Finance

A Guide to ‘Payments on Account’ for SMEs

Allison S Robinson | 15 November 2021 | 2 years ago

Payments on account; a guide for SMEs

Congratulations, you have chosen the challenge of being an entrepreneur and a sole trader. We are here to help guide you through the myriad components of an SME business and the terminology that confronts you. One of the small-medium enterprise phrases you will encounter in your new journey is ‘payments on account’. Here is a comprehensive, practical guide to what it means, is it necessary and what other terminology it gets confused with.

What are payments on account?

As an entrepreneur launching into the exciting world of business ownership, you will soon hear the phrase ‘payments on account’. This is sometimes confused with ‘payment made on account’ or ‘paid on account’. We will discuss these latter two phrases later on in the article. For now, we are focussing on the very important ‘payments on account’.

Payments on account are your self-assessed tax payments made to the HMRC. They are payable to HMRC in two instalments every year.

This means that starting out as a sole trader, you do not have to pay your taxes upfront, every month. You might see delayed tax payments as a heaven-sent benefit as it eases your cash flow and, as we all know, cash (and the resulting cash flow) is king. This delay in tax payments is due to sole traders not having tax deducted monthly, as per employee salaries that have deductions made at source based on the PAYE system. Be cautious with that sigh of relief.

Not having to pay the tax immediately can bite you in the proverbial derriere if you do not accrue correctly for it. Playing ‘catch-up’ at tax payment time is a gamble and can put you into a sticky pit of debt, so tread (and trade) cautiously.

What are the payment date time periods relative to payment on account?

Your first payment deadline is set by HMRC as 31st January. The second one is set for 31st July. Each of these split payments is equal to half the amount of tax that you owe as a result of tax calculations for earnings in the previous tax year.

As an SME business owner, you will be categorised as self-employed. If this is your launching year and your first year of trading, then your first tax bill won’t be in July. This is because you will have no tradings from the previous tax year against which to calculate tax.

Your first payment will, therefore, most likely have the due date of the 31st January (i.e. The January that falls after the end of your first tax year). Each tax year period runs until 5th April.

Split payment example

As an example, if your launch as an SME sole trader entrepreneur started last year, 2020, in the month of November, then your tax bill payment is due, by midnight, on 31 January 2022 and 31 July 2022.

Note: If your payments made in January 2022 and July 2022, against your tax bill, don’t completely zero out your tax bill, then you will be obliged to make an additional payment, called a ‘balancing payment’, by midnight on the following 31 January 2023.

Referring to our cautionary note in the previous paragraph, that is a long time to not accrue your tax obligations, and you will have set yourself a dangerous catch-up target for January 2022 by failing to accrue.

Directors of companies and payments on account

If your SME is a limited company, with one or a few directors, it is important to note that Self Assessment legislation also affects the obligations of limited company directors too. The director’s earnings are usually primarily a salary initially until the company starts producing dividends. They will then earn a salary and dividends. The salary component is treated like any other employee salary and has any tax PAYE calculations deducted at the time of the salary being paid. In addition to this deduction of PAYE, the directors are also obliged to submit an annual Self Assessment tax return. This tax return gives them the opportunity to declare any additional income they might receive through dividends from their own company, through rentals or via other income-earning sources.

Note:  It is important to be careful about declaring all your income. As an example, if you have received income payments for:

  • a furlough award (for example, the Coronavirus Job Retention Scheme), or
  • the self-employed income support scheme (SEISS)
These need to be included in the Self Assessment tax return as they are deemed, by the HMRC, to be taxable income.

COVID impact on POA (Payment On Account)

If you are a Self Assessment taxpayer and your 2020/21 estimated taxable income is dramatically less than the 2019/20 tax year (due to COVID effects, for example), then you can formally request an adjustment. After calculating the relevant and appropriate deductions from the income, you can then formally apply to HMRC for a reduction in your POA obligations.

A formal application can be done telephonically or via Royal Mail (using a Form SA303) or, if you are a registered online taxpayer with an HMRC tax online account, you can process and submit a formal request online.”

Note: Self Assessment taxpayers should be cautious with attempting to inflate any claim for the reduction of their POAs. If such an action is verified by HMRC, then the taxpayer will typically be notified of a liability to not only pay the outstanding tax amount but also to pay interest on the late paid tax. The interest amounts and the outstanding amounts will need to be settled as part of an overall Self Assessment tax return submission and an agreed final payment process.

There additional layer of Payment on account (POA)

Now that you have weaved through that information, here are some more details. The HMRC “payment on account” system only applies to taxpayers who pay the majority of their tax via Self Assessment. If, however, eighty per cent or more of your income is taxed and treated via the HMRC PAYE process, then the POA system does not apply to you.

However, as a Self Assessment taxpayer, there is another layer of payment that might be applicable to you. If your Self Assessment calculation for the 2021/2022 tax bill (for example) works out to be more than GBP 1,000, then you will need to do another layer of payment on account.

What does this mean? Let’s assume that you have calculated your 2020/21 tax obligations and you know that you need to make full and final payment by midnight on 31st January 2022. If, however, your 2021/22 calculation shows that your tax obligation for that period is over GBP 1,000, then you will have to pay across half of the projected tax for the 2021/22 year by 31st January 2022.

