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When a sole trader takes money or goods out of the business for their own personal use this is known as Drawings.
It confuses many sole traders when they are told that Drawings are not included as an expense of the business when preparing the profit and loss account. They think of it as their wages and therefore a business expense just as an employee's wage is an expense of the business and included in the Profit and Loss A/C. The difference is that an employees wages are taxed through the PAYE system whereas the sole trader’s drawings are not.
As far as HMRC are concerned the Profit & Loss A/C is drawn up to show the profits of the business so that tax can be calculated on those profits. Only after the tax has been paid can the owner truly know how much he can take out of the business in Drawings. Drawings are the Owner’s Personal Income, all income of the business owner must be taxed no matter where it came from. As drawings have effectively already been taxed by not including them as an expense in the Profit and Loss A/C they are not then taxed as a separate source of personal income. Also by not treating them as wages you avoid having to pay Employer’s NI Contributions.
Perhaps the confusion comes from the difference between a sole trader business and a limited company. For tax purposes a sole trader’s business is treated as the same person as the sole trader whereas a limited company is treated as a separate entity/person from the owners of the company.
With a Limited company the owner may take a wage but will be taxed on this wage just as any other employee of the business, through the PAYE system. The profit of the Ltd company will be the figure after the deduction of the owner’s wages, therefore these wages will be included in the Profit and Loss Report. The profit of the Ltd company is then subject to corporation tax.
Here is a simple calculation to prove that you are not paying more in tax by excluding drawings from the Profit & Loss A/C.
Drawings included in P&L
Less Expenses £500
Less Drawings £100
20% Tax on Profit £80
Owners personal Income
20% Tax on Income £20
Total Tax to pay £100
Drawings excluded from P&L
Less Expenses £500
20% tax on Profit £100
Total Tax to Pay £100
|Profit & Loss|