Accounting for the Self-Employed
How to read a P&L and balance sheet, what records you need to keep, allowable expenses, sole trader vs limited company, and how self-assessment actually works. Plain English. No jargon.
Sole Trader vs Limited Company
The first decision every self-employed person faces. There is no universally right answer — it depends on your income level, risk appetite, and long-term plans.
You and the business are legally the same entity. Simpler to set up and run — no Companies House registration required, no corporation tax return, no annual accounts filing. You pay Income Tax and National Insurance on your profits via self-assessment. Personal liability is unlimited — if the business is sued or goes into debt, your personal assets are at risk.
A separate legal entity owned by shareholders (you) and run by directors (also you). Personal liability is limited to your share capital. Pays Corporation Tax using the current small-profits and main-rate bands; use the rates and allowances 2026/27 page for the current thresholds. More admin — annual accounts, confirmation statement, Corporation Tax return — but can be more tax-efficient above ~£35,000 profit.
| Factor | Sole Trader | Limited Company |
|---|---|---|
| Setup | Register with HMRC only | Incorporate at Companies House + HMRC |
| Tax on profits | Income Tax (20–45%) + NI Class 4 (6–9%) | Corporation Tax (19–25%) |
| Taking money out | All profit is yours immediately | Via salary, dividends, or director's loan |
| Personal liability | Unlimited | Limited to share capital |
| Privacy | No public accounts | Accounts filed publicly at Companies House |
| Admin burden | Low — self-assessment only | Higher — annual accounts, CT600, payroll |
| Typically better when profit is... | Under ~£30,000–35,000/year | Over ~£35,000/year (with planning) |
Records You Must Keep
HMRC requires self-employed individuals to keep records for at least 5 years after the 31 January filing deadline for the relevant tax year. For limited companies, records must be kept for 6 years. "Records" means evidence of income and expenses — invoices, bank statements, receipts, contracts.
From April 2026, self-employed individuals with income above £50,000 must keep digital records and submit quarterly updates to HMRC. This extends to those earning above £30,000 from April 2027, and above £20,000 from April 2028. If you are affected, start using accounting software now — free options include HMRC's own app, and low-cost options include FreeAgent, Xero, and QuickBooks.
- Record all income. Every invoice, payment, or sale. Include the date, amount, customer, and what it was for. Bank statements alone are not sufficient — HMRC wants to see the underlying transaction details.
- Record all business expenses. Every expense you want to claim must have a receipt or invoice. Keep digital copies — HMRC accepts scanned receipts. Record the date, amount, supplier, and business purpose.
- Keep bank statements. Separate business and personal bank accounts. Mixing them creates an accounting nightmare and raises HMRC questions.
- Record asset purchases. Capital items (equipment, computers) used in the business are treated differently from day-to-day expenses — claimed through capital allowances rather than as a direct expense.
- Keep vehicle records. If using your own vehicle for business, record every business journey — date, destination, purpose, and mileage. The HMRC approved mileage rate is 45p/mile for the first 10,000 business miles per year.
How to Read a Profit & Loss Statement
The Profit and Loss (P&L) statement — also called an Income Statement — shows your business's financial performance over a period of time (typically a month, quarter, or year). It answers the question: did the business make money?
It flows from top to bottom: Revenue → Gross Profit → Operating Profit → Net Profit. Each line subtracts a category of costs from the previous total.
