What should a sole trader do if HMRC believes their profits are too low?

What it means when HMRC thinks your sole trader profits are “too low”

If you are a sole trader and HMRC believes your profits are too low, it can feel unsettling—especially if you know you have been honest. The phrase “profits are too low” can mean a few different things in practice. Sometimes HMRC is questioning whether your reported profit is realistic for the type of work you do. Sometimes they think you have missed income, claimed too many expenses, or mixed up personal and business costs. In other cases, they may suspect you are running a commercial business but recording it in a way that makes it look like a hobby, or they may simply be comparing your figures to information they hold from other sources and want an explanation.

It is important to remember that HMRC can open an enquiry even if you have done nothing wrong. Their approach is increasingly data-led, and their systems compare your returns and accounts against patterns, benchmarks, and third-party information. That does not automatically mean they have “caught” you; it often means they think something needs checking. Your job is to respond calmly, get organised, and make sure you can explain how your profit was calculated and why it is accurate.

This article explains what a sole trader should do, step by step, if HMRC believes profits are too low. It also covers how enquiries typically work, the kinds of evidence HMRC looks for, practical ways to defend your position, and what to do if you discover a mistake. The goal is not just to “get through” the enquiry, but to strengthen your record-keeping so you are better protected going forward.

How HMRC might signal a concern about low profits

HMRC rarely writes a letter saying, “We believe your profits are too low,” in those exact words. More commonly, they will:

1) Open a compliance check or a Self Assessment enquiry and ask for information about your income and expenses.

2) Ask specific questions that reveal what they are worried about, such as why certain expenses are high, why turnover fell, or how you worked out private-use adjustments (for example, for a vehicle or home working).

3) Request records like invoices, bank statements, mileage logs, appointment diaries, cashbooks, or bookkeeping exports.

4) Ask about your business model, pricing, typical margins, and how you find customers.

Sometimes HMRC will start with a “nudge” letter encouraging you to check your return. Sometimes it will be a formal enquiry notice. Either way, your response should focus on clarity and evidence rather than emotion. HMRC’s concern might be accurate, partially accurate, or completely misplaced, but the fastest route to resolution is usually a tidy, well-evidenced explanation.

Why HMRC might think your profits are too low

Understanding why HMRC is suspicious helps you respond effectively. Common triggers include:

Unusually low profit margins for your trade

If your turnover looks normal but your reported profit is far lower than expected for your industry, HMRC may wonder whether you have underreported income or overstated expenses. This is especially likely where the business is cash-heavy (hospitality, trades, beauty, taxis, market stalls) or where there is a lot of scope for informal payments.

Consistent losses or near-zero profits year after year

A genuine business can make losses, particularly early on, during expansion, or during a difficult period. But persistent losses can raise questions: is this really a commercial trade, or are you claiming personal expenditure as business costs? HMRC may ask whether you are running the activity on a commercial basis with an intention to make a profit.

Expenses that look personal

Clothing, meals, travel, “office at home” claims, mobile phones, vehicles, and “repairs” are common categories where personal and business use can overlap. If your returns show high claims in these areas, HMRC may ask for evidence and for how you restricted claims to the business element.

Cash takings that do not match lifestyle indicators

HMRC sometimes compares reported profit to what appears affordable based on your mortgage or rent, vehicles, holidays, school fees, and other spending. They might also consider whether your drawings from the business seem inconsistent with your living costs. This does not mean they know your private life in detail, but their questions may be driven by an impression that reported profits do not “fit.”

Data mismatches with information HMRC holds

HMRC can receive information from third parties such as banks, payment processors, online platforms, and other sources. If your declared turnover does not align with the payments flowing into your accounts, they may suspect undeclared sales or incomplete records.

Accounting errors or poor record-keeping

Sometimes the simplest answer is the correct one: a spreadsheet error, missing invoices, duplicate expense entries, or not posting sales correctly. If you use software, there can be issues with bank feed categorisation, VAT settings (if registered), or recording transfers as sales.

