…and why you’ve got to pay two years’ taxes in one year

You have had a cracking year. The late nights have paid off, revenue is up, and your business profits have finally pushed past the point where you no longer need to think about whether it was worth giving up employment to sail your own ship.

You’re expecting to pay a bit more tax this year because, hey, you’ve made some good money. 

You sit down with a cup of tea, open the Tax Return from your accountant, and brace yourself for a slightly bigger tax figure.

Then your tea goes cold.

The number staring back at you is not just your tax bill. It looks like your tax bill plus half as much again. Before you panic and assume your accountant’s got it in for you, take a breath. 

What you are witnessing is a rite of passage for almost every sole trader, shareholder or landlord in the UK. 

Congratulations: you have officially triggered Payments on Account (POA).

Here is the lowdown on what has happened, why it happens, and how to avoid getting caught out.

The £1,000 threshold that changes everything

When your business was smaller, tax was relatively straightforward. You earned your profit, the first £12.5K was tax-free, and you paid a bit of tax on the extra, annually on 31st January.

However, HMRC operates on a simple principle: if you owe them a decent chunk of money, they would rather not wait a whole year to see it.

The moment your combined annual Income Tax and National Insurance Contributions (NIC) bill goes over £1,000, you become (literally) a paid-up member of the POA club.

The 150% hit

The way HMRC structures this is where most business owners feel the pinch. HMRC assume that your profit for the current year will be the same as last year. To collect that future tax early, they split the estimated bill into two equal payments of 50%.

The first payment on account is due on 31 January, the same day as you pay the outstanding balance for the tax year that just ended. The second payment is due on 31 July.

In your first year crossing that £1,000 threshold, you have to pay 100% of last year’s tax bill (as normal), plus 50% in advance for the next tax year, all on 31 January. 

Paying 150% of a tax bill in one go is enough to test anyone’s sense of humour, especially when your bank account is still recovering from Christmas spending.

And then another 50%…

As well as paying a 50% POA in January, HMRC will also need another 50% six months later, in July. You’ll have more time to plan for this, but with POAs you’ll always be making two payments in advance – one in January and another in July.

However, before you despair, it’s important to know that in subsequent years, the payments you made in advance get knocked off your final bill, and then you just pay the difference (Assuming your business is booming) or get a refund (if things haven’t gone so well) when you file next year’s tax return.

But that first January stings like a ***** if nobody warned you about it.

A Worked Example

Assume your tax bill for the 25/26 tax year was £900, but business is booming and for 26/27 it’s £1,200, and for 27/28 it’s £1,500.

Here’s what the timeline looks like:

Jan 2027 – £900 to settle for 25/26. That’s it.

July 2027 – nothing. Fab.

Jan 2028 – £1,200 to settle 26/27 PLUS 50% again, so total payment of £1,800 due.

July 2028 – another £600, i.e. £1,200 @ 50%.

So, by July 2028, you’ve paid £600 + £600 = £1,200 towards your 27/28 tax bill.

Jan 2029 – this is where it gets complicated. The amount due is as follows:

• £1,500 tax bill
• Less, £1,200 POA already made (£600 + £600)
• Plus, £750, your first POA for the 28/29 tax year
• Total: £1,050.

Essentially, after the pain of the first year, you just get into a cycle of paying roughly 50% of your tax bill every 6 months, rather than just all in January each year.

Can you reduce your payments on account?

Although business profits will – hopefully – be increasing each year, what happens if you know that the coming year will not be nearly as profitable? Perhaps business isn’t doing quite so well, or you’re taking some time off to travel? Maybe you’ve invested heavily in new equipment? Or you’ve closed the business and have moved on to something else.

If you’ve got reasonable grounds to believe that your tax bill for next year will be lower than last, you can apply to HMRC to reduce your payments on account.

This can be done at any point directly with HMRC, although we recommend doing this at the same time as preparing your tax return, as part of the submission.

For every tax return we prepare, part of our process is to assess whether we could make an application for the client, and discuss with them if applicable.

There is a catch, however. When you ask to reduce your payments, you have to provide an estimate of what you think your final tax liability will be. HMRC takes a dim view of wishful thinking. If you reduce your payments and it turns out at the end of the year that your estimate was too low, HMRC will charge you interest on the difference from the original due date.

Because of that, our advice is always to err on the side of caution. It is far better to estimate slightly higher rather than lower. If you pay a bit too much, HMRC will refund the difference with interest, which is nice of them.

Or, depending on the amount, you can choose to have any overpayment kept on your account and rolled forward against next year’s tax bill. 

The side-hustle exemption

There is one solid exemption from POAs, and that kicks in when you’ve already had more than 80% of your total tax for the year deducted at source – even if your year-end liability is more than £1,000.

The most common example is where you’re full-time employed, paying tax through PAYE, and have a small side-hustle. In this case, there’s a good chance you’ll be exempt from POA.

Alternatively, if you’re in the construction industry and you have CIS deductions, then you’ll have already been paying a lot of your tax throughout the year, via deductions from your customers. 

Staying ahead of the game

The golden rule of running a business is never to let HMRC surprise you. As Chartered Accountants regulated by the Institute of Chartered Accountants in England and Wales (ICAEW), we spend a lot of time making sure our clients know what is coming down the road months before the deadline arrives.

However, unless we’re preparing interim figures for you every month or quarter, it isn’t until the end of the year that we’ll know just how well you’ve done.

Hence, the simplest way to manage payments on account is for us to prepare your accounts as soon as possible after the tax year ends in April. That gives you nine months to budget for your January bill, rather than finding out four days before the deadline, whilst you’re still paying off the Christmas credit card debt.

If you are expanding your business, wrestling with your self-employed tax, or simply want someone to be in your corner to navigate the maze of Payments on Account (and everything else HMRC insist on throwing at small business owners!), our team in Taunton are here to help. 

Head over to www.blue-penguin.co.uk/contact to fill in an application form, and we’ll be in touch.