What is payment on account?
Payment on account refers to the payment of part of your tax liability in advance as a self-employed person. Once you have submitted your self assessment tax return, the tax owed is split into two amounts.
The payment on account system is intended to help you spread the cost of your tax bill, but it also boosts the Treasury’s funds mid-year as payments are due at the end of July. Not everyone is liable to make payments on account – if 80% or more of your income tax was deducted at source in the previous tax year, via the PAYE system for example, then you will not have to make a payment on account.
Similarly, if your tax and Class 4 NIC liability for the previous year was below £1,000 after tax has been deducted at source, there will be no requirement for a payment in advance. Class 2 National Insurance is not included in a payment on account.
How does the payment on account system work in practice?
Self assessment tax payments are made twice a year, at the end of each January and July, with the payment in advance representing half of the previous year’s tax bill and including Class 4 National Insurance contributions.
Problems can arise if you are in your first year of business, and many people are caught out by this system. At the end of January you have to pay your full tax bill for the previous year, plus half of that amount – HMRC take the previous year’s bill and use it as the basis for estimating payments on account.
In the first year of business, this is often an unexpected financial liability that can cause serious issues if a company cannot pay. There may be a chance to reduce your payments on account if you contact HMRC, but this also has potential drawbacks.
Reducing your payments on account
If you think your income will be lower in the current tax year, you can apply to HMRC to reduce your payments on account. Although this might make financial sense at first glance, you need to consider the fact that you will be charged interest on any underpayment should your earnings be higher than anticipated.
Depending on how much you have underpaid, the addition of interest can increase your tax bill quite significantly, so it pays to be fairly certain about your predicted level of income before applying for a reduction. You can make your application online, or via Form SA303.
It is also worth noting that HMRC are likely to charge a penalty if they believe you did not take reasonable care when applying for reduced payments on account. Should you decide not to request a reduction and make the full payment on account, you can request a refund from HMRC if the payments later exceed your total tax liability.
HMRC payment on account is a complex and often misunderstood system that can lead to financial problems if liability is not correctly anticipated. Businesses in their first year of trading are at particular risk, but those already experiencing cash flow issues can also suffer a rapid decline because of these tax demands. If this is happening to your business, you should make contact with HMRC quickly before the situation becomes unmanageable.
Handpicked Accountants can put you in touch with a trustworthy and proactive accountant in your area, and ensure that you fully understand your tax obligations as a company director. You can find out more about payments on account, and all other corporate and personal accountancy matters.