Understanding Business Tax Codes

We’ve created this article to help new businesses understand everything there is to know about tax codes
Chartered Certified Accountant
Hayley Hedges-Quinn
However, have you ever looked at payroll statements and genuinely wondered what all the highly cryptic letters and numbers mean? Don’t worry, you’re not alone. Many new business owners feel baffled trying to understand tax codes and which ones they should give to an employee. 
As a business, you are responsible for working out the correct tax code and starter declaration to use in your payroll software for new employees. You are then required to submit this information to HMRC using a Full Payment Submissions (FPS) on or before your new employee’s first payday.
But, understanding tax codes and PAYE is an important part of professionally running your business and looking after your staff correctly.

Read our comprehensive guide to understanding business tax codes.
What are tax codes?
Tax codes are used by an employer or pension provider to work out how much Income Tax to deduct from an individual’s pay or pension. They are information which make up part of the PAYE system (Pay As You Earn system). All employees have a specific code based upon their earnings, so they understand how much tax they have to pay HMRC.
Do I need to give contractors or freelancers a tax code?
No, if you are using contractors or freelancers, they do not require a tax code.
What the numbers mean
The numbers in the tax codes relate to how much tax-free income your employees are entitled to in a tax year — this is called their Tax-free Personal Allowance.
The formula to work out an employee’s Personal Allowance
Usually all you have to do is multiply the numbers in the tax code by 10 to know an employee’s Tax-free Personal Allowance. For example:

Tax code 1257L = 1257 x 10 = £12,570. Your employee is entitled to earn up to £12,570 in a tax year, before they are required to pay tax.

If an employee earns £27,000 per year, their taxable income is £14,430. £27,000 - £12,570 = £14,430.

What the letters in tax codes mean 
Tax code letters relate to an employee’s situation and how it affects their Personal Allowance. 
Emergency tax codes
An emergency tax code is given to an employee if HMRC does not receive their income details in time after a change in circumstances occurs, such as a new job, working for an employer after being self-employed, or getting company benefits or the State Pension.

An emergency tax code means your employee will pay tax on their income above their Personal Allowance.

Emergency tax codes are temporary and HMRC update the tax codes to the correct one once you or your employee have provided them with the correct details such as their previous income or pension.
The Emergency tax codes:
If your employee is on an emergency tax code their payslip will show:
·      1257 W1 (W1 means Week 1)
·      1257 M1 (M1 means Month 1)
·      1257 X (X means that the employee should operate on a non-cumulative — week 1, month 1 — tax basis)
Calculate your employee’s tax only on what they are paid in the current pay period, not the whole year.
How to help new employees
To help prevent new employee’s being placed on Emergency tax codes ask your employee for their P45 which they should have received from the previous employer and pass the details on to HMRC as soon as possible.
How to help new employees who were previously self-employed and do not have a P45
Provide your new staff member with a ‘starter checklist’. This form will ask them about their previous employment and provide you with all the details you require. You can download the form from here: https://www.gov.uk/government/publications/paye-starter-checklist
Letter K Tax Code Formula
Multiply the number in your employee’s tax code by 10 to show how much to add to their taxable income before deductions are calculated. For example:

K475 with an income of £27,000 has a taxable income of £31,750. 
£27,000 + £4,750 (475 x 10) = £31,750.
The tax deduction for each pay period cannot be more than half an employee’s pre-tax or pension.
What does the letter K mean?
Tax codes with a letter K mean an employee has income that is not being taxed another way and it’s worth more than their tax-free allowance. For example, when an employee still owes tax from a previous year through their wages or pensions or when they are receiving benefits that they need to pay tax on, such as state benefits or company benefits. 

As an employer you will take the tax due on the income that has not been taxed from their wages or pension, even if another organisation is paying the untaxed income for them.
Blind person’s allowance
If you employ a blind person an allowance of £2,600 is added on to their Personal Allowance for tax year 2022- 2023.
Taking on staff for the first time can be stressful for many reasons; working out tax codes is one more added worry. If you would like to chat through any business concerns you have as a new employer, please feel free to call Hayley from Hedges-Quinn & Co. on 01473 657853
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