What should a sole trader do if HMRC issues a penalty notice?

Understanding what a penalty notice is (and why HMRC sends them)

A penalty notice from HMRC can feel alarming, especially if you’re a sole trader juggling invoices, customers, and day-to-day cash flow. But a penalty notice is not the same thing as an accusation of fraud, and it doesn’t automatically mean you’ve done something intentionally wrong. In many cases, it’s HMRC’s way of applying a charge because something was filed late, paid late, or filed incorrectly according to their rules.

As a sole trader, the most common penalties relate to Self Assessment tax returns, late payment of tax, errors in returns, VAT (if you’re VAT-registered), PAYE issues (if you employ staff), and sometimes Construction Industry Scheme (CIS) obligations if you’re in construction. HMRC uses penalties to encourage timely compliance and to deter careless or deliberate inaccuracies.

The key point is this: you usually have options. Your job is to work out exactly what the penalty is for, whether it’s correct, whether you have grounds to challenge it, and how to prevent it from repeating.

First steps: stay calm and verify the notice

Before you do anything else, take a breath and approach the problem methodically. Penalties are time-sensitive, and rushing can lead to missed deadlines or unnecessary payments.

Start by checking that the notice is genuine. Most HMRC correspondence arrives through your online tax account, by letter, or via your agent if you have one. If you receive something that looks suspicious (odd email addresses, requests for bank details, unusual payment methods, links that don’t look right), treat it cautiously. It is generally safer to access your HMRC account by typing the official address into your browser rather than clicking links. If you’re unsure, contact HMRC through official channels and quote the reference number on the letter.

Once you’re confident it’s real, identify:

1) What type of penalty it is (late filing, late payment, inaccuracy, VAT, PAYE, etc.).

2) Which tax period or tax year it relates to.

3) The amount and any additional interest charged.

4) The date of issue and any deadline for payment or appeal.

5) Any reference numbers you’ll need when contacting HMRC.

Work out exactly what HMRC thinks happened

Penalty notices usually include a short explanation, but you may need to dig into your records or online account to understand the full picture. For example, HMRC might say you filed your tax return late. That could mean:

- You missed the filing deadline for your Self Assessment return.

- HMRC’s system shows your return as not received (even though you believe you sent it).

- You filed on time, but under the wrong UTR or using an old account.

- You submitted it but it failed validation and wasn’t accepted.

Or, if it’s a late payment penalty, it could mean:

- You paid after the due date.

- You paid the wrong amount.

- Your payment was allocated to a different tax period.

- Your bank transfer arrived late due to weekends/bank holidays.

Or, if it’s an inaccuracy penalty, HMRC may think there’s an error in your return that led to too little tax being paid, and the penalty level may depend on whether they believe the error was careless, deliberate, or deliberate and concealed.

This stage is about facts. Get your timeline clear: when you filed, when you paid, what you declared, and what evidence you have.

Check whether the penalty amount looks right

Different HMRC penalties follow different rules, and the amounts can vary depending on how late something was, how much tax was involved, and whether HMRC believes the issue was careless or deliberate.

For sole traders, common patterns include:

- Fixed penalties for late filing (often starting at a set amount, then increasing if the return is still outstanding after certain periods).

- Late payment penalties that can be a percentage of unpaid tax after certain time thresholds, plus interest.

- Inaccuracy penalties based on a percentage of the additional tax due, adjusted for behaviour (careless vs deliberate) and how helpful you were in correcting it.

You don’t need to memorise the technical rules to take action, but you do need to ask: does HMRC’s number align with what actually happened? If you paid everything on time, a late payment penalty may be wrong. If you filed on time, a late filing penalty may be wrong. If the tax underpaid is tiny and the penalty seems huge, it may relate to a filing issue rather than the amount of tax.

If something looks off, that’s a signal to gather evidence and consider a challenge.

Gather your evidence before contacting HMRC

It’s much easier to resolve a penalty dispute if you have clean, organised evidence. Build a folder (digital is fine) with:

- Copies of the penalty notice and any related letters.

