it would affect a large number of the population as well as businesses.
The structural question in this chapter is “how would a central taxation structure for small businesses be designed to ensure there is perfect neutrality between various legal forms of business execution?” Small businesses include employees and businesses of various nature, an issue that creates difficulty in ensuring neutrality in taxation. The fact that the businesses occupy vast part of the economy also means that a taxation structure that influences a small part of the employees or businesses will be felt in the overall economy of the country (Harvey, 1995). This chapter tries to explain the structural problem that is faced in the course of designing the small business tax structure and goes ahead to give approaches that can be used in addressing the structural problem.
A look into employees in small businesses reveals the existence of the employed people ad those who are self-employed. The employed people refer to the citizens who are employed by the owners of the small business to help in running the activities of the businesses. They receive their salaries from undertaking the duties in the small businesses, and it is a legal requirement that these employees are taxed (Slemrod, 2004). The self-employed on the other hand refer to the owners of the small businesses. These are the people who start small businesses as a way of earning some form of income. Evidently, a structure that require the employed and the self-employed in the small business sector to pay taxes at a similar rate may not seem fair due to the major differences in the incomes of these employees (Atkinson & Storey, 1993).
The nature of the small businesses is another factor that raises questions with regard to taxation structure. Small businesses can either be incorporated of unincorporated. An unincorporated small business is relatively smaller, and include sole proprietorship as well as partnerships. Incorporated small businesses are believed to offer higher benefits than the unincorporated businesses as they include protection from liability as well as the ability to raise capital through selling shares of the corporation (Bjuggren, & Sund, 2002). The differences in the benefits of these two types of small businesses call for differences in the structure of taxation that they should comply with in the economy.
There is also an issue related to the taxation of income from labor versus income from capital. The income from labor refer to the receipts from the duties of the employees in the small businesses while capital gains refer to the receipts that the businesses receive from the use of machines. There has been a debate that businesses may manipulate their accounting systems by transferring more receipts to the side of capital gains (Derregia & Chittenden, 2006). This enable them protect they income from higher taxation on labor income. This practice deprives the State the opportunity to receive the right amount of taxation revenue from businesses, while the businesses themselves gain from shielding their income from higher taxation levels. This has raised the debate regarding the right structure that would ensure the businesses do not shield their income from taxation by transferring them to the side of capital gains (Adam, 2008).
The presence of these diversity in the sector may make one conclude that the best way is to designed a structure that impose the same rate on employees and businesses across the small business sector. This is however impractical as it will highly disrupt the sector. The fact that employees’ salaries cannot be equated to receipts from the businesses, and that labor income cannot be compared to capital income makes it impossible to implement such a strategy. The best taxation structure that would be applicable in the sector is thus a major problem that is addressed in this chapter.
Question Two: Approaches to Address the Tax Implications
The major problem is the inequality that exists in the tax rates that are applied on both unincorporated and incorporated small businesses. The rates on the employees of the businesses, the profits from the businesses, as well as the income from labor and income from capital show some significant inequalities (Bloom & Van Reenen, 2006). From the chapter, the possible approaches of eliminating these inequalities include prevention of deterring incorporation, implementation of a pass-through treatment, creation of special rules for the companies whose owners are active, and rejection of the approaches that are definition-based.
Incorporation is a major way through which small businesses use to minimize the level of taxation that they pay to the government. The businesses strive to become incorporated as a strategy of moving from the payment of personal tax to corporate tax that involves taxation of income from labor and income from capital (Carney, 1995). The businesses have the opportunity to manipulate accounting figures and place more income under capital, thus reducing the amount of tax that they pay. This can be controlled by regulating the rate at which firms become incorporated, possibly through increasing the level of capital requirement for incorporation. Such a strategy would discourage small businesses from being incorporated and thus will still be taxed under the system of personal tax (MacKie-Mason, & Gordon, 1997).