The balance of the 2021/22 tax bill will then need to be settled by midnight on 31st July 2022.

This methodology was brought about by HMRC to prevent self-employed workers from gaining an unfair advantage of benefiting from cash on hand through delays brought about by the tax payment deadlines. It historically gave self-employed workers a huge advantage by delaying the payments of possible huge amounts by many months in arrears.

Note: The bad news for many newly launched entrepreneurs is that they commonly land up lumped with a tax bill that is roughly 50% higher than they had budgeted for. Keep this factor in your accrual plans.

Note 2: POAs will include any Class 4 National Insurance obligations (if applicable to you) but will exclude student loan repayments as well as Capital Gains Tax.

Non-standard POAs

Late-payment penalties

If you are transferring from a salaried existence to an entrepreneurial journey, then payment on account and the Self-Assessment system will not be familiar to you.

Nasty surprises like a GBP 15,000 tax obligation instead of the GBP 10,000 you budgeted for is not something that is easy to cover at that bat of an eyelid. That is a fifty per cent increase in budget expectations.

If you have been ‘caught out’ by miscalculations of forwarding projections and cannot pay the entire tax bill by midnight on 31st January, you will, unfortunately, be faced with interest charges on the unpaid amount.

Most people can project this looming crisis before January even arrives, and it is therefore highly advantageous if you contact HMRC urgently and try to negotiate a ‘Time-To-Pay’ agreement. Forward planning is always better than scrambling for forgiveness after the deadline.

Payment Adjustments

As explained, the amount that you will be obliged to submit as payment on account is calculated on your tax bill from the previous tax year period. The HMRC works on the assumption that you are a great entrepreneur and will earn at least the same amount as last year and hopefully more. Their assumption is, therefore, that you will also pay approximately the same amount of tax in the current year.

If your earning situation has changed and you are:

  • adjusting into a full-time job commitment, or
  • expecting that your earnings will change to being taxed at source,
Then, you should contact HMRC and negotiate for permission to reduce your payment on account. As per the earlier caution in this article, it is highly advisable that you err on the side of overpaying because if your reduced payment ultimately lands up with your underpaying tax overall, there is a negative outcome. HMRC will, or can, charge you interest on the underpaid amount and, in addition to that, they could also add a stiff penalty on top of the underpaid amount plus the interest. It is always advisable to consult with a professional, like an accountant, when doing non-standard HMRC calculations.

The good news about POAs

The good news is that, once you are up and running and over the initial year of POAs, the system calms down into a simple spreading out of your tax bill, split across the year, and it will make it easier to budget.

The most important takeaway from the above information is the vital importance of accruing enough money for your projected tax bill. Don’t wish upon a star for a windfall to dig you out of a hole at the 11th hour. Another important take-away is the benefit of completing and submitting your Self Assessment tax return sooner rather than later. This is particularly important if you are a newly launched entrepreneur, fresh into the arena of self-employment. This will eliminate nasty new year surprises and missing bits of your derriere.

What do payments on account have in common with paid on account?

Short answer – nothing.

The former relates to tax finance, and the latter relates to bookkeeping finance. We have explained what payments on account are, so now we will clarify what paid on account is to avoid any future misunderstandings.

Whether your business is managing sales of £10,000 or £10 million, one of the critical success factors for your business is the accurate maintenance and tracking of transactions in your financial records. As mentioned earlier in the article, cash is king, and that makes accounts payable and accounts receivable vital for the health of your company. The need for accuracy in the capturing of data includes the need for the proper classification of payments received.

What does paid on account mean?

The term ‘paid on account’ refers to a payment made by a client or debtor that only partially covers the total sum due to your business and, specifically, is not matched to an individual invoice.

Some clients or debtors want to make payments when they have cash available and do not want to wait for an invoice. They will pay in advance against a quotation or estimation, and then the bookkeeper is left with an amount and no invoice to reconcile against. You might be the debtor making such a payment to a supplier.

Payments made and received in this manner are known as “payments on account” (like the tax phrase) and “paid on account”. This type of transaction is common in businesses where credit is commonly used for purchasing.

“Paid on account” transactions by your clients

A quick initial clarification is required here. Firstly, accounts receivable are payments made by your clients against purchases they have made for goods or services. Then there are receivables (without the ‘accounts’ in front of it) which can cover money expected by your business from any source that is not customer sales, e.g. rental of part of your premises.

Each company has its own accounts receivable risk profile and appetite, so the financial arrangements with each debtor will be different, company to company and, possibly, debtor to debtor. Most accounts receivable arrangements give a debtor a defined and contracted period of time to make repayment instalments. This can range from thirty days to 60 months (for big-ticket items). The date of payment can be from the invoice date, delivery date, handover date or statement date.

Note: Accounts receivable represent positive financial flows and value coming into the business. They are therefore categorised, at a higher level, as company assets.

Payments on account and paid on account both relate to financial transactions. Payments on account can mean a tax payment system of the HMRC for Self Assessment taxpayers but are also sometimes used to refer to a payment made against debt to a supplier. Paid on account only refers to payments made against debt to a supplier.

Topic

Finance

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