Self-employment is also known as ‘working for yourself’. This is a misnomer; no one works for himself or herself. You always work for someone else if you want paying.
The most important distinction between being an employee and being self-employed is the way the authorities tax you. Every tax regime is different, and constantly changing. This is no place to go into detail except to say that in general terms, tax authorities have no choice but to tax self-employed people based on their annual profits and not their incomes. (Profit is the difference between income and costs). Tax becomes payable when profits are known, or may be reasonably estimated. In the UK tax is payable in January and July. This is distinctly different from the way employees are taxed, which is based on annual income and usually paid weekly or monthly and deducted at source by the employer. (Employers are tax authorities’ tax collectors. Rather than deal with millions of self-employed people, tax authorities would prefer to deal with a handful of large firms that regularly pay into the state’s coffers, as it is much more cost-effective and reliable).
Self-Employment Versus Employment
There are many different terms for self-employment and being employed as an employee, but these are the terms used here. Other terms include freelancer, contractor, independent contractor, temporary worker, and salary man and they will not be used hereafter because they may cause confusion. Neither will specific taxation rules be mentioned for the same reason.
Tax authorities may challenge someone in the courts if they believe they are claiming to be self-employed when they are not. Ultimately maximising the number of employees makes collecting taxes easier and guarantees tax receipts by placing the onus of collecting them on an employer. Some employers would prefer to avoid this legal requirement.
When you are an employee you are normally told what to do, and when, and provided with the tools and location to do it. In return you get a regular wage, which is agreed when you enter employment. If you are lucky your remuneration will rise over time as you get promoted or as the minimum wage increases.
When you are an employee you may also join your employer’s ‘final salary’ pension scheme, but these schemes are now becoming rare outside the public sector. The alternative types of employer-provided pension schemes (including Defined Contribution) transfer the risks to the employee from the employer. Sometimes your pay may also be enhanced by bonuses, profit sharing or share (stock) options. Your job may also involve paid travel, in business class, as well as expense account ‘entertainment’ or ‘subsistence’. Many employees enjoy and value travel across the Atlantic Ocean because of the ability to appear important, especially in the stretch limo at the airport.
Self-employment is usually different. It means you must provide your own tools to do the work, train yourself, do the work to satisfy the requirements embodied in a legal contract, make your own pension arrangements, complete an annual tax return and pay the resulting tax bill, take out indemnity insurance, hire an accountant or lawyer, hire office or other workspace, use your own transport, pay your own medical and personal insurance and be prepared to work long hours, miss holidays and retire in penury, or in great wealth, or more usually somewhere in between. You are also usually paid irregularly and at the mercy of your customers.
You may be the director of a small company that also does all these things but, technically, you are not self-employed. (A director in a large firm will have a team of management accountants and a human resources department to do them for him or her). Why? Because the tax authorities treat you as an employee of your own company and you pay income tax every month or week under a pay-as-you-earn scheme. Your company’s annual profits, if there are any, are taxed separately.
Some people are employees and may also be self-employed, at the same time. Many politicians are both, because not only do they derive the security and regular pay (and, as we now know for UK MPs, huge expense allowances) of an employee working in the public sector (with its index-linked final salary scheme pension) but, at the same time, work as a self-employed lawyer, accountant, writer, lecturer, tax advisor or landlord. Only those with sufficient free time from their employee roles will be able to do this. UK MPs are only required to be in Parliament for a few weeks a year and then only to attend important debates and votes. They have other constituency commitments as well, of course.
The Route to Self-Employment
Most people do not begin their working lives as self-employed because it is risky, difficult and demanding and they probably do not have the requisite knowledge or business skills. (There are exceptions to this. For example a lawyer or general practitioner may be a self-employed partner in a firm of lawyers or general practitioners. In this case they are able to rely on other partners initially to ensure they avoid the pitfalls of their ignorance).
Being an employee however is on-the-job-training for the future self-employed. You learn how business works, the importance of customers, sales and management accounts. You will also discover the value to the business of purchasing, organising, prioritising, managing your time, what makes people tick, personality defects, office politics, office parties, travelling in style, expenses and how to claim them. You will also learn about keeping records, avoiding legal problems, contracts, product specifications, product design, delivering on time, quality control, and after sales service. You may come across illegal behaviour and learn how to spot it, harassment and bullying, promotion of the uninvolved, corporate training events and programmes, the stationery cupboard and its contents. You may also learn about pension contributions, bonus schemes and other financial incentives to work long hours and travel the world while missing your family and friends.
Once you have acquired this knowledge, some people call it work-experience; you are in a position to become self-employed. Many people reach this stage after several years of being told what to do by increasingly incompetent managers. They suddenly realise that their current boss, apart from being one of a string of bosses, the previous of which was there for only three weeks, is blocking their rise to bigger and better things in the corporate hierarchy, is bad at their job and hates them. It is time to take stock.
