What happens to the profits earned by a sole trader?

As a sole trader, there is no legal distinction between you as an individual and your business (unlimited liability). This contrasts with a limited company structure, which has limited liability, and which will also pay corporation tax (rather than income tax) on its profits.

As a sole trader, your profits belong to you only after income tax and National Insurance have been deducted. You are taxed on all profits – even those you do not withdraw from the business , but will need to keep back at least 20–40% of what they earn each month to cover their tax bill and NI contributions at the end of the tax year (6 April–5 April).

SOURCE: https://www.gov.uk/guidance/rates-and-thresholds-for-employers-2025-to-2026

While the rules are simplified somewhat for self-employed/sole traders in terms of who owns the company profits, this does not mean that all the profits from the business are yours to keep. Only once income tax and National Insurance (NI) contributions have been deducted is what is left yours to keep as “wages”.

Our sole trader accountants have put together this blog with you in mind. Read on to learn how to calculate your profits as a sole trader in order run your business compliantly and how our DNS CloudCo can help.

Key Takeways

Sole trader profits are treated as your personal taxable income.
You pay Income Tax on your business profit after allowable expenses.
You also pay Class 2 and Class 4 National Insurance on those profits.
Sole traders do not pay Corporation Tax; tax is handled via Self Assessment.
Any profit left after tax is yours to keep, reinvest, or withdraw.
You must keep proper records and file an annual Self Assessment tax return.
Planning and setting aside tax money helps avoid surprises and cash‑flow issues.

Note : This article was originally published on 26 October 2022 and republished on 05 April 2026 to include the latest information.

Are Sole Traders Taxed on Profits They Don’t Withdraw?

Yes. Unlike a limited company – where profits can sit retained in the business – HMRC taxes sole traders on their total net profit for the tax year, regardless of how much they actually withdraw as drawings. There is no way to defer tax by leaving money in your business account.

Does a sole trader get to keep all the profits?

A minority of sole traders do seem to be under the misconception that what they earn as profit from their business is all theirs.

Some people who are “self-employed” are not even registered with HMRC. This is a serious error, because everything a sole proprietor of a business earns is not theirs to keep.

Like every other working person who is not taxed at source via PAYE, everyone earning income over the personal tax allowance (£12,570) must pay 20% basic rate income tax (or 40% at the higher rate tax from £37,701–£125,140 or 45% for income above £125,140). Sole traders must also pay two types of NI contributions.

But to be able to pay tax on your profits, if you are intending on becoming self-employed, you must first register with HMRC.

Records a sole trader must keep

HMRC requires sole traders to keep business records for at least 5 years after the 31 January self-assessment deadline.

These include

Once you have registered with HMRC as self-employed, you are then legally obliged to account for what you earn from your business. Your accounts must be up to scrutiny by the tax authorities.

If you earn anything at all, you must account for it, even if you do not make a profit over and above the tax-free personal allowance of £12,570.

So, this is why a sole trader cannot keep all their profits. Anything earned that has not been taxed at source (e.g. via pay-as-you-earn, PAYE) must be declared on a self-assessment tax return

This goes for anyone earning money from property or shares; or above the thresholds for online sales or letting out a room.

To be compliant with HMRC’s rules and company law, you must keep all the paperwork that relates to your business for five years.

This goes for any business structure: limited company, a sole trader business or a partnership, a charity even.

The books and accounts that relate to the organisation must be available for inspection if requested.

The documents you need to keep in good order are:

• Bank statements
• Sales and income (purchase orders, accounts received (invoices), etc)
• Business expenses (receipts, accounts payable; money owed by the sole trader)
• VAT records (if VAT registered)
• PAYE records (if employing people)
• Records relating to personal income (e.g. interest on shares, income liable for capital gains tax, rental income from a property, that is, any money earned that is not taxed at source)
• Any state benefits you have received

A record should also be kept up to the end of the tax year (5 April) of:

• Money owed but not yet received/work in progress
• Money committed but not yet spent (e.g. unpaid invoices)
• Year-end bank balances
• Money awarded to yourself “wages”
• Investments
• Charitable donations
• Share value

What do sole traders pay on their profits?

Income Tax for sole traders (2025–26 tax year):

Sole traders also pay two types of national insurance contributions

NI contributions go towards the National Health Service and entitle you to certain benefits, e.g. Universal Credit, support allowance when statutory sick pay runs out, and the State Pension.

The value of your NI contributions can affect how much State Pension you will receive and affect the value of benefits should you need to claim them.

It is important to keep up to date with your NI contributions.

Class 2 NI contributions:

• From 2024–25, Class 2 NICs are no longer collected via self-assessment for most sole traders. If your profits exceed the Small Profits Threshold of £6,845 (2025–26), NI credits are received automatically at no cost. If your profits fall below this threshold, you may choose to pay voluntarily at £3.50 per week to protect your State Pension entitlement.