First steps: stay calm and get the basics right

The first thing to do is take the matter seriously but not personally. The second is to avoid knee-jerk replies. HMRC letters usually include a response deadline, but you can often ask for a little more time if needed. What you should not do is ignore it or send a rushed, incomplete response that creates confusion. A methodical approach is your friend.

1) Confirm what HMRC is actually doing

Read the letter carefully. Is it a formal Self Assessment enquiry? A compliance check into a specific area? A request for information under particular powers? Or a general prompt to review your figures? The type of contact affects your rights, the scope, and how you respond. If it is unclear, you can call and ask for clarification, but keep notes of who you spoke to, the date, and what was said.

2) Note the deadlines and what they are asking for

Write down each item HMRC has requested and the date it is due. If the request is too broad or you cannot realistically comply in time, ask for an extension and explain why. Being proactive tends to go down better than going silent.

3) Stop making the problem worse

Do not start “fixing” your books by deleting transactions or rewriting records without keeping an audit trail. If you find you need to correct something, do it transparently. HMRC is generally more concerned about concealment than mistakes.

4) Consider getting professional help early

If the amounts are significant, the records are messy, or you feel out of your depth, speaking to an accountant or a tax adviser can be a wise investment. They can help you understand what HMRC is likely to focus on, prepare a clean pack of evidence, and communicate in the right tone. Even if you handle the enquiry yourself, a short consultation can save you from common pitfalls.

Get organised: build a “profit defence file”

If HMRC believes your profits are too low, you need to show how the numbers were arrived at. That means having a set of records that tie together logically. Think of it as a narrative supported by evidence: “This is what I earned, this is what I spent, this is why those expenses were necessary for the business, and this is why the resulting profit is what it is.”

Core records to gather

Most enquiries will involve some combination of the following:

Sales evidence: invoices raised, receipts issued, online order summaries, till reports, appointment schedules, job sheets, platform statements, and any contracts or quotes that show what you charged and when.

Bank evidence: bank statements for all accounts used in the business. If you have mixed personal and business banking, you may need to provide personal statements too, at least where business income is received.

Expense evidence: supplier invoices, receipts, bills, mileage logs, finance agreements, insurance documents, and records of home-working calculations.

Bookkeeping records: your spreadsheet, software exports, cashbook, or ledgers, plus any year-end adjustments (accruals, prepayments, depreciation if applicable, and private-use restrictions).

Business context: price lists, marketing material, evidence of reduced trade (for example, loss of a major client, illness, time off, change in hours), and notes explaining unusual items.

Create a clean summary

HMRC is more likely to accept your explanation if you can present a clear summary. A helpful structure is:

1) Turnover reconciliation: explain how you calculated total income and link it to bank deposits, invoices, and platform statements.

2) Expense breakdown: list major expense categories and provide evidence and explanations for each.

3) Private-use adjustments: show how you restricted mixed-use costs (vehicle, phone, home working).

4) Profit explanation: explain why profit is low (pricing, downtime, high input costs, one-off costs, investment, bad debts, or a difficult period).

When you can reconcile your turnover to cash received and show expenses are genuine and business-related, the “too low” suspicion often softens significantly.

Turnover is usually the key: prove you have reported all income

When HMRC suspects profits are too low, they often suspect turnover is understated. Even if you are confident you have declared everything, you should still treat turnover as the first major area to test. A few practical steps help here.

Reconcile bankings to sales

If most of your income goes through the bank, do a reconciliation:

• Start with total bank deposits that represent business receipts.

• Remove transfers between accounts, loans introduced, refunds, and any personal money that is not business income.

• Add income received in cash and not banked (if applicable), supported by your cashbook or daily takings records.

• The final figure should match your turnover (or be explainable by timing differences).

If you accept card payments through a payment provider, remember that fees may be deducted before you receive the net amount. HMRC may expect you to record gross sales with fees as an expense, rather than recording only the net receipts. If you have mistakenly recorded net figures, that can make turnover look “too low” and reduce profit in a confusing way. Showing your provider statements can clear this up quickly.

Check for missing invoices or unrecorded sales

Even honest traders can miss items. Look for:

• Work done near the year end but invoiced later.

• Cash jobs recorded in a diary but not in the books.

