I’ve recently been doing some freelance work for a friend, and while it won’t be putting me near the thresholds for tax as a sole trader in the UK, it got me thinking about side hustles in general and how to best optimise the tax side of things.

Now I’m not an accountant or tax expert of any kind, so you might have to bear with me on this one, and I’m also going to try and avoid politics if I can, so here goes.

Let’s imagine you’re employed full time, you’re earning an average UK salary and in the 20% tax band. You have a great idea for a SaaS start-up that you think you could monetise, but what’s the best way of managing it? How do you maximise the value you’re getting from your sacrificed free time.

The usual recommendation would be to start a limited company, pay yourself a minimal salary, and then use dividends to take money from the business. As dividends have a lower tax rate this is usually the most tax efficient way to do it.

When I started looking into this more closely however, it didn’t make for great reading. The problems arise in many forms - and while I appreciate that some of them are nice problems to have as it means you’re successful, it feels less than ideal when taking a step back.

First up, as a SaaS business, you can’t trade in cash - so everything is on the books (not that I’m encouraging that sort of thing, but we all know it happens). Secondly, while dividends have a lower tax rate - especially when under the 40% threshold, once you hit that point they become less viable. We then have additional taxes such as Corporation Tax, and VAT when your business is generating enough value. Finally, you have your general operational overheads for hosting, payment providers, etc.

It’s far easier to demonstrate the problem with an example, so let’s assume you’ve launched a product with a £6 a month fee. You’ve been fortunate enough to get 1250 monthly users, and you’re now unfortunate enough to have to register for VAT. You were wise though, and priced that in ahead of time to avoid a price shock for your customers. What does that look like after all the deductions?

Well VAT takes 20% straight away, then I’ve allowed for £1 per user for operational overheads. That felt roughly appropriate as a ballpark figure. We then have corporation tax at 19%, and dividend tax at 8.75% on earnings up to £50k, and then 33.75% after that. Bearing in mind you’re already on an average salary, most of your dividends are getting charged at the latter rate. My napkin maths puts it at close to £2 per customer.

This feels like a particularly damaging system for someone trying to start a side-hustle, or potentially thinking they might transition away from their current job to running their own business once it’s viable. This multi-layered system of taxation gradually erodes your earnings - and it’s not just limited to business.

I remember watching Top Gear a long time ago, and James May having a rant about the taxation of cars. You pay National Insurance and Income Tax on your salary, then with what you have left, you buy a car - which you pay VAT on. Then to run the car you need to pay Road Tax and you need insurance; cue Insurance Premium tax. Then you put fuel in your car, and pay Fuel Duty Tax. And I’m probably missing some taxes in there somewhere.

Whilst they’re separate issues, I definitely drew parallels here between the taxes being applied to driving, and the taxes that are applied to businesses. It feels very much like death by a thousand cuts. That said, I don’t want to address the pros and cons of this system of taxation, instead I want to focus on the alternatives that would incentivise digital side-hustle startups.

First up, let’s talk about dividend tax. The problem with dividend tax in my view is that it is also tied to the tax rate you pay for your primary income. If you’re anywhere near the 40% tax threshold, or as in my example even £10k away, it isn’t going to take long for your dividends to start being taxed at the higher rate.

What about if instead we either untie dividend tax from other income taxes? Keep the tax rates the same, but have them purely consider dividend income. Any change in this area would need to be carefully considered to avoid abuse, but it feels like it may be worth it to incentivise genuine startups. This could even be time boxed, for example, limit it to 5 years to reward the substantial effort and risk of giving up time and money to start a business, after which it becomes tied to overall total income as it does now.

Second, I think an issue comes longer term with VAT. If you’re fortunate enough to get to that point, the cliff edge of 20% being implemented in full feels fairly negative. An alternative might be some sort of stepped VAT system. What if for digital startups we implement a stepped VAT system? Rather than going straight to 20%, why not go to 5% first, then 10% at £120k, and then 20% from £150k? It feels like that would be a much more palatable system in my view.

Finally, what about making the sole trader option more appealing? The current sole trading allowance allows for £1k of earning before you need to start declaring that to HMRC for tax. That seems like an extremely low figure for me in 2025. Why couldn’t we increase that to something like £5k instead? It feels like this would encourage experimentation and small ventures, and potentially reduce people using cash to skirt around the tax system.

This isn’t going to discourage me from some of the ideas I’m hoping to pursue at the moment, but it feels to me like as someone with a full time job the UK tax system seems to almost discourage you from pursuing a digital side hustle. In my view, the government should be looking at ways to encourage these startups, and addressing some of this taxation might be a good move in that direction.