January 22, 2026
By Merranti

Sole traders – basis of assessment, losses and Making Tax Digital

Sole traders and other unincorporated businesses have experienced some of the most significant tax changes in recent years. The move to a new basis of assessment, combined with the introduction of Making Tax Digital for Income Tax (MTD IT), means that forward planning and good record-keeping are now more important than ever.

Basis of assessment – the move to the tax year basis

The old rules

Historically, sole traders were taxed on the “current year” basis of assessment. Under this system, profits charged to income tax for a tax year were based on the results of a 12-month accounting period ending in that tax year. While familiar, this approach often led to complexity, particularly for businesses with accounting dates that did not align closely with the tax year.

The transition to the tax year basis

Tax year 2023/24 was the transition year to the new “tax year” basis of assessment. Under the new rules, profits are taxed based on the profits actually arising in the tax year itself, regardless of the business’s accounting year-end.

Only businesses with an accounting date between 31 March and 5 April were largely unaffected by this change, as their accounting periods already aligned closely with the tax year.

Transition year rules (2023/24)

For businesses affected by the change, the transition year rules meant that:

Up to 23 months’ worth of profits could potentially be brought into charge in 2023/24
Any overlap profits (typically arising when the business first commenced) were set off against the additional months’ profits
The resulting “transition profits” (i.e. profits relating to the extra months) are spread over five tax years, rather than being taxed all at once

This spreading mechanism was designed to prevent an unmanageable spike in tax liabilities in a single year.

Accelerating transition profits

Taxpayers are not required to spread transition profits evenly if this is not beneficial. Instead:

They may elect to bring some or all of the spread profits into an earlier year
This election is made on the Self-Assessment tax return
It can be useful, for example, to:
- Use up unused basic rate band
- Offset losses or allowances
- Avoid higher tax rates in later years

The cash basis – now the default

Cash basis from 2024/25 onwards

From 2024/25, the cash basis is the default method of calculating taxable profits for all unincorporated businesses, regardless of profit level.

Under the cash basis:

Income is taxed when received
Expenses are deducted when paid
There is no need to match income and expenditure to a particular accounting period

This approach is simpler for many businesses and aligns more closely with cash flow.

Electing out of the cash basis

Some businesses may still prefer to use the accruals basis, particularly where:

Stock levels are significant
Work in progress is material
The business wants profits to reflect economic performance rather than cash timing

If you wish to elect out of the cash basis for 2024/25, the election must be made by 31 January 2027. Under the accruals basis, profits are calculated by matching income and expenditure to the period to which they relate, regardless of when cash changes hands.

Loss relief for sole traders

Loss relief remains an important area of planning, particularly for newer or cyclical businesses.

Losses in 2025/26

Losses made by an unincorporated business in 2025/26 can be offset against:

Other income of the same tax year (2025/26); and/or
Income of the previous tax year (2024/25)

However, this relief is subject to a cap of the greater of:

£50,000, or
25% of your total income for the year

Carrying losses forward

Any unused losses can be:

Carried forward indefinitely
Set against future profits of the same trade only

This provides long-term value, even where immediate relief is restricted.

Other loss relief options

Additional reliefs may be available:

In the early years of a business, where losses may be carried back more extensively
On cessation of trade, where terminal loss relief may apply

These rules are complex and can be highly valuable, so advice should be taken where significant losses arise.

Making Tax Digital for Income Tax (MTD IT)

Overview

Making Tax Digital for Income Tax (MTD IT) represents a major change in how sole traders and landlords report their income to HMRC.

MTD IT will be phased in from 6 April 2026 for landlords and the self-employed with qualifying income above £50,000.

Once within MTD IT, affected individuals will need to:

Keep digital records
Submit quarterly updates of income and expenditure to HMRC using MTD-compatible software
Submit a finalisation statement after the end of the tax year (effectively replacing the traditional tax return)

Reporting quarters

MTD IT quarterly reporting will be based on fixed tax-year quarters, regardless of the business’s accounting year-end:

Quarter to 5 July
Quarter to 5 October
Quarter to 5 January
Quarter to 5 April

Taxpayers with an accounting date of 31 March will be able to operate MTD from 1 April in their first year of MTD, simplifying the transition slightly.

Who must enrol and when

Individuals with qualifying income above £50,000 must enrol from 6 April 2026
Qualifying income is the gross combined income from:
- Sole trade(s); and/or
- Property business(es)

In deciding whether someone needs to register for MTD IT for a given tax year, HMRC will look at the Self-Assessment tax return that should have been submitted in the January before the start of that tax year.

Increased compliance burden

MTD IT will significantly increase the administrative and compliance burden for affected businesses. Quarterly reporting, digital record-keeping and new software requirements will all require time, cost and adjustment.

It is important not to underestimate the impact of these changes and to prepare well in advance.

Planning points for sole traders

Employing family members

Employing a spouse or child can be an effective planning strategy, provided the arrangement is genuine.

Salary paid can:
- Utilise the employee’s personal allowance
- Provide a National Insurance record for state pension purposes
Pay must be:
- Commensurate with the duties performed
- At least the National Minimum Wage, where applicable

Pension contributions for family employees

Where you employ a spouse or child:

Employer pension contributions can be made on their behalf
This can save tax and National Insurance
Contributions must be reasonable in relation to:
- Working hours
- Salary level

(These principles apply equally to companies.)

Managing profits under the cash basis

Where the cash basis applies:

Bringing forward business expenditure into the current tax year can reduce taxable profits
Conversely, deferring receipts may also reduce current-year tax, where commercially appropriate

Care should be taken to ensure that expenditure is genuinely incurred for business purposes.

Budgeting for transition profits

If you have transition profits being spread over five years, ensure that:

You understand how much is being taxed each year
You budget appropriately for the additional tax liabilities
You consider whether accelerating the spread profits would be beneficial

Preparing for MTD IT

Do not underestimate the practical impact of MTD IT. In particular:

Ensure you have MTD-enabled software in place well before April 2026
Review bookkeeping processes and record-keeping habits
Consider whether additional professional support will be required

Final thoughts

Sole traders face a period of significant change, with the new tax year basis of assessment and the introduction of MTD IT fundamentally reshaping how profits are calculated and reported. While these changes bring opportunities for simplification in some areas, they also increase compliance demands and the risk of errors.

Early planning, robust systems and professional advice will be key to navigating this new landscape efficiently and ensuring that tax liabilities are managed as effectively as possible.