The pass-through treatment on the other hand can be made either mandatory or optional. It refers to the situation where some incorporated businesses get a tax treatment similar to the unincorporated businesses. Making the pass-through treatment mandatory calls for the creation of an alignment of the self-employed and the employed people (Davis, Haltiwanger & Schuh, 1996). This would be closely followed by the treatment a portion or the whole income of the companies that are owner-managed as labor income, without the consideration as to whether it was a salary payment of not. This strategy would lead to the alignmeant of tax on labour as well as capital income for the incorporated businesses (Boyns et al., 2003). This treatment would definitely discourage firm from incorporation, as they operations under unincorporation would have less severe tax rates. Many businesses will thus avoid incorporation, as the tendency to place some income under capital gains to evade higher tax rates would be eliminated.
The fact that making the pass-through treatment mandatory would come with disadvantages like the need to manipulate definitions and the treatment of all profits of the companies that are owner-managed as labour income without considering the investments that the companies had on capital makes it hard to implement the approach (Chennells, Dilnot & Emmerson, 2000). However, an optional pass-through treatment can be used more conveniently than the mandatory pass through treatment. This implies that the pass-through treatment should be provided as an option that the owner-managed companies can use over the other methods. Making this option applicable call for designing a tax system that makes it hard for the companies to escape from some forms of social security and labour taxes. This would make some of the owner-managed companies to prefer the pass-through treatment to other forms of treatment. This option actually means the alignment between legal forms in a country should be increased in order to allow companies to choose the form that will give them a tax advantage compared to other forms. For example, when the system being used involves a corporate tax rate that is lower than an income tax rate and other advantages like implementation of a system for tax credit on divided are incorporated, companies that are making losses would prefer the use of the pass through treatment. Businesses that are incorporated but have small number of members would obviously prefer the use of the pass-through treatment rather than the implementation a limited liability that has the ability of offsetting the losses of the business against the personal income of the owners (Blow et al., 2002)
The other approach to the solution of the structural problem is the creation of rules specifically for the active owners of the small businesses (Sørensen, 2005). The dual system of income tax that involves flat rate taxation on capital gains that are relatively low and the higher taxation on labour income is the major structural problem that results in taxation of the small businesses (Chittenden, Kauser & Poutziouris, 2003). Designing special rules for the active shareholders of the small businesses like imposing a lower tax rate on their labour income up to a specific point of share prices after which the rate rises back to normal, would ensure a solution to the problem.
The last solution would be the elimination of the definition of the sub-catteries of shareholders and companies (Dean, 2005). Some businesses are believed to manipulate their accounting figures after understanding the definitions of active shareholders or differences between labour income and income from capital. The manipulations help them escape the actual amounts of tax that they would pay. A solution to this problem would thus be a total elimination of the definitions to treat shareholders the same way and income in a similar manner (Devereux & Freeman, 1991).
Table 11C.1. Tax and NICs to be paid in the UK in 2014-15, by legal form
£25,000 income/profits per annum £75,000 income/profits per annum
Employed Self-employed Incorporated Employed Self-employed Incorporated
Salary £22,648.00 £25,000.00 £9,718.00 £65,748.00 £75,000.00 £9,718.00
Income tax £2,529.60 £3,000.00 £15,926.20 £19,627.00
Class 1 employee £2,045.00 £245.00 £4,731.00 £245.00
NICs Class 1 employer £2,352.00 £282.00 £9,252.00 £282.00
NICs Class 2 £143.00 £143.00
NICs Class 4 NICs £1,533.96 £3714.51
Corporation tax £2,951.00 £12,951.00
Dividend tax £0.00 £5,773.90
Total tax and NI £6,926.60 £4,676.96 £3,478.00 £29,909.20 £23,484.51 £19,251.90
