This article will help explain the main areas of tax efficiency to be aware of as a sole trader.

You will likely need to consider at first if you should set up as a limited company or a sole trader. We cover the main factors to consider here. If you expect to make losses in the first few years of trading then you will often be better trading a sole trader initially as you will be able to claim for these losses quicker and more efficiently especially if you have other taxable income.

Once profits begin to exceed £30,000-£50,000 from your sole trade business you may want to consider incorporation as a limited company. You can use our handy calculator here to help determine this however, we would always recommend you discuss this with an accountant first.

In this article we will cover the following topics:

One of the best ways to be tax efficient is to ensure you claim all relevant business expenses against your income. The lower your sole trade profits are, the less tax you will pay to HMRC when completing your self assessment.

As a general rule all expenses that are wholly and exclusively related to your trade will be claimable as an expense. If you spend money on something that has a dual purpose (business and personal) then you can only claim the business proportion provided you can accurately identify the proportion that relates to business.

We have created an expenses guide which outlines what expenditure you can claim as a sole trader and where to categorise these in Ember.

The below advice relates to pension contributions not made through an employer if your are in PAYE employment and instead relates to payments made to qualifying pension schemes by UK tax residents from their own income.

As a sole trader, you will not have an employer pension scheme (unless you are also employed), therefore you may be considering putting money into a pension pot for your future.

Pension contributions will not be deducted from your sole trade profits as expenses.

However you will receive an increase in your tax bands by the gross amount of your contribution.

For example:

If you contribute £100 to your pension, it will increase your tax bands by £125 (£100 *100/80).

This means an additional £125 of your sole trade profits would be taxed at 20% rather then 40% if you are a higher rate tax payer.

This only has a positive impact on your tax if your income from your sole trade profit/all your taxable income is greater then £50,270.

If you are a sole trader who is a higher rate tax payer and keen to put money aside for your future then pension contributions can be a great way to increase your retirement fund whilst also reducing the tax you will pay.

Its worth saying that those individuals who are not a higher rate tax payer will still benefit from the government topping up your pension payments by an additional 25%.

Donations work in a very similar way to pension contributions in terms of the potential for tax savings. Again this advice relates to donations not made through an employer if your are in PAYE employment and instead relates to payments made to qualifying pension schemes by UK tax residents from their own income.

Charitable donations (only those that qualify for gift aid - see HMRC link here)

Charitable donations will not be deducted from your sole trade profits as expenses.

However you will receive an increase in your tax bands by the gross amount of your contribution.

For example:

If you donate £100 through gift aid, it will increase your tax bands by £125 (£100 *100/80).

This means an additional £125 of your sole trade profits would be taxed at 20% rather then 40% if you are a higher rate tax payer.

This only has a positive impact on your tax if your income from your sole trade profit/all your taxable income is greater then £50,270.

If you are a sole trader who is a higher rate tax payer and keen to donate money to charity, this can be a great way to do some good whilst also saving yourself some tax ( I mean no act is truly altruistic right? )

Its worth saying that for those individuals who are not a higher rate tax payer, the charity will still benefit from an extra 25% - paid by the government.

The trading allowance of £1,000 means that the first £1,000 of trading, casual and/or miscellaneous income per tax year is tax free.

This allowance is still available even if you have only trader for part of the tax year. For example for 22/23 if you started trading in February 2022 you would still be able to claim the full amount of the trading allowance as if you had been trading for the entire 22/23 tax year.

This means that if your trading income for the tax year is £1,000 or less then the whole of the income can be covered by the trading allowance. For instance if you made casual income as a sole trader of £400. The full £400 would be covered by the trading allowance and this would not need to be reported on a self assessment (unless you received Self-employment Income Support Scheme during the period).

For most sole traders however they will have trading income of over £1,000. If this is the case then you choose to deduct the trading allowance from the trading income instead of deducting your actual business expenses for the period.

Therefore as part of your self assessment, Ember will deduct the trading allowance of £1,000 from your trading income if your expenses are less then £1,000. If your expenses are greater then £1,000 then we will claim for your expenses. The personal tax report in Ember will only take off your expenses when calculating your income tax, however your Ember accountant will determine which is most tax efficient for you when completing the self assessment.

For example:

Trading income £30,000

Expenses of £400

Profit of £29,600. Normally this would be subject to income tax.

However by utilising the trading allowance we can reduce the profit that is taxable to £29,000 (£30,000 trading income less £1,000 trading allowance).

If your income is above the trading allowance of £1,000 you are required to register for self assessment.

If you have made a loss from trading, then its normally more beneficial to claim losses against general income (covered below).

The loss regime for sole traders is largely more beneficial then that of limited companies. It is often more efficient to start as a sole trader if you expect to make a loss in your first few years of trading. This is especially the case if you are working in employment at the same time.

At Ember we will work closely with you when completing your self assessment to ensure we claim the losses in the most efficient manner for you.

Here is a summary of the potential loss reliefs you can claim as a sole trader:

If you make a loss in a tax year as a sole trader you make a claim to offset this against your general income of the current year, the prior year or both. Which year is more efficient will depend on your other income.

This may be extended to include set off against capital gains once all taxable income has been extinguished.

This is beneficial specifically if you have been trading for some time and have other sources of income.

Early year loss relief

If you make a loss in the first four years of trading you can offset against your general income of the last three tax years. This would be done on a first in, first out basis.

Carried forward relief

If it is not beneficial or you unable to utilise the reliefs above, any losses that have not been utilised will automatically carry forward to be offset against first available future profits from the same trade.

Terminal loss relief

If you make a loss in the last twelve months of trading, you are able to offset against trade income of the last three tax years.

Losses are offset against trading profits of most recent years first.