- Screenshots or confirmation emails showing the date/time you submitted your return.

- Bank statements or payment confirmations showing when tax was paid and to what reference.

- Your bookkeeping records supporting the figures you filed (sales, expenses, mileage, invoices, receipts).

- Notes of any problems (system downtime, illness, bereavement, serious disruption).

- A simple timeline of what happened and when.

If you use accounting software, export relevant reports. If you filed through commercial software, you may be able to retrieve submission receipts. If you filed through an accountant, ask them for submission proof and any correspondence they have.

Decide your route: pay, appeal, ask for a review, or negotiate a plan

Once you understand the notice and have evidence, you can choose your next step. Broadly, sole traders usually fall into one of these situations:

1) The penalty is correct and you can pay it

If you agree the penalty is correct and you can afford to pay, the simplest route is to pay promptly to avoid additional interest or escalation. Even then, it’s still worth reflecting on how to prevent a repeat, because repeated issues can increase HMRC attention and create ongoing stress.

2) The penalty is correct but you can’t pay it all at once

If money is tight, don’t ignore the notice. HMRC can sometimes agree a payment arrangement (often referred to as a “Time to Pay” arrangement) depending on your circumstances. The sooner you act, the more options you tend to have. Prepare a realistic budget: what you can pay now and what you can pay monthly. Be honest, and make sure the plan is sustainable. If you default on a plan, problems can escalate quickly.

3) The penalty is wrong or unfair and you want to challenge it

If you believe the penalty is incorrect, you can challenge it. Depending on the type of penalty, you may be able to appeal on factual grounds (for example, you filed on time) or on the basis that you had a “reasonable excuse” for missing a deadline. HMRC generally expects appeals within a specific time window shown on the notice. Missing the appeal deadline can make things harder, so prioritise this.

4) The penalty relates to an error and you want to correct things proactively

If the notice relates to an inaccuracy or you realise you made a mistake, it’s often better to correct it quickly and cooperate. In many cases, penalties can be reduced depending on how the error happened and how you respond. Making a disclosure and being transparent can materially improve the outcome compared to waiting for HMRC to force the issue.

Understanding “reasonable excuse” (and what tends to work)

For many penalty types, HMRC may cancel a penalty if you can show you had a reasonable excuse for failing to meet an obligation and that you put things right as soon as you could. “Reasonable excuse” is not just “I was busy” or “I forgot” (which HMRC commonly rejects), but it can include serious events or circumstances that made compliance genuinely impossible or unreasonable.

Examples that often have a better chance of being accepted include:

- Serious illness or hospitalisation around the deadline, especially if you’re a one-person business.

- Bereavement of a close family member near the filing/payment deadline.

- Fire, flood, theft, or another event that destroyed records or prevented access.

- Technical failures that prevented filing (where you can show you attempted to comply and acted promptly afterward).

- Unexpected loss of key records due to factors outside your control, coupled with reasonable efforts to reconstruct them.

It usually helps to show two things: (1) the event was beyond your control, and (2) you acted promptly and responsibly once the problem passed. Keep the explanation clear, factual, and supported by documents where possible (doctor’s note, death certificate, insurance claim reference, police incident number, repair invoices, system error evidence).

How to appeal: make it clear, concise, and evidence-led

If you decide to appeal, your aim is to make it easy for the person reviewing your case to understand what happened and why the penalty should be cancelled or reduced.

A good appeal typically includes:

- Your details: name, UTR, National Insurance number (if needed), business name, address.

- The penalty reference and the date of the notice.

- What you are appealing (for example, late filing penalty for the 2024–25 return).

- A short timeline of events.

- The reason you believe the penalty is wrong or should be cancelled.

- A list of evidence attached.

- A polite request for confirmation of the outcome.

Keep your tone calm and professional. Avoid emotional language or long rants about how unfair HMRC is. You can express that you take compliance seriously, but focus on facts and proof.