• Platform sales that were paid out after fees and refunds, where the bookkeeping entries do not reflect the gross activity.

• Deposits or advance payments that were treated inconsistently.

If you discover genuine omissions, it is usually better to disclose them proactively, quantify them accurately, and explain how you will prevent a repeat. HMRC’s reaction often depends on whether they think the mistake was careless, deliberate, or prompted by genuine confusion.

If you are cash-based, strengthen your takings story

Cash businesses face more scrutiny because cash is harder to trace. If you deal in cash, you should be able to show how you recorded takings day by day or job by job. Useful evidence includes:

• Daily till Z-reports or summaries.

• A written cashbook that records takings and cash expenses.

• Job sheets, appointment books, or customer records that demonstrate volume of work.

• Stock records (if relevant) that support sales volumes.

HMRC may test whether your business output (for example, number of appointments) could realistically produce the turnover you reported. Being able to demonstrate your capacity, pricing, cancellations, and downtime helps support your figures.

Expenses are the next battleground: justify and evidence them

If turnover looks complete, HMRC may focus on whether expenses have been overstated. This is particularly common where the overall profit looks unusually low and there are expense categories that often contain personal items.

Separate “allowable” from “not allowable” and explain the difference

Expenses for a sole trader generally need to be wholly and exclusively for business to be allowable. Mixed-use items can often be claimed only for the business proportion. In an enquiry, it helps to show you understand this and have applied it consistently.

Typical categories HMRC questions include:

Motor and travel: vehicle running costs, fuel, repairs, insurance, parking, and mileage. HMRC may ask for a mileage log, how you calculated business use, and whether you have also claimed private travel. If you use simplified mileage, be able to show business miles.

Subsistence and meals: meals are often not allowable unless they are in the context of qualifying travel for business. HMRC may ask why the expense is business-related and whether it is actually everyday personal food.

Clothing: ordinary clothing is usually treated as personal. Protective gear or specialist uniforms may be different. HMRC will want to know what was purchased and why it is necessary for the trade.

Home working: HMRC may ask how you calculated the claim, what rooms you use, and how you restricted for private use. A clear calculation (and consistency year to year) matters.

Mobile phone and internet: if you have one contract that you use personally and for business, HMRC may expect an apportionment. If you have a separate business line, that is easier.

Repairs, tools, and equipment: HMRC may question whether items are personal, capital, or business, and whether the timing and classification are correct.

Build a “receipt and explanation” pack

For each expense category that looks large or unusual, create a simple bundle:

• A list of transactions by date and amount.

• The matching receipt or invoice where possible.

• A short explanation of what it was for and why it relates to the business.

• If mixed-use, your calculation for the business percentage.

If you cannot find every receipt, do not panic. Try to obtain duplicates (many suppliers can reissue invoices), and for missing items, provide alternative evidence such as bank transaction details and a written explanation. HMRC may disallow some items if evidence is weak, but a structured approach still puts you in the best position.

Explain why your profits are genuinely low

Sometimes profits are low because the business genuinely had a tough year. HMRC may not know that context. Your explanation should be specific and evidence-based where possible. Vague statements like “trade was quiet” are less persuasive than a clear account of what happened.

Common genuine reasons for low profits

Reduced working time: illness, caring responsibilities, maternity/paternity, studying, or another job. Evidence might be diary notes, hospital appointment letters (you can redact sensitive details), or simply a credible timeline of time off.

Pricing strategy: introductory pricing, discounts, or competition. Evidence might be your advertised prices, promotions, or messages with clients confirming discounted rates.

One-off costs: a major repair, replacing equipment, legal fees, professional fees for a big project, moving premises, or paying for training required for the business. Evidence is invoices and an explanation of why it was necessary that year.

Bad debts: you did work but did not get paid. Evidence could be copies of unpaid invoices, reminders sent, and notes on attempts to collect.

High input costs: materials, subcontractors, platform fees, or shipping costs that rose sharply. Evidence could be supplier invoices or a comparison of costs to prior periods.

Change in business model: moving from high-volume low-margin to lower-volume higher-quality work, or vice versa. Evidence could be marketing changes, new product lines, or changes in client mix.

