Managing the COVID-19 income tax bill of the self-employed
COVID-19 has caused untold disruption to businesses across the world. This of course is secondary to the suffering of those who have been struck down by the virus. However, the world of business must go on and that means that businesses must plan ahead for the income tax deadline in the Autumn of 2020. Sole traders and partners as self-assessed taxpayers must file their 2019 income tax return, pay the balance of income tax for 2019 and pay preliminary income tax for 2020. A number of possibilities to manage the tax payment burden may be open to sole traders/partners depending on their circumstances. The key to exploring these options is to start the process now so that the sole trade/partner has time to consider what works best for them. In this article, we look at the option of changing an accounting year and the option of basing preliminary tax on 90% of estimated income tax for 2020 which in turn means drafting tax calculations based on profits and loss accounts for 2020. Tax rules for using losses in 2020 are also considered.
Consider changing the accounting year
Changing a sole trader/partnership year end makes sense for tax purposes if profits are falling. Tax rules in section 65 TCA 1997 say that in the case of a change to the accounting year-end, the sole trader/partner’s prior year tax assessment must be reviewed to capture any tax that may fall out of assessment due to the change in accounting year-end. So, changing the accounting year end has implications for the prior year which must be factored into the decision on whether to change the year-end or not. As each sole trader/partnership’s circumstances are different, it is very important to prepare calculations to establish the tax consequences of changing the accounting year in advance of making the decision to change. Commercial consequences of changing the year-end must also be thought through in advance.
Taking an example to illustrate the pros/cons of a change to an accounting year-end, say we have a sole trader who operates a 31 March year-end. That means for 2020, the sole trader is assessed to tax on profits from 1 April 2019 to 31 March 2020. As the economic impact of the COVID-19 restrictions took hold from April, then this sole trader’s taxable profits for 2020 are not going to reflect reduced profits and possible losses experienced from April 2020. Based on a 31 March 2020 year-end, this sole trader’s 2020 preliminary liability must be paid based on 100% of the tax liability for 2019 or 90% of the tax liability for 2020 – both scenarios may present a high tax bill for 2020 preliminary tax purposes. On 31 October 2021, the balance of tax for 2020 will be due which will be based on the accounting year 31 March 2020. Again, this could present a high tax bill which is not reflecting the economic damage of COVID-19 restrictions experienced by this sole trade from April onwards in 2020. This sole trader may not have funds to pay the tax bills generated by the 31 March 2020 accounting year-end.
The sole trader could change the accounting year-end to 31 December 2020. This could be done by running a 21-month accounting period to 31 December 2020 or a 9-month accounting period to 31 December 2020 (however, capital allowances are restricted where the accounting period is less than twelve months in length). In this case, the preliminary tax bill for 2020 will be more closely aligned with the financial impact of COVID-19 on the sole trader’s business.
The taxable profits in the 2019 tax return must be recalculated as prescribed by section 65 TCA 1997. In this case, the profits for the year ended 31 March 2019 would be compared to theoretical profits for 1 January 2019 to 31 December 2019 and if additional profits arise, then tax must be paid on the additional profits on the submission of the tax return for 2020 which would be due on 31 October 2021 as per section 959AO(6(A)) TCA 1997. If additional tax arises because of the “prior year” review for 2019, this additional tax does not disturb the preliminary tax paid for 2019 as per section 959AO(6(b)) TCA 1997 and will not trigger an interest change for underpaid tax.
The change in the accounting year-end will not eliminate tax liabilities but it may defer the timing of the payment. For the sole trader in this example, any extra income tax generated by the change to his accounting year end is pushed out to 31 October 2021 and his income tax bill due on 31 October 2020 is more reflective of his actual financial position for 2020 if profits declined from April onwards due to the COVID-19 restrictions.
Preliminary Tax for 2020
Preliminary income tax can be based on 100% of the prior year’s tax liability or 90% of the current year’s estimated tax liability. It is likely that most sole traders and partnerships will opt to base preliminary tax on an estimate of 2020’s tax liability as the COVID-19 restrictions may mean that taxable income for 2020 is significantly less compared to 2019. This means that draft income and expenditure accounts along with draft income tax calculations must be prepared for 2020 in advance of the October 2020 deadline.
What might go into the draft income and expenditure COVID-19 accounts? The sole trader or partnership may have worked from home over the lockdown and the business may also have had staff working from home. Expenditure on the provision of work-related supplies of a revenue nature should be tax deductible if the expenditure meets the wholly and exclusively incurred for the purpose of the trade test. Expenditure on equipment such as computers and printers purchased for the purpose of the trade should qualify for a tax deduction in the form of a capital allowance. Section 291 TCA 1997 provides that computer software or the right to use such software for the purposes of a trade also qualifies for a tax deduction in the form of a capital allowance.
The sole trader/partnership cannot take a tax deduction for the Temporary Wage Subsidy paid to employees of the business in the calculation of income tax for 2020. Remember also EIIS relief or SURE relief cannot be factored into the calculation of preliminary tax.
Options for 2020 trading losses
Unfortunately, many sole traders and partners will not have the problem of tax to manage in 2020 as the COVID-19 restrictions mean that some will breakeven while more will incur substantial losses. The tax rules for using trading losses are reasonably flexible provided the business is not a part-time trade or farming trade.
In the case of a full-time trade operated by a sole trader or partner, tax relief for trading losses is set out under section 381 TCA 1997. The loss for an accounting period is computed in the same manner as a profit is computed in accordance with the rules of Cases I and II. Loss relief under section 381 TCA 1997 should be calculated for the actual year of assessment, that is for the tax year 1 January to 31 December. Revenue practice allows loss relief for a tax year to be based on the loss for the 12-month accounting period ending in that year. For example, if a sole trader makes his 12-month accounts annually to 30 September, the loss per the 30 September 2020 accounts will be allowable in his or her 2020 tax return. This practice does not apply to start-up trades or a trade ceasing business.
A claim for loss relief under section 381 TCA 1997 must be applied in the following order:
- Against the earned income of the individual, i.e. trading income, employment income;
- The unearned income of the individual, i.e. investment income (rents, dividends, deposit interest);
- The earned income of the spouse, i.e. trading income, employment income;
- The unearned income of the spouse, i.e. investment income (rents, dividends, deposit interest).
Once a section 381 TCA 1997 claim is made, the full loss must be deducted from the total income, even if that means total income is used up and no benefit is obtained from the taxpayer’s personal tax credits etc.
The taxpayer must make a claim to use the section 381 loss within two years of the end of the year of assessment to which the claim relates.
Where the trading loss has not been used under section 381 TCA 1997, a claim can be made under section 382 TCA 1997 to carry the loss forward to subsequent years of assessment. It is important to note that a section 382 TCA 1997 loss can only be carried forward against the profits of the same trade. If there is any possibility that the trade may not exist in the future, then all efforts should focus on maximising the loss relief claim in the year it arises.
With income tax deadlines looming in the background of very difficult economic circumstances, it is important for sole traders and partners to consider any possible options to manage their tax payment burden early. Early engagement, in advance of October 2020 may provide sole traders and partners with much needed cash flow benefits.