Net receipts £18,073.40 £20,323.04 £21,522.00 £45,090.80 £51,515.49 £55,748.10
Total tax and NI as a % of gross income/profits 27.7% 18.7% 13.9% 39.9% 31.3% 25.7%
Increase in net receipts compared to employed £2,249.64 £3,448.60 £6,424.69 £10,657.3
Table 11C.2. Total tax and NICs to be paid in the UK over time, by legal form
£25,000 profits per annum £75,000 profits per annum
Employed Self- Incorporated Employed Self- Incorporated
(%) employed (%) (%) employed (%)
1996-97 29.2 23.4 20.1 37.1 31.6 26.6
1997-98 28.4 22.6 17.7 36.5 31.1 24.3
1998-99 28.5 22.6 17.7 36.6 31.1 24.3
1999-2000 28.3 22.3 15.8 37.2 31.0 23.3
2000-01 27.4 22.2 12.6 36.9 31.0 23.2
2001-02 26.9 22.0 12.4 36.7 31.1 23.2
2002-03 26.6 22.0 8.9 36.5 31.1 22.3
2003-04 27.8 22.8 8.9 37.8 32.0 22.5
2004-05 27.9 22.9 14.7 37.9 32.0 22.6
2005-06 27.9 22.9 14.7 37.9 32.0 22.6
2006-07 27.9 22.8 14.7 37.9 32.0 22.6
2007-08 27.8 22.8 15.5 37.8 32.0 23.2
2008-09 27.0 21.9 16.1 37.6 31.8 23.9
2009-10 26.9 22.4 19.9 37.4 32.2 27.0
2014-15 27.7 18.7 13.9 39.9 31.3 25.7
Tables 11C 1 and 11C 2 show the show the comparisons between the levels of taxation of the self-employed, employees and incorporations. Table 11C 1 indicates the 2014-2015 taxation rates of the employees, self-employed, and incorporated small business that earn 25,000 pounds and those that earn 75,000 pounds. The table indicates the levels of salaries earned, the income tax paid, the contributions made to the national insurance, and finally a comparison between the net receipts among the three categories of employees.
Evidently, from the table, the employees have the lowest net receipts, followed by the self-employed, and finally the incorporated small businesses. The employees have their PAYE deducted from the gross income. This is followed by deduction of the income tax from the taxable income and the employee NIC contribution. The net receipts are received from a deduction of the NIC contributions and income tax from the gross salary. The self-employed on the other hand have their income tax deducted directly from the gross salary. This is followed by a deduction of the flat rate NIC contribution of the NIC class 4 contribution. The net receipts are a deduction of the NIC contributions and income tax from the gross salary. The incorporated small businesses take the tax allowance as their salary from the gross profits of the firms. The employers and employee’s NIC contributions as well as the corporation tax and dividend tax are then subtracted from the gross profits to determine the net income of the business.
A comparison of the net receipts of the employees and the self-employed indicates that the employees have a lower level of receipts than the self-employed. The major differences from the two categories of taxpayers result from the level of NIC contributions that they pay. The employees pay higher employer and employee’s NIC contribution compared to the self-employed. The flat rate NIC contribution paid by the self-employed is low, making them have higher receipts than the employees (Tiley & Collison, 2007). A comparison with the difference in 2008/09 period indicates a rise in the difference, implying that as tax structure is reviewed, the employees continue to pay higher amounts of taxes than the self-employed who have a similar range of gross income.
The incorporated small businesses pay the least amounts of taxes among the three groups. The major tax burden that they incur is the corporation tax. With a small salary that amounts to the tax allowance, these businesses do not pay any income tax and the levels of employer and employee’s NIC contributions are extremely low (Goolsbee, 2004). The final receipts indicate that the net receipts of the incorporated small businesses are higher than those of the self-employed and the employees. A comparison of the differences between the 2008/09 figures and the 2014/15 figure indicates that the gap is continuously widening. This indicates that as the structure of taxes continue to be revised in the UK, the employees continue to bear more burden, followed by the self-employed, and the incorporated small businesses continue to benefit from the system. This is an indication that citizens would strive to become self-employed and finally incorporated in order to pay lower levels of taxes. Unfortunately, the largest percentage of the taxpayers is the employees, indicating that the burden of tax in UK is carried by a large number of the population, an issue that may trigger the lack of cooperation of the employees.