Most people get to this stage and think they have too much to lose by leaving, or changing to a similar cubicle in the company next door, and reluctantly resign themselves to ploughing the same rut until retirement, or more likely, redundancy forces them to take action.
Redundancy is a word that conjures up horror in the mind of the employee. Although they had the opportunity of acquiring the skills for self-employment, they didn’t. They know a lot about their current employer’s business but nothing about business.
In summary, the two main reasons for becoming self-employed are opportunity and failure. In one case it is a proactive desire to do something to improve your quality of life by replacing, for example, a management role with something more creative. In the other case it is because you didn’t see the writing on the wall and someone else took the decision for you.
You have decided that there is no alternative to becoming self-employed. (You could become unemployed, as part of your move from employment to self-employment. The decision depends on the individual’s financial and mental state). Talk to an accountant. An accountant will also give you some advice on your business structure, (sole trader, partnership or some form of incorporation), how to keep financial records and what expenses you can claim against tax. They may also offer you some professional indemnity insurance, some legal advice and offer you an introductory fee reduction in your first year. They will also advise you if there are any government grants or loans you might be eligible for and which of your local banks is likely to offer the best service and/or lowest bank charges. You will need a business bank account, so this is vital knowledge.
You also need to inform the tax authorities. They will hereafter send you an annual tax return (which is a formal declaration of your income and expenses) and demand a monthly payment of (in the UK) national insurance contributions or (outside the UK), contributions to state medical and pension provision.
The next thing to do is register for VAT (in Europe) if you want to. You don’t have to (if your turnover, not profits is below a threshold of around £60,000 annually, which it is unlikely to be, initially), but it could be beneficial. Your accountant will advise you. If your turnover is likely to exceed the VAT threshold you will have to register to charge VAT on your products and services and reclaim VAT on purchases and pay a VAT bill every quarter. You will also then need to understand how exports outside the EU are treated for VAT.
Cash is King
This basic business set-up activity should take only part of your initial energy. During this time you will also be thinking about cash flow. This is the most important part of being self-employed. Whatever advice you have ever had in your life, this is the most important for the self-employed. Without cash coming into the business (cash in its broadest sense which includes payment for your products or services by bank transfer, cheque, electronic funds transfer, credit and debit card, as well as coinage of the Realm) you are heading for financial ruin with your family, house, pets and future retirement all in jeopardy.
Cash needs to be generated either from savings, which you will invest in the business, loans from family, ex-friends (thinking ahead), or the bank, the taxpayer, via a government grant or loan, or a redundancy fund provided by your erstwhile employer.
Cash flow is the difference between cash in and cash out. The time it takes from billing a customer to receiving payment could leave you with an expensive bank overdraft. You may be fortunate to have already received payment on account for work you are about to do. In that case you are already showing signs of success and have learned this vital lesson.
The other side of the cash flow equation is expenses. You may have to buy goods or services to set up the business, funded out of capital and also to purchase supplies funded out of working capital. If you can defer these expenses, rent rather than buy, borrow rather than pay up-front, you will maximise cash flow. Also use up any credit terms to their maximum. Use other people’s money as much as possible.
Customers for Your Business
The financial planning is behind you (and it will have included a business plan if you are borrowing money or want to make sure you will not run out of it), so what about your business and its potential customers? Hopefully you have started in a business area you understand, have some experience in (or have been recently trained in), have some customers or can get them quickly by attending meetings, seminars, conferences or trade shows. It is a business area you are passionate about and one in which you are likely to excel. There is no point being second-rate or half-hearted. There will be times when your enthusiasm is all you have and it had better be stronger than a damaged parachute. The business plan would, helpfully, have listed all these things so that you may remind yourself why you began this venture before you have run out of paper clips.
The Pitfalls to Avoid
Here is some advice about being self-employed and the main pitfalls to avoid.
· Always be honest, especially with the tax authorities. They will close your business down and put you in prison if they have to. This also means paying your taxes on time. Talk to them before a problem becomes a crisis.
· Get every contract vetted by a lawyer, make sure it is legally watertight and if the customer shows any signs of not meeting its payment terms, cancel it. Do not wait.
· Take a holiday, even if it’s only a weekend, a few days here or there or even half a day off when the sun is shining.
· Enjoy what you are doing. If that stops so will everything else in time. If you are being creative and have happy customers the business will grow because you are likely to be competent at what you do.
· Make sure your accountant understands your business and earns his or her keep by providing timely advice on any tax changes relevant to you.
· Have a website professionally designed that accepts electronic funds transfers if that will help grow your business. (You can also design it yourself if you are able).
· Keep a close watch on cash flow. Profits are for annual accounts; cash is for bread on the table. Which can you eat? Also see the first point above, which is also relevant to cash flow. Mainly, get paid in advance or at least partly in advance.
If you have employees, or associates in the business, remind them of these points from time to time.