It's a Date

Many dentists set up their private practice without thinking about the implications of a particular financial year end - choosing a financial year end in line with the tax year, almost by default. Alternatively, they might choose a financial year end that is a year after their start-up date because it seems logical to have an accounting period to fit in with their practice anniversary.

However it does not have to be this way. Under the system of self assessment, taxpayers are free to choose whichever financial year end they wish. When the system of self assessment for income tax was first mooted in the 1990s there was some spirited discussion about whether taxpayers should be forced to have a financial year end in line with the tax year end but this was dropped at an early stage. A dentist is therefore free to prepare accounts to any date that he or she chooses - there is no requirement for accounts to be made up for a period in line with the tax year.

Current year Basis

All self employed dentists in private practice who are not trading through a limited company are taxed on the current year basis. This means the tax payable for each year will be calculated according to the profit earned for the accounting year ending in the relevant year of assessment.

So, a practice with a 30 April year end will be assessed for the 2007-08 tax year on its profits for the year ended 30 April 2007 as that falls in the tax year 2007-08. Similarly, a practice with a 31 March year end will be assessed for 2007-08 tax year on its profits for the year ended 31 March 2008 - more about this later.

Opening years and Overlap Relief

Because of the way a new business is assessed to tax under the current year basis for the first two tax years, some profits may be taxed more than once. To compensate for this and ensure that over the lifetime of the practice, tax is paid only on the actual profits earned over the period - overlap relief is given when the practice ceases. This is given by way of a deduction for tax purposes in the last year of trading. However, overlap relief is not inflation-proofed so that over a working life of say 25 years this has an impact even at a low level of inflation.

Planning points

For an unincorporated business such as a dentist trading as a sole trader or partnership, choosing a financial year end early in the tax year, such as 30 April, gives more time for the funding of tax payments. In short, it does not reduce the amount of tax you pay over the life of the practice but it does delay the payment of tax. This surely must be a good thing because it means paying tax on the practice profits later rather than sooner. Here is an example to illustrate.

Mary and Anne commence identical practices on 1 May 2007. They both earn identical profits of £1,000 per month in the first year, £2,000 per month in the second year and likewise, £3,000 per month in the third year. Mary chooses a 31 March year-end and Anne chooses a 30 April year-end.

In the first 3 years Anne (with an April year end) will have paid tax on profits of £47,000, compared to Mary's £69,000 who has a March year end. As a result, the practices are identical other than their financial year-end.

This example illustrates the advantage of having a year end one month later, i.e. 30 April as opposed to the 31 March, and how it can mean a cash flow benefit equivalent to the tax payable on eleven months' profit. It also illustrates that a dentist is paying tax each year on profits that were largely earned in the previous year, giving an obvious advantage when profits are on a rising trend which is usually going to be the case in a young practice.

Tax Time-Bomb

A disadvantage with a year end early in the tax year is when the practice ceases (such as when a dentist retires). This can generate a nasty surprise, in the form of a hefty tax bill! In this instance the final tax bill may be particularly high for two reasons; firstly ,because the profits being earned at that time may be very much higher than the early overlap profits for which relief is given on cessation and secondly, the tax on the profits in the final year have to be paid out of savings - not current earnings - as that source of income will have ceased by the time it comes to paying the tax. Dentists should ensure that so far as possible they are well prepared for the shock and put their money aside to pay the tax.

The effect of this 'tax time-bomb' leads many dentists to adopt a year end in line with the fiscal year and so avoid the nasty effect of having to settle past tax liabilities from savings. You may be paying the tax earlier but one view is that as you are going to have to pay the tax anyway then pay it and be damned. It does avoid any complications when you cease trading.

Changing your financial year

A dentist may change his accounting year end at any stage but there are certain restrictions imposed by statute. The first condition is that the initial accounting period ending with the new accounting date must not exceed 18 months. The second condition is that the notification of the change in accounting date must be given in a tax return before 31 January following the tax year in which the change is made. Also, changes of accounting date are not permitted more than once in every 5 years unless HMRC are satisfied that the change is for general commercial reasons. The rules for dealing with the change broadly ensure that 12 months' profit is charged to each tax year bar the opening and closing years. They are designed largely to negate any advantage gained from chopping and changing year ends.

Key Points to remember

* Cash flow advantage from 30 April year end.
* 30 April year end can generate "tax time-bomb" on retirement.
* 31 March year end - easy to understand and avoids complications of overlap relief.
* Over the life of the practice it all evens out, no matter what year end you have.