| Line Item | What it means | Example (£) |
|---|---|---|
| Revenue | ||
| Consulting fees | All money received for services | 68,000 |
| Product sales | Revenue from goods sold | 12,000 |
| Total Revenue (Turnover) | All income before any costs | 80,000 |
| Cost of Sales (Direct Costs) | ||
| Subcontractors | Third parties paid to deliver work | 18,000 |
| Materials / stock | Costs directly tied to products sold | 4,000 |
| Total Cost of Sales | Costs directly linked to generating revenue | 22,000 |
| GROSS PROFIT | Revenue minus direct costs — the margin on your core activity | 58,000 |
| Operating Expenses (Overheads) | ||
| Office rent / home office | Fixed premises costs | 6,000 |
| Salaries (inc. yours if Ltd Co.) | Staff wages including director salary | 14,000 |
| Software subscriptions | Tools used in the business | 2,400 |
| Marketing & advertising | Customer acquisition costs | 3,000 |
| Professional fees (accountant, legal) | External professional costs | 1,800 |
| Travel & subsistence | Business travel costs | 1,200 |
| Depreciation | Annual cost of using capital assets (e.g. equipment losing value) | 2,000 |
| Total Operating Expenses | Fixed and variable overhead costs | 30,400 |
| OPERATING PROFIT (EBIT) | Gross profit minus overheads — the business's core earning power | 27,600 |
| Below the Line | ||
| Interest income | Interest on business savings | 200 |
| Loan interest paid | Cost of business borrowing | 800 |
| NET PROFIT BEFORE TAX | The bottom line — taxable profit | 27,000 |
Gross margin = Gross Profit ÷ Revenue = £58,000 ÷ £80,000 = 72.5%. Shows how efficiently you convert revenue into gross profit. Net margin = Net Profit ÷ Revenue = £27,000 ÷ £80,000 = 33.8%. Shows overall profitability. Compare these to industry benchmarks and track them over time — a falling margin is the first warning sign.
How to Read a Balance Sheet
The balance sheet is a snapshot of what the business owns (assets) and what it owes (liabilities) at a specific date. It answers: what is the business worth right now? The fundamental equation is: Assets = Liabilities + Equity. It must always balance — hence the name.
| Line Item | What it represents | £ |
|---|---|---|
| Fixed Assets (Non-Current Assets) | ||
| Equipment / machinery | Physical assets used in the business, stated at cost minus accumulated depreciation | 8,000 |
| Computer & technology | IT assets, similarly depreciated | 1,500 |
| Total Fixed Assets | Long-term assets held for business use | 9,500 |
| Current Assets | ||
| Cash at bank | Money in the business bank account right now | 12,400 |
| Debtors (Accounts Receivable) | Money owed to you by customers — invoiced but not yet paid | 8,600 |
| Stock / Inventory | Goods purchased for resale, not yet sold | 2,000 |
| Total Current Assets | Assets that will convert to cash within 12 months | 23,000 |
| TOTAL ASSETS | Everything the business owns | 32,500 |
| Current Liabilities | ||
| Creditors (Accounts Payable) | Money you owe to suppliers — bills received but not yet paid | 3,200 |
| VAT owed to HMRC | VAT collected from customers, not yet remitted | 2,400 |
| Tax owed (Income/Corporation Tax) | Tax liability for the current year, not yet paid | 5,400 |
| Total Current Liabilities | Amounts owed and due within 12 months | 11,000 |
| Long-Term Liabilities | ||
| Business loan | Borrowed money repayable over more than 12 months | 6,000 |
| Total Liabilities | Everything the business owes | 17,000 |
| NET ASSETS (EQUITY) | Assets minus liabilities — the owner's stake. Must equal equity section below. | 15,500 |
| Equity (Owner's Funds) | ||
| Share capital / capital introduced | Money the owner put into the business | 5,000 |
| Retained profit | Cumulative profits kept in the business and not drawn out | 10,500 |
| TOTAL EQUITY | Must equal Net Assets above — the balance sheet balances | 15,500 |
Cash Flow vs Profit — the critical distinction
Profitable businesses can go bust. This sounds paradoxical but it is one of the most common causes of business failure. The reason: profit and cash flow are not the same thing.
Recognised when a sale is made — even if the customer hasn't paid yet. If you invoice a client £10,000 in March and they pay in June, the profit appears in March's P&L. But you don't have the cash until June. This is the accruals basis of accounting.