Use numbers to tell the story

HMRC responds well to simple, logical comparisons. For example:

• “Turnover fell by 25% because I reduced working days from five to three for six months.”

• “Cost of materials increased due to supplier price rises; gross margin fell from 45% to 30%.”

• “I invested in new equipment and training, which increased costs this year but is expected to raise income next year.”

Even if you do not have perfect data, a clear explanation supported by some evidence is far better than leaving HMRC to guess.

Understand HMRC’s methods: what they might do next

HMRC has a range of ways to test whether your profits look plausible. Knowing this helps you prepare.

Requests for records and explanations

This is the most common route. HMRC will ask you to provide documents and answer questions. Your goal is to respond accurately, completely, and in an organised format that makes it easy for them to see you have nothing to hide.

Comparisons and “business economics” tests

HMRC may compare your margins and costs to typical patterns for similar businesses. They might also consider whether the level of activity you describe could plausibly generate the turnover and profit reported. If your business is unusual or you have a niche model, explain that clearly.

Bank deposit analysis

They may examine bank statements to identify deposits that could be sales. If there are deposits you say are personal (gifts, loans, transfers), you may need to explain and evidence them. Keeping personal and business banking separate helps a lot here.

Sampling and extrapolation

Sometimes HMRC will sample a period, identify issues, and then attempt to project that across a wider period. If this happens, focus on whether the sample is representative and whether their extrapolation is fair. If your business is seasonal or irregular, that is a key point to raise.

How to respond to HMRC: practical communication tips

Your tone and structure matter. A response that is cooperative, clear, and evidence-led is more likely to reduce friction and shorten the process.

Be prompt and professional

Meet deadlines where possible. If you cannot, request more time before the deadline and explain what you are doing to gather information.

Answer the question that was asked

It is tempting to provide extra information “just in case,” but that can create confusion or open new lines of enquiry. Provide what they requested, plus any context that directly addresses their concern about profits being low.

Keep a paper trail

Keep copies of everything you send and receive. If you speak on the phone, write a note of what was discussed. If you email, save the thread.

Present information in a structured way

Use headings, a contents list, and clearly labelled attachments if you are sending documents. Number your pages or files. If you provide bank statements, consider highlighting or listing which transactions relate to sales versus non-sales items, with an explanation.

Be honest about uncertainties

If you are not sure about something, do not guess. Say you are checking and will revert, or provide your best explanation with appropriate caveats. HMRC often becomes more suspicious when answers sound overly confident but later prove wrong.

If you find errors: correct them strategically and transparently

It is common, during an enquiry, to discover that something was recorded incorrectly. The best approach is generally to deal with it openly. Trying to hide an error can turn a manageable issue into a serious one.

Quantify the error

Work out the amount and the impact on profit and tax. Provide a clear calculation. If multiple years are affected, identify which years and how.

Explain how the error happened

Was it a misunderstanding, a bookkeeping mistake, a software setting, or missing paperwork? A credible explanation matters because it influences how HMRC views behaviour (careless versus deliberate) and what they might do next.

Explain what you have done to prevent a repeat

For example: separate business bank account, improved bookkeeping process, regular reconciliations, using accounting software properly, or engaging an accountant for quarterly checks. HMRC tends to respond better when they see practical improvement.

What outcomes to expect and how to protect yourself

There are a few common outcomes when HMRC thinks your profits are too low:

No change

If you provide strong evidence and your explanation is credible, HMRC may accept that the profits are correct and close the enquiry with no amendment.

Adjustments to expenses or income

HMRC may disallow some expenses (especially where evidence is missing or the expense is partly personal) or add income (for example, where bank deposits are not explained). If you disagree, you can challenge the assumptions, provide further evidence, and argue your case.

Penalties and interest if tax is understated

If HMRC concludes tax was underpaid, interest may apply, and penalties may be considered depending on behaviour and disclosure. The exact impact depends on the facts and how you engaged with the process. Early, full, and honest cooperation usually reduces the risk of severe outcomes.

Wider enquiries into other years

If HMRC finds significant issues, they may extend their review beyond the year originally checked. That is why it is sensible to review your records for adjacent years, so you are not caught off guard.

