What you need to know about tax codes for your business

Tax codes are a basic requirement when running payroll but they can be a little complicated. As an employer, here’s what you need to know about using the correct tax codes. However, if you’re in any doubt then you should consult an expert.

What is a tax code?

A tax code is a component of the PAYE system and is applied to each of your employees to indicate how much income tax HMRC will take. As such, they apply only to your employees and not contractors or freelancers, who handle their own income tax.

Many payroll software packages will help you work out the relevant tax code as required, although you can also discover it using HMRC’s step-by-step guide.

You could potentially work it out manually via an understanding of the individual components within the code but this isn’t advisable because it’s easy to miss a vital component.

You have to tell HMRC what the tax code is via a Full Payment Submission (FPS) on or before your new employee’s first official payday. In most circumstances, you’ll do so via your first payroll run that includes the new employee.

Tax codes are also be applied to pension payments, but this is not of relevance to employers and so isn’t discussed here.

What is the basic tax code for 2019/20?

The basic tax code for 2019/20 used by the majority of basic employees in the UK with an average salary is 1250L (or S1250L if the employee lives in Scotland, or C1250L if they live in Wales).

This assumes the employee is entitled to the full basic personal allowance for 2019/20 of £12,500, and receives no perks such as a company car, and they don’t have a complicated tax situation where they owe HMRC money outside of their wage from you.

How do I know if a tax code is correct?

A tax code consists of letters and numbers. Read on for details on what they mean, so you can check if the tax code is the right one, or what an updated tax code sent to you by HMRC actually means.

Tax codes can be tricky to understand if you’re not an expert on them. If in doubt, contact an adviser such as an accountant or tax specialist.

Scottish and Welsh tax codes

If the employee lives in England or Northern Ireland then the tax code usually begins with numbers.

However, if the employee lives in Scotland or Wales then, even if your business is based in another country in the UK, their tax code will be prefixed with an S or C, respectively.

This indicates the employee pays the Scottish or Welsh income tax rates, which might be different to England or Northern Ireland.

Letters at the start of a tax code

In addition to S and C to indicate the employee pays Scottish or Welsh income tax rates, a tax code might begin with tax code K.

This is a special tax code that can mean an employee has income that’s not being taxed in any other way, and which is worth more than their tax-free personal allowance.

Another way of saying this is that the total number of deductions from an employee’s salary are greater than their personal allowance.

Typically, this means the employee is currently paying tax owed from a previous year, or they are receiving state or company benefits.

The numbers following a K tax code indicate the amount of tax owed, rather than their personal allowance.

As an employer, once a K tax code is applied, you have to take the tax due even if the employee’s income comes from another source, although there’s a limit—you should not take more than 50% of the employee’s pre-tax wage.

Numbers within a tax code

The numbers in the tax code display the personal allowance the employee is entitled to, minus the sum of any income the employee hasn’t paid tax on AND the value of any benefits that come with the job (such as a company car).

The last digit of the result of the sum above is simply discarded.

For an employee on an average salary of circa £30,000 per annum, for example, who has no extra income and no perks, and who across 2019/20 is entitled to the standard tax-free personal allowance of £12,500, the number component of the tax code will be 1250.

Letters following a tax code

The number will be followed by at least one letter. For most employees, this will be tax code L, to indicate the individual is entitled to the personal allowance.

However, a number of other letters might appear at the end of the tax code, or be appended after L, as follows:

Tax code M

The employee’s partner has shared their Marriage Allowance with them.

Tax code N

The employee has shared their Marriage Allowance with their partner.

Tax code T

The tax code includes additional calculations to work out the personal allowance amount. The main example for this tax code applies to those earning more than £100,000, who therefore see their personal allowance potentially reduced to zero if they earn £123,700 or more.

Tax code 0T (sometimes incorrectly referred to as OT)

Strictly speaking, this code means a personal allowance “has been used up”, according to HMRC. But another way of saying that is the employee is not known to have any personal allowance.

Perhaps they’ve started a job and it’s not yet been possible to assign a tax code to them, for example, because they haven’t provided the details required.

Tax code BR

Usually this applies when an employee has more than one job, or also gets a pension, and indicates all income from the employment with you is taxed at the basic rate with no personal allowance applied.