Figure 11C.2 on the other hand indicates the percentages of total deductions to the gross income or profits of the employees, self-employed and the incorporated. The figure indicates that the percentages do not have a consistent way of changing. They often decrease or increase decimally as time changes. A comparison among the four categories indicates that the percentage of the incorporated small businesses is constantly the lowest. This is followed by the percentage of the self-employed, and the employees have the highest percentage of total contributions to gross income. Evidently, the UK tax structure makes the employees bear a larger tax burden while the self-employed and the incorporated businesses pay lower levels of tax (De Mooij, & Nicodeme, 2007).
Question Four: Need to Address the Differential Tax Treatment
The differential tax treatment that is addressed in this chapter relates to the difference in taxation rates imposed on the self-employed and the employees, unincorporated businesses and incorporated businesses, and equity and debt. It is addressed in the chapter that the small businesses cover a large portion of the economy and any treatments that may have influence on a small section of the small businesses have a vast effect on the economy. The chapter addresses the ways through which various participants in the small businesses as well as various categories of the businesses should be treated to ensure that not all the participants in the sector are disadvantaged by the taxation structure and the case of escaping the required levels of taxation by some businesses are evaded. There is a great need of addressing the differential treatment of tax as addressed in the chapter.
The chapter indicates that the differential tax in the UK coupled with the way NIC treats individuals across the activities of the small businesses and the employment spectrum makes many citizens have the desire of self-employment instead of becoming an employee (Davies, 2003). It also makes businesses strive to be incorporated instead of remaining unincorporated. It makes citizens strive towards self-employment, after which they upgrade to incorporation (Keatinge, 2007). Unfortunately, a larger number of the citizens have no other options rather than being employed. The whole issue arise from the desire of the citizens to have the opportunity of converting labour income that is highly taxed, to capital income that has lower rates of taxes (CIOT & ATT, 2005). This means that the differentials have a negative impact on the larger population that is unable to become self-employed and be incorporated. The system of taxation should however be neutral, with the use of commercial factors to enable both the employees and self-employed to make a favorable legal form choice. Tax differentials have effects on the legal form choice and often target the efficiency of the entrepreneurial businesses through the creation of costs to the businesses as well as the revenue authorities (Cowling et al., 2008). Some of the taxpayers utilize the differentials to their advantages, and this may make the revenue authorities to try curbing the problem through creating complex provisions that may give a sub-category of taxpayers a tax advantage. The practice often make many tax payers dissatisfied with the system, as the revenue authority evade the actual structural problem that make some taxpayers avoid taxes due to the differentials and impose complex provisions that are less beneficial compared to elimination of the differentials. The co-operation of the taxpayers may be lost by the revenue authority, which will have to incur more costs in collecting the taxes.
The fact that the differential tax system advantages incorporation is an issue that may actually discourage entrepreneurship in a country rather than boosting it (Crawford, 2008). The differentials should be eliminated to ensure that entrepreneurship is encouraged in the country, and the employees are not taxed more than the self-employed (Gordon, 1998). The first option lies in ensuring that the rates of taxing labour is made similar to the taxation of capital in order to eliminate the differential I incorporation. The integration of the national Insurance Contributions and the income tax would ensure that the differential between the small companies’ rate and the basic rate is eliminated (Loutzenhiser, 2007).The differential in NICs that are paid by employees and the self-employed can be eliminated through the alignment of the two rates, though the practice should not include the employer contribution (Golding, 2006).
These practices may not have a complete elimination of the differential that exist between incorporation and unincorporation, as well as employment and self-employment, but have the ability of reducing the obvious gap that exist (Curran et al., 1993). The taxation structure should have the ability of encouraging growth in a country. Entrepreneurship is one of the major ways through which growth is ensured, and the elimination of the differentials is an important factor of promoting entrepreneurship (Abramovsky, Griffith & Harrison, 2006), Differentials also reduce the cooperation of taxpayers, an issue that results to the use of more costs in tax collection. The elimination would ensure that the taxpayers cooperate and employees would not feel disadvantaged by the tax structure (Lindhe, Södersten, & Oberg, 2002). Growth in a country would therefore take place at a higher rate when the differential tax treatment is adequately addressed.
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