The tax basis period reform for sole traders and partnerships

By Team Starling

If you’re a sole trader or a partner in an unincorporated partnership, you could be affected by the upcoming basis period reform, which is changing the way these types of businesses are taxed.

Specifically, the reform affects sole traders or partnerships with an accounting period end that doesn’t align with the UK tax year. Here’s the reform calendar:

• 2022/23 - final year for the existing basis period

• 2023/24 - transitional period

• 2024/25 - first year of the new basis period

From 5 April 2023, we enter a transitional period, moving from the ‘current year’ basis of calculating tax, to the ‘tax year’ basis in the tax year 2024/25 (see below for more on this).

You may also end up paying more tax than expected in 2023/24 - which is why HMRC has created relief measures.

The intention of these reforms is to simplify the basis period rules for self employed taxpayers by aligning the taxation of self employed income to the rules for other sources of income such as property and investment income.

Who’s affected by the basis period reform?

The basis period reform will affect any unincorporated businesses (sole traders and partnerships) with an accounting period that doesn’t align with the UK tax year.

The UK tax year runs from 6 April to 5 April each year. Most sole traders and partnerships already align their accounting period with this, so won’t be affected. Those that have a different accounting period such as 1 January to 31 December will use the tax year 2023/24 as a transition year.

HMRC allows any businesses with an accounting period ending between 31 March and 5 April to be treated as if it falls at the end of the tax year. So if your accounting period ends on 31 March, you won’t be affected.

Limited companies aren’t affected by these reforms in any way.

What’s the difference between an accounting period and a tax year?

An accounting period is usually a 12 month period (but can sometimes be longer or shorter) that’s covered by your business’s accounts. Business transactions, such as income and expenses that fall within this 12 month period, will go towards calculating the overall profit or loss for the business in that year.

An accounting period is unique to your business and as a business owner, you’re free to choose any date to be your accounting period end, although moving forward it may be simpler to align this with the tax year (but there may be other legitimate business reasons to select an alternative date such as seasonal businesses).

The tax year in the UK is 6 April to 5 April and is the same for everyone.

What is basis period reform?

HMRC is changing the way taxable profits are calculated. At the moment, unincorporated businesses are taxed on a ‘current year basis’, but starting from the tax year 2024/25 we’ll be moving to a ‘tax year basis’.

With the ‘current year basis’, profits are taxed based on the 12 month accounting period that ends in a particular tax year. So if an accounting period is 12 months long and ends in December 2022, all the profits generated in that 12 month period will be taxed in the 2022/23 tax year.

Under the new ‘tax year basis’, profits generated in an accounting period will be split between the tax years that they fall into. So if a business has a 12 month accounting period ending on 31 Dec 2024, then profits generated in that period will split between the 2023/24 and 2024/25 tax years.

Here’s a practical example:

Caroline runs her business as a sole trader and the business has an accounting period 1 January to 31 December.

Accounting period ended 31 December 2022 - the ‘current year’ basis

In the 12 month period to 31 December 2022, the business made a taxable profit of £20,000.

As this accounting period ends in the tax year 2022/23, Caroline will include the entire £20,000 taxable profit on her self assessment tax return for that year.

Accounting period ended 31 December 2024 - the ‘tax year’ basis

In the 12 month period to 31 December 2024, Caroline made a taxable profit of £24,000.

This accounting period ends in the tax year 2024/25, however, following the basis period reform, Caroline now needs to apportion this profit between the two tax years that her accounting period straddles.

This means £6,000 of this profit (3/12; January to March) will be included within her 2023/24 self assessment tax return and £18,000 will be included within her 2024/25 self assessment tax return.

You may notice we skipped the accounting period ending 31 December 2023 in this example. This is because this accounting period will fall into the 2023/24 transitional period which is explained in the next section.

Also, for the purpose of illustrating how profits will be apportioned, this example ignores the transitional rules in which the £6,000 proportion of profit will be captured. The transitional rules are explained below.

The transitional period

The tax year 6 April 2023 to 5 April 2024 will be a transition period which has specific rules associated with it. This is essentially a ‘catch-up’ year in which some businesses could find themselves having to pay additional tax. The government has introduced special rules to help.

In this period, businesses will pay tax on any ‘current year’ profits as they did previously (i.e. for the 12 months to the end of their accounting period which falls in 2023/24) but in addition, there may also be a need to pay tax on any profits made in the period between the end of the accounting period and 5 April 2024 (transitional profits).

Depending on your business’s accounting period, this could mean paying tax on up to two years’ worth of profits at once. For example, businesses with a 1 May - 30 April accounting period could end up paying tax on 23 months worth of profits (profits from the period 1 May 2022 to 30 April 2023 plus profits from 1 May 2023 to 5 April 2024.)

HMRC recognises the additional burden this could place on businesses and will therefore automatically spread the transitional profit (that’s the profit generated in the period between the accounting period end and the end of the tax year) over the next five tax years so that the cash flow impact is reduced. In addition to this, you may be able to reduce the amount of transitional profits you pay tax on by deducting any overlap profits your business may have generated in the past - this is explained in more detail below.

Overlap profits

When your business first started trading, some profits may have been taxed twice. This is normal under the old rules and you or your accountant should have a record of this. If your business does have overlap profits, these can be deducted from the transitional profits and could ultimately reduce the amount tax you pay.

Here’s how it looks when Caroline fills out her taxes

Caroline made a taxable profit of £22,000 in the 12 month period to 31 December 2023. Caroline will include this £22,000 on her self assessment tax return for the tax year 2023/24.

As 2023/24 is the transitional year, Caroline also has to consider the profit her business has made in the period between her accounting period end of 31 December 2023 and the end of the 2023/24 tax year (5 April 2024).

We already know from the example above that Caroline’s business made a taxable profit of £6,000 in this 3 month period (January to March 2024). Caroline also has overlap profits of £1,000 that arose when she first started her business. After deducting these overlap profits, Caroline is left with taxable transitional profits of £5,000 which will be spread evenly over the next five tax years.

So for the tax year 2023/24, Caroline will pay tax on total taxable profits of £22,000 plus an additional £1,000 in relation to her self employment (1/5 of the £5,000 transitional profit).

Finally, going back to our example for 2024/25 above, Caroline will also need to include the additional £1,000 relating to the transitional profits on top of the £18,000 she is already including in her 2024/25 self assessment tax return, plus a proportion of the profits arising in the accounting period ending 31 December 2025.

We’ve only covered one scenario here but there are many other scenarios that could arise depending on your individual circumstances, particularly if your business is loss making. HMRC’s Business Income Manual sets out the rules and scenarios in more detail.

A summary of Caroline’s taxable profits from 2022/23 to 2025/26

My business will be affected by the basis period reform, what do I need to do?

If your business will be affected by the basis period reform, the most important thing to do is plan ahead. Transitional profits may mean you need to pay more tax in relation to 2023/24 than initially expected so it’s important to ensure you have enough money set aside to cover this.

Many businesses are opting to change their accounting period to align with the tax year in order to simplify their tax affairs and to avoid having to deal with transitional profits. Doing this may not be a viable option for some businesses and you may wish to seek professional advice from a qualified accountant to understand if changing your accounting period is right for your business.

We’re busy updating the sole trader tax estimation tool within our Business Toolkit to comply with the basis period reform, so if you are a Business Toolkit customer, you’ll soon be able to use it to help estimate your transitional profits.

This article is intended as general information only and does not constitute advice in any way. For any specific questions, you may want to consult a qualified accountant.