SOURCE: Self-employed National Insurance rates

Class 4 NIC contributions (Sole traders calculate the Class 4 NI they owe on their self-assessment tax return, based on their profit):

• 6% on profits between £12,570–£50,270
• 2% on profits above £50,270
  SOURCE: https://www.gov.uk/self-employed-national-insurance-rates

NOTE: The NI rates and thresholds change periodically and these rates have been confirmed for the 2025–26 tax year. Class 2 NICs are only payable voluntarily if profits are below the Small Profits Threshold, otherwise NI credits are received automatically.

What Happens If a Sole Trader Makes a Loss?

If your allowable business expenses are higher than your income, you may make a trading loss – and HMRC can allow loss relief to reduce tax (rules depend on your circumstances). 

Common options include:

• Carry the loss forward: offset against future profits from the same trade (often the default approach).
• Set the loss against other income (same year and/or previous year): in some cases, a loss can reduce tax on other income (subject to the specific claim conditions).
• Carry the loss back: you may be able to carry a loss back to an earlier year and claim a refund (where rules allow).

Loss claims can be technical, so it’s worth getting accountant support if you have other income sources, you’re newly self-employed, or the amounts are significant.

How to Calculate Your Sole Trader Tax Bill?

You will have been keeping accounts, and from these you will be able to work out what your gross income is.

To work out your gross income you will add together all your invoices and any other income that has not been taxed at source.

You will then apportion your allowable expenses and capital costs to come to the figure of your gross income.

For example if you gross income is £55,000:

National insurance

Class 2: @ fixed rate of £3.50 p.w. / £182.00 p.a. (2025–26 rate)

Class 4: @ 6% on profits between £12,570–£50,270, and 2% on profits above £50,270. (2025–26 rates – reduced from 6% in April 2024)

How to pay yourself as a sole trader

As a sole trader, it is easy to withdraw money, but it needs to be done carefully. Unlike a company, you don’t receive a monthly salary; instead, you take “drawings” from your profits. This keeps your cash flow consistent and also complies with HMRC tax regulations.

What are the Requirements to Register as a Sole Trader in the UK?

To operate as a sole trader in the UK, you must register with HMRC as self-employed by 5 October in your second year of trading. You will need a National Insurance number, and once registered, you must file a self-assessment tax return each year, keep business records for 5 years, and register for VAT if your turnover exceeds £90,000.

Sole Trader vs Limited Company – How Are Profits Treated?

Here’s the simplest “profits and tax” difference:

When to review incorporation: It’s usually worth reviewing when profits grow and you don’t need to withdraw everything, or when liability/admin/trust factors matter (not just tax).

How and When to File Your Self-Assessment Tax Return

Sole traders pay their tax by filing a self-assessment tax return with HMRC. The balancing payment and first payment on account are due by 31 January; a second payment on account (if applicable) is due by 31 July.

If your self-assessment tax bill exceeds £1,000 and less than 80% was collected at source, HMRC requires two advance payments on account – the first by 31 January and the second by 31 July of the same tax year.

Making Tax Digital (MTD)

From April 2026, sole traders with qualifying income over £50,000 will be required to keep digital records and submit quarterly update reports to HMRC using compatible software. MTD will extend to those earning over £30,000 from April 2027, and further to those earning over £20,000 from April 2028 – as confirmed in HMRC’s latest MTD roadmap.

Remember, it is highly advisable, essential even, to keep back between 20–40% of what you have earned to cover your income tax and NI.

So, keep in mind that the tax year runs from 6 April to 5 April and that you must file a self-assessment tax return to report your self-employed income each year by 31 January, and pay any tax you owe on your profits and two types of NI.

What expenses can sole traders claim?

All businesses – self-employed sole traders included – must keep accounts, and calculate their profits after having deducted expenses. But, these expenses must have been “wholly and exclusively” incurred for business purposes.

Allowable expenses incurred under the “wholly and exclusively” rule can be direct business costs, or may be apportioned between personal and business expenses as appropriate.

Consumable sorts of allowable business expenses differ from business items that are “fixed assets” of the business, such as a work vehicle, tools, or a new computer, as these are taxed under capital allowances rules.

Expenses businesses can claim include:

• Office costs, e.g. stationery, letterhead, phone bills
• Travel costs, e.g. fuel (mileage), parking, train or bus fares
• Subsistence (work-related trips for the day or on overnight business trips)
• Clothing expenses, e.g. uniforms
• Staff costs, e.g. salaries or subcontractor costs
• Things bought to sell on, e.g. stock or raw materials
• Financial costs, e.g. insurance, bank charges, an accountant
• Business premises costs, e.g. rent, heating, lighting, business rates
• Advertising/marketing, e.g. website hosting, design or redesign, print or online leaflet or brochure
• Training courses, but only if specifically related to your business, e.g. a refresher course
• Books and magazine subscriptions (only in relation to your business)

Costs you can claim as capital allowances

Capital allowances can be claimed for something bought for the business and used over time, for example:

• Equipment
• Machinery
• Business vehicles, e.g. a car, van, lorry

But capital allowances cannot be claimed if you are using the £1,000 tax-free “trading allowance”.