If you filed or paid on time: common proof that resolves disputes quickly

When HMRC penalties are incorrect, it often comes down to allocation issues or system mismatches. Common proof that can help includes:

- Submission receipt showing date/time and confirmation that the return was accepted (not just “sent”).

- Evidence of successful online submission in your HMRC account history.

- Bank transfer confirmation showing the payment date, amount, and the exact reference used.

- Screenshots of payment screens and the reference number entered.

- A statement of account from HMRC showing how the payment was allocated.

If you discover you used the wrong payment reference, you may be able to ask HMRC to reallocate the payment. That can sometimes eliminate a late payment penalty if the money arrived on time but was parked against the wrong period.

What if the penalty relates to an error in your return?

Inaccuracy penalties can be more stressful because they imply your return contained wrong information. Start by separating two issues: (1) whether the figures are actually wrong, and (2) whether any wrong figures were careless or deliberate.

If the figures are wrong, fix them. If you’re unsure, get help from an accountant. For many sole traders, errors happen because of misunderstandings about allowable expenses, mixing personal and business spending, or missing income (like cash jobs, platform income, or card takings) when records are incomplete.

When HMRC assesses inaccuracy penalties, they often look at behaviour and cooperation. Practical ways to improve outcomes include:

- Provide clear records showing how you calculated your figures.

- Explain the misunderstanding or process failure that led to the error.

- Correct the return promptly and pay any tax due.

- Cooperate with reasonable information requests.

Even if you feel embarrassed or worried, it’s usually better to engage early. Silence or evasiveness can make HMRC assume the worst.

When to get professional help (and how to choose it)

Many sole traders can handle a straightforward late filing penalty appeal themselves. But professional support can be valuable if:

- The penalty is large or you have multiple penalties across different taxes.

- HMRC is alleging deliberate behaviour or raising an inaccuracy penalty with serious implications.

- You’re facing an enquiry, compliance check, or repeated disputes.

- Your bookkeeping is not up to date and you need help reconstructing accounts.

- You’re overwhelmed, unwell, or struggling to engage within deadlines.

Look for a suitably qualified accountant or tax adviser with experience in HMRC disputes. Ask what similar cases they’ve handled, how they charge (fixed fee vs hourly), what they need from you, and what outcome they think is realistic. A good adviser will ask for your documents and will not promise guaranteed results.

If you can’t pay: dealing with HMRC proactively

Cash flow problems are common for sole traders, and tax bills can be lumpy. If you can’t pay the penalty (or the underlying tax) in full, address it head-on. Ignoring HMRC usually makes the situation worse through interest, further penalties, debt collection, or enforcement action.

To prepare for a payment arrangement discussion, work out:

- How much you owe in total (tax, penalty, interest).

- What you can pay immediately.

- What you can pay monthly without defaulting.

- Your essential household and business costs.

- Any upcoming income you’re confident you’ll receive (signed contracts, recurring clients).

Keep your proposal realistic. If you offer too much and then miss payments, you may end up in a tougher position. If you’re already struggling, also consider whether you need broader financial advice or support, especially if personal debts are involved.

Don’t accidentally make things worse: common mistakes after a penalty notice

Sole traders under stress sometimes take actions that backfire. Watch out for these common pitfalls:

1) Missing the appeal deadline. Even if you need time to gather evidence, start the appeal process promptly and explain that further evidence will follow if needed.

2) Paying the wrong reference. If you pay, double-check you’re using the correct reference for the correct tax and period.

3) Ignoring letters because you feel anxious. HMRC letters can pile up, but the best outcomes usually come from engagement.

4) Submitting an appeal with no evidence. A weak appeal can be rejected quickly. Even a short, evidence-backed appeal is better than a long unsubstantiated complaint.

5) Guessing numbers to “get it filed.” Filing something inaccurate to avoid late penalties can create bigger problems later. If you must file with incomplete info, keep careful notes and correct it properly as soon as you can.

How to prevent future penalties: build a simple compliance system

Once you’ve dealt with the immediate issue, invest a little effort in preventing repeat penalties. You don’t need an elaborate system. You need something that works consistently in a one-person business.