How to strengthen your position for the future

Whether HMRC’s concern is justified or not, an enquiry is a strong signal to improve systems. The aim is to make your profits easy to explain and hard to dispute.

Separate your banking

Open and use a dedicated business bank account. Pay business income in and business expenses out. This is one of the simplest ways to reduce suspicion and make reconciliations straightforward.

Do regular reconciliations

Monthly bank reconciliation is a powerful habit. It helps you catch missing sales, duplicate expenses, and miscategorised transactions early.

Keep simple but consistent records

You do not need an elaborate system, but you do need consistency. Store receipts digitally, label them, and link them to your bookkeeping entries. Keep a running list of invoices and ensure they tie to money received.

Document private-use calculations

If you claim home working, phone, or vehicle costs, keep a short calculation document and update it annually. If your business use changes, note why and when. A small file of notes can be the difference between an easy explanation and a long dispute.

Be cautious with “grey area” expenses

If you are unsure whether something is allowable, treat it cautiously and seek advice. Expenses that often cause trouble include clothing, meals, and mixed personal/business purchases. If you decide to claim them, be ready to justify the business need and any apportionment.

Track the operational drivers of profit

Many sole traders focus on cash in and cash out, but HMRC concerns often revolve around “business logic.” Keep simple metrics: number of jobs, average invoice value, hours worked, cancellations, and cost of materials. When profit looks low, being able to show the drivers makes your numbers more believable.

When to escalate: complaints, reviews, and formal dispute routes

Most enquiries can be resolved through providing information and reasoned discussion. But sometimes disputes arise—particularly if HMRC applies assumptions you believe are unfair. If that happens, you can:

• Ask for the reasoning behind their proposed adjustments and request that they consider your evidence.

• Provide a structured counter-analysis (for example, why their sample period is not representative, or why a bank deposit is not income).

• Use professional representation if the dispute becomes technical or high-stakes.

If the interaction becomes unreasonably slow or you feel you are being treated unfairly, you may consider using HMRC’s complaints process. If a decision is made that you disagree with, there are formal routes to challenge it, but those routes depend on the nature of the decision and the stage of the enquiry. The key is to remain factual and organised throughout, because credibility and clarity are your biggest assets.

A sensible action plan for a sole trader facing “low profit” scrutiny

If you want a practical checklist, here is a step-by-step plan you can follow:

Step 1: Identify what HMRC is asking and by when. Make a list of requests and deadlines.

Step 2: Gather core records. Bank statements, invoices, receipts, bookkeeping exports, and any relevant contracts or platform statements.

Step 3: Reconcile turnover. Tie declared turnover to invoices and money received. Explain differences clearly.

Step 4: Review expenses. Ensure each category is supported by evidence and that mixed-use costs are restricted appropriately.

Step 5: Write a clear profit narrative. Explain why profit is low using specific reasons and, where possible, numbers and evidence.

Step 6: Prepare a structured response pack. Use headings, numbering, and labels so HMRC can follow it easily.

Step 7: Disclose and correct any errors. Quantify, explain, and show improvements to prevent repeat issues.

Step 8: Improve systems going forward. Separate banking, reconcile monthly, store receipts, and document key calculations.

This approach not only helps you respond to HMRC efficiently, it also reduces stress. When your business records tell a coherent story, “low profit” stops being a vague accusation and becomes something you can explain calmly and defensibly.

Final thoughts: low profits are not automatically wrong, but they must be explainable

HMRC’s suspicion that your profits are too low is, at its core, a request for reassurance: reassurance that your income is complete, your expenses are legitimate, and your records support your return. Many sole traders experience a year where profits are low for entirely genuine reasons—reduced hours, increased costs, investment, a difficult market, or life events. The problem arises when the records do not clearly demonstrate how those circumstances translated into the figures reported.

If you respond promptly, organise your evidence, reconcile your turnover, justify your expenses, and explain the commercial reality behind your results, you put yourself in the best possible position. If you find mistakes, deal with them openly and show that you are improving your processes. Whether you handle it yourself or with professional support, the path through this situation is the same: clarity, consistency, and proof.