Recognised only when cash actually moves — when money hits your account or leaves it. The same £10,000 invoice appears in your June cash flow, not March. Cash flow is the oxygen of a business — run out of it and you cannot pay suppliers or staff, regardless of how profitable the P&L looks.
This gap between profit and cash is called working capital. Managing it means chasing invoices promptly, negotiating payment terms, and never confusing a full order book with a full bank account.
Allowable Expenses — what you can and cannot claim
HMRC's test for an allowable expense: it must be incurred wholly and exclusively for the purposes of the business. Personal expenses — even if loosely connected to work — are generally not allowable. The key word is "exclusively."
Rent for business premises. For home workers: use the HMRC flat rate (£6/week) or calculate the business proportion of actual costs.
Computers, phones, tools used wholly for business. Claimed via Annual Investment Allowance (up to £1M/year for immediate 100% relief).
Travel to client sites, business meetings (not commuting to a fixed regular place of work). Can use HMRC mileage rates: 45p/mile (first 10,000 miles), 25p/mile thereafter.
Software (accounting, design, CRM), industry memberships, professional body fees relevant to your work.
Accountant fees, legal fees, business insurance. Even the cost of your self-assessment tax return preparation is allowable.
Wages, salaries, NI contributions, pension contributions for employees. If you're a limited company director, your salary is allowable against Corporation Tax.
If used for both business and personal: only the business proportion is allowable. A dedicated business SIM with a separate contract = 100% allowable.
Can claim the business proportion of rent, utilities, broadband. Calculate: business-use rooms ÷ total rooms × hours used for business. Complex — many prefer the £6/week flat rate.
HMRC does not allow client entertainment as a business expense for Income Tax or Corporation Tax purposes. Staff entertaining (e.g. Christmas party up to £150/head/year) has specific rules.
Ordinary clothing worn for work is not allowable — even if you only wear it for work. Protective clothing (safety gear, uniforms with a logo) can be allowable.
Travel from home to a fixed regular workplace is specifically disallowed. Only travel to temporary workplaces or client sites qualifies.
Food (unless away overnight on business), gym membership, personal subscriptions. If it fails the "wholly and exclusively" test, it's not allowable.
Self-Assessment for the Self-Employed
As a sole trader, you report your profits to HMRC annually through a Self Assessment tax return (SA100 + SA103 for self-employment). You pay Income Tax on profits (not turnover) and Class 4 National Insurance (6% on profits between £12,570 and £50,270; 2% above).
| Tax | Rate | On |
|---|---|---|
| Income Tax — basic rate | 20% | Profits £12,571–£50,270 |
| Income Tax — higher rate | 40% | Profits £50,271–£125,140 |
| Class 4 NI | 6% | Profits £12,570–£50,270 |
| Class 4 NI — upper | 2% | Profits above £50,270 |
| Class 2 NI | Check current HMRC rules | Use the current rates page and HMRC guidance before treating this as an automatic weekly charge; it now matters mostly as a State Pension record issue. |
| Total effective tax on £50,000 profit (est.) | ~29% | Income Tax + NI combined |
In your first year of self-employment, you will owe the full year's tax by 31 January. But HMRC also demands 50% of the estimated next year's bill at the same time — and another 50% by 31 July. This means in your first self-assessment January, you could owe 150% of a year's tax bill simultaneously. Prepare for this early by setting aside 25–30% of all income into a dedicated savings account throughout the year.
VAT — When It Applies
VAT registration is compulsory when your taxable turnover (not profit) exceeds the current registration threshold in any rolling 12-month period. Use the rates and allowances 2026/27 page for the current threshold before relying on an older summary. You can also register voluntarily below the threshold, which can be beneficial if your customers are VAT-registered businesses because they can reclaim the VAT you charge.
The standard VAT rate is 20%. Some goods and services are 5% (reduced rate) or 0% (zero-rated). Exempt supplies (e.g. financial services, education, healthcare) do not charge VAT and VAT cannot be reclaimed on related costs.
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