For an employee living in Scotland, the equivalent is tax code SBR and indicates they pay the basic rate of tax in Scotland.

Tax code D0 (sometimes incorrectly referred to as DO)

As above, this usually applies when an employee has more than one job, or also gets a pension, and indicates all income from the employment with you is taxed at the higher rate with no personal allowance applied.

For an employee living in Scotland, the equivalent is SD1 (not SD0, as you might assume) and indicates they pay the higher rate of tax in Scotland.

Tax code D1

As above, this usually applies when an employee has more than one job, or also gets a pension, and indicates all income from the employment with you is taxed at the additional rate with no personal allowance applied.

Tax code SD0 (sometimes incorrectly referred to as SDO)

This usually applies when an employee living in Scotland has more than one job, or also gets a pension, and indicates all income from the employment with you is taxed at the intermediate Scottish income tax rate with no personal allowance applied.

Tax code SD2

This usually applies when an employee living in Scotland has more than one job, or also gets a pension, and indicates all income from the employment with you is taxed at the top rate of Scottish income tax with no personal allowance applied.

Tax code NT

No tax is paid on the employees income.

Tax code W1

This is an emergency tax code and means the pay for the week is taxed on the basis of ignoring the employee’s cumulative tax paid to that point across the tax year.

Instead, the employee is taxed as if they have their personal allowance available for that period (that is, the personal allowance divided by the 52 weeks of the year).

Tax code M1

This is an emergency tax code and means the pay for the month is taxed on the basis of ignoring the employee’s cumulative tax paid to that point across the tax year.

Instead, the employee is taxed as if they have their personal allowance available for that period (that is, the personal allowance divided by the 12 months of the year).

Tax code X

This is an emergency tax code that means the tax paid by the employee is not being calculated on a cumulatively basis (that is, it’s not being calculated across the whole tax year).

Instead, the employee is taxed as if they have their personal allowance available for that period (for example, the personal allowance divided by the 12 months of the year in the case of a monthly pay run).

Tax code C

This isn’t a tax code as such, but often appears after a tax code on a wage slip to state that the employee’s income tax is calculated on a cumulative basis. Most income tax is calculated on a cumulative basis.

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What is an emergency tax code?

If you’re unable to gather the details mentioned above before the first wage is due to be issued for your employee, you’ll need to apply an emergency tax code.

For 2019/20, the emergency tax is 1250L—the same as the basic tax code applied to the majority of employees earning an average wage. In other words, you’re assuming the employee is entitled to the full basic personal allowance.

However, emergency tax codes take differing forms depending on the employee’s personal circumstances. HMRC will be able to advise you.

An emergency tax code might be applied to an employee by HMRC if your employee has underpaid tax for whatever reason, in which case you’ll be informed.

Additionally, emergency tax codes might also be applied if the employee is receiving company benefits, is employed with you after being self-employed, or is receiving the state pension in addition to their employment with you.

What is a week 1 or month 1 tax code?

As an employer, you might apply week 1 or month 1 tax codes for certain employees, which is to say, you will use tax code W1 or tax code M1 (most likely the latter considering most businesses run a monthly pay run). This is an emergency tax code and should only be used temporarily.

Week 1 or month 1 tax codes are often used if an employee changes jobs and their cumulative income tax payments to that point in the tax year will no longer be correct for their new salary.

It might also be used if the employee’s hours dip temporarily, in order to avoid them receiving an incorrect tax refund.

Why does a tax code change?

It’s not uncommon for HMRC to notify you of a tax code change for an employee.

If an employee earns more or less in a second job, or they receive a new taxable benefit such as a company car, or for various other reasons, their tax code might change. It also might change if they owe money to HMRC for unpaid taxes elsewhere.

HMRC will send you a P6 form (more than likely an email) telling you the new tax code that you should then use immediately. You should then login to PAYE Online or use the PAYE Desktop Viewer to make note of the new tax code.

Conclusion on tax codes

There’s little doubt that understanding tax codes requires expertise and experience but with the tools provided by HMRC and your payroll software, it’s not difficult to remain compliant and ensure your employees are correctly identified.

Maintaining a proactive attitude and responding to HMRC’s updates as soon as possible will put your business and your employees in the best possible position moving forward.