Penalties for Late Filing and Non-Registration

Late filing penalties (Self Assessment return):

• 1 day late: £100 fixed penalty
• 3 months late: £10/day (up to 90 days = max £900)
• 6 months late: extra 5% of tax due or £300 (whichever is greater)
• 12 months late: further 5% or £300 (whichever is greater)

Late payment penalties (tax you owe): a 5% penalty can apply at 30 days, then again at 6 months and 12 months, plus interest.

Non-registration / not telling HMRC: If you fail to notify HMRC when you should be in Self Assessment, HMRC can charge a “failure to notify” penalty based on behaviour and circumstances (it can be tax-geared and, in serious cases, can be up to 100% of the tax due). 

Payments on Account

Payments on account are advance payments towards next year’s Self Assessment bill, usually split into two instalments.

They usually apply unless:

• your last Self Assessment bill was under £1,000, or
• you already paid 80%+ of your tax another way (e.g., PAYE).

How much & when:

• 31 January: 50% of last year’s bill (first payment on account) + any balancing amount due
• 31 July: the other 50% (second payment on account)

Mini example: If last year’s bill was £4,000, you’ll usually pay £2,000 on 31 January and £2,000 on 31 July (then a balancing payment next January if your actual bill is higher).

You can apply to reduce payments on account if you genuinely expect profits to fall – but underpaying can lead to interest.

What is the rule about something bought for business and personal use?

Under HMRC’s ‘wholly and exclusively’ rule, only genuine business costs are allowable. For mixed-use items – such as a mobile phone – you must apportion the cost between personal and business use accordingly.

Same goes for if you are working from home, you can apportion the cost of using the premises, such as use of broadband and landline etc. And it’s the same with a vehicle you use for personal and business use.

As an example, take your broadband bill; this adds up to £350, p.a. You work from home, so let’s say that £150 relates to personal use and £200 to business use. A business expense of £200 can be claimed for business use.

What if you work from home?

A proportion of costs for the following can be claimed if working from home:

• Heating
• Electricity
• Council tax
• Mortgage interest or rent
• Telephone use
• Broadband

A reasonable method of dividing costs between personal and business use would be to work out the portion used for business and/or the amount of time spent working from home.

The percentage of time you have spent at work is a good way to work out what portion of broadband, energy, water use belongs to the business.

What are simplified expenses?

You can avoid the complexity of working out sole trader business expenses by using simplified expenses.

Simplified expenses are flat rates that can be used for:

• Vehicle use
• Working from home
• Living on your business premises

While the process of claiming allowable expenses appears simple, beware! Applying expenses correctly can be more complex than it appears.

Should you still be unsure, you can check on the HMRC website or contact a qualified bookkeeper or accountant such as DNS CloudCo.

Can sole traders register for VAT?

Some sole traders are VAT registered – either because their taxable turnover exceeds £90,000 (the mandatory registration threshold since April 2024) – or because they sell to VAT-registered businesses.

If this is the case, sole traders will need to manage their VAT compliantly too. You must register for VAT with HMRC, calculate what you owe accurately, and file a VAT return every three months and pay what you owe.

Conclusion

The profits earned by sole traders belong to them only after income tax and National Insurance have been paid. Like any business operating in the UK, sole proprietors have legal responsibilities to stay compliant.

If appropriate, you must register for VAT, file returns on time every three months, and pay what you owe. Treating all business income as personal money can lead to costly mistakes, tax problems, and even legal action.

To protect your business and personal assets, and to ensure smooth financial management, consider professional bookkeeping and accounting help. Hiring an accountant can save you time, reduce errors, and often pays for itself through tax savings.

At DNS CloudCo Accountants, we offer online accounting services with online bookkeeping systems and accounting software, which makes the recording of expenses and keeping track of invoices a lot more straightforward.

And remember, accountancy fees are a legitimate business expense – an expense that, frequently, pays for itself in terms of the amount of time an accountant can save you, not to mention the money accountants tend to save their clients in taxes as well.

To find out more about our Sole Trader accounting services, contact us today!

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Divyanshi Patel

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Divyanshi is a subject matter expert in the UK accounting space, creating clear and easy-to-read content for accountants and businesses. She covers topics such as VAT returns, Self-assessment tax, bookkeeping, business planning and Year-end accounts. By understanding the common challenges faced by accountants and business owners, she focuses on writing content that answers real questions and simplifies complex topics. Her approach keeps information clear, relevant and useful for everyday business needs.

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