Understanding Business Accounting For Dummies, 2nd Edition (26 page)

Start-up costs:
You can't just deduct the cost of everything needed to start a business in year one. Some assets, such as cars and equipment or machinery, have to be written down over a number of future years. This area of the tax law can get a little hairy. If you have just started a new business, you may be wise to consult a tax professional on this question, especially if your start-up costs are rather large.

Working from home:
If you use part of your home for work, you will need to keep sufficient records to back up the proportion of heating and lighting costs that relate to your business and your private use. Sometimes you may not get evidence, such as a receipt, for cash expenses, especially where the amounts are small. If this happens, make a brief note as soon as you can of the amount you spent, when you spent it, and what it was for. HM Revenue and Customs don't expect you to keep photocopies of bills, although you may find them useful.

Life insurance premiums:
A business may buy life insurance coverage on key officers and executives, but if the business is the beneficiary, the premiums are not deductible. The proceeds from a life insurance policy are not taxable income to the business if the insured person dies, because the cost of the premiums was not deductible. In short, premiums are not deductible, and proceeds upon death are excluded from taxable income.

Travel and convention attendance expenses:
Some businesses pay for rather lavish conventions for their managers and spend rather freely for special meetings at attractive locations that their customers attend for free. The Revenue takes a dim view of such extravagant expenditures and may not allow a full deduction for these types of expenses. HM Revenue and Customs holds that such conventions and meetings could have been just as effective for a much more reasonable cost. In short, a business may not get a 100 per cent deduction for its travel and convention expenses if the Revenue audits these expenditures.

Transactions with related parties:
Income tax law takes a special interest in transactions where the two parties are related in some way. For example, a business may rent space in a building owned by the same people who have money invested in the business; the rent may be artificially high or low in an attempt to shift income and expenses between the two tax entities or individuals. In other words, these transactions may not be based on what's known as
arm's-length bargaining
.
A business that deals with a related party must be ready to show that the price paid or received is consistent with what the price would be for an unrelated party.

You can find a useful guide to business expenses on the
www.bytestart.co.uk
small business portal. Just click on ‘Tax and Accounting' and ‘Business Expenses Guide'.

Equity capital disguised as debt

The general term
debt
refers to money borrowed from lenders who require that the money be paid back by a certain date, and who require that interest be paid on the debt until it is repaid.
Equity
is money invested by owners (such as shareholders) in a business in return for hoped-for, but not guaranteed, profit returns. Interest is deductible, but cash dividends paid to shareholders are not - which gives debt capital a big edge over equity capital at tax time.

Not surprisingly, some businesses try to pass off equity capital as debt on their tax returns so that they can deduct the payments to the equity sources as interest expense to determine taxable income. Don't think that HM Revenue and Customs are ignorant of these tactics: Everything that you declare as interest on debt may be examined carefully, and if the Revenue determines that what you're calling debt is really equity capital, it disallows the interest deduction. The business can make payments to its sources of capital that it calls and treats as interest - but this does not mean that HM Revenue and Customs will automatically believe that the payments are in fact interest. The Revenue follows the general principle of substance over form. If the so-called debt has too many characteristics of equity capital, HM Revenue and Customs treat the payments not as interest but rather as dividend distributions from profit to the equity sources of capital.

In summary, debt must really be debt and must have few or none of the characteristics of equity. Drawing a clear-cut line between debt and equity has been a vexing problem for HM Revenue and Customs, and the rules are complex. You'll probably have to consult a tax professional if you have a question about this issue. Be warned that if you attempt to disguise equity capital as debt, your charade may not work - and the Revenue may disallow any ‘interest' payments you have made.

Chapter 4
:
Accounting and Your Personal Finances

In This Chapter

Boiling down income tax into a simple model

Making sure that you know how interest works when borrowing

Accounting for how your money grows when saving and investing

Understanding how your return on investment is measured

Planning for your pension

I
n this chapter, we look at you as an
individual
. We look over your financial shoulder at four different roles in which some accounting tips can help you - as a taxpayer, as a borrower, as an investor, and as a retirement planner. Income tax regulations require self-employed individuals and those earning over a certain amount to do some accounting once a year to determine their taxable income and income tax. You may decide to farm out your income tax return preparation to a tax professional. Even so, you should keep in mind the income tax consequences of earning and spending your income.

The Accounting Vice You Can't Escape

All of us have to earn income, right? Therefore, we're all subject to the income tax regulations, whether we like it or not. These regulations are written in the complex and frustrating language of accounting and so they provide employment for a large number of accountants who are hired to prepare the annual tax returns of individuals and businesses. The alternative to using an accountant is to grit your teeth and do your own taxes. Either way, we strongly suggest that you see the forest and not get lost in all the trees. A thumbnail-sized model of how income tax works will help you in making many important financial decisions and is very useful for mapping your overall financial strategy.

The basic income tax model is also useful for testing investment opportunities that seem too good to be true. We have seen too many people get suckered into questionable investments because of alleged income tax advantages. We're sure you've heard the saying, ‘There's one born every minute.'

Don't let the extraordinary complexity of income tax stop you from trying to understand how it works. Here's a basic income tax model for an average taxpayer that's very useful, even though just four factors (numbered 1 to 4) affect the amount of the income tax in this example.

Basic Income Tax Accounting Model

(1) Annual Income £62,700

(2) Less Personal Allowances £5,405

(3) Less Deductionfor a Stakeholder Pension
£3,600

Equals Taxable Income £53,695

(4) Times the Tax Rates (20% on first £35,800 and 40% on excess)

Equals Amount of Income Tax £14,318

Note:
Some sources of income are not taxable or are subject to more favourable tax treatment. Some personal expenditure is deductible, and some is not. Persons over 65 or blind get . . . Hold on! Once you start getting into technical details, you're on a slippery slope, and there's no turning back. Our purpose here is not to provide a detailed tax guide but to provide a simple, hands-on income model to show the basic income tax effects of your financial decisions. Several good tax guides are available, including
Tolley's Tax Guides,
published by
Butterworths
.
Web sites such as the
Daily Mail
's
www.thisismoney.co.uk
(check out the ‘Tax and Wills' section) provide the latest tax tables for every category of taxpayer.

Following is a brief - and we do mean
brief
- explanation of each factor in the basic income tax model:

Income:
Money flowing in your direction from working or owning assets is subject to income tax - unless income tax regulations specifically make the inflow not subject to income tax. (An example is interest income on Tax Exempt savings such as ISAs.)

Personal Allowances:
Income tax regulations give every individual a so-called
personal allowance
. The term
allowance
means that a certain amount of income is excused from income tax. For 2008 (the amount changes from year to year), the personal allowance was £5,405or £8,990 for people over 65 but under 74. On top of these allowances are Children's Tax Credits upwards of £2,390 for, yes, you've guessed it, having children.

Deductions:
The Government allows certain deductions but not others in arriving at taxable income. For example, payments up to a certain level are allowed into pension schemes.