Put every deadline in two places

Add key dates to a digital calendar with reminders, and also to a simple monthly checklist. Important deadlines may include:

- Self Assessment filing deadline.

- Self Assessment payment deadlines (including payments on account if applicable).

- VAT return and payment deadlines (if registered).

- PAYE submission and payment deadlines (if you have staff).

Set reminders well ahead of time (for example, 6 weeks, 2 weeks, and 2 days before), not just the day before.

Keep bookkeeping lightweight but regular

Penalties often start with messy records. A simple routine can prevent that:

- Weekly: upload receipts, reconcile bank transactions, update invoices.

- Monthly: review profit, set aside money for tax, check upcoming deadlines.

- Quarterly: review VAT (if applicable) and ensure all records are complete.

If you dread bookkeeping, shorten the sessions. Ten minutes twice a week beats a panicked weekend in January.

Separate business and personal money

A dedicated business bank account (even if not legally required for sole traders) can make it easier to track income and expenses accurately. Mixing transactions increases the chance of missed income, duplicated expenses, and errors that can lead to penalties.

Set aside tax as you go

Many sole traders get caught out because the tax bill feels like it arrives out of nowhere. Consider setting aside a percentage of income every time you get paid into a separate savings pot. The “right” percentage depends on your income level and circumstances, but the principle is consistent: treat tax like a cost of doing business, not an optional future problem.

Use an accountant strategically (not just at filing time)

If you do use an accountant, consider checking in during the year rather than only at the deadline. A mid-year review can catch issues early, help you budget for tax, and reduce the risk of filing errors or late submissions.

If HMRC opens a compliance check: what to do as a sole trader

Sometimes a penalty notice is accompanied by questions, or it triggers a wider compliance check. If HMRC asks for information, respond within the timeframe given. If you need more time, request it. Keep copies of everything you send.

In a compliance check, HMRC may ask for:

- Sales records and invoices.

- Expense receipts and explanations of business use.

- Bank statements and reconciliations.

- Mileage logs or vehicle cost details.

- Details of cash income handling.

Organise what you provide. Label documents clearly. Provide summaries where helpful. If you’re unsure what’s being asked, or if the scope feels broad, get professional advice. The aim is to be cooperative without being careless about what you disclose.

What if you genuinely made a mistake? A practical approach to putting it right

Plenty of sole traders make honest mistakes: claiming an expense that’s partly personal, misunderstanding the rules on home office costs, missing small amounts of income from a platform, or misclassifying costs. If you spot an error, deal with it proactively.

A sensible process is:

- Identify the mistake and how it happened.

- Calculate the impact on tax as accurately as possible.

- Correct the return (or ask your accountant to do it).

- Pay any additional tax and interest.

- Keep a note of the correction and the reasoning.

- Improve your process so it doesn’t happen again.

HMRC often distinguishes between a one-off mistake and a pattern. A clear corrective action plan can help demonstrate that the issue won’t repeat.

Handling communication with HMRC: keep it organised and polite

When you contact HMRC—whether by phone, online message, or letter—treat it like a business interaction. That doesn’t mean being robotic. It means being clear and prepared.

Best practices include:

- Have your UTR and the penalty reference to hand.

- Keep a written log of who you spoke to, when, and what was agreed.

- After a call, write down the key points immediately while they’re fresh.

- If you send documents, keep copies and note when they were sent.

- If you upload evidence, label it clearly (for example, “Bank transfer confirmation – 31 Jan – reference XYZ”).

This level of organisation can make the difference between a quick resolution and months of back-and-forth.

What outcomes are possible?

After you respond to a penalty notice, several outcomes are possible depending on the facts:

- The penalty is cancelled in full (for example, HMRC accepts you filed on time or accepts a reasonable excuse).

- The penalty is reduced (common with inaccuracy penalties where cooperation and disclosure reduce the percentage).

- HMRC upholds the penalty, but you agree a payment plan.

- HMRC reallocates a payment, reducing or removing a late payment penalty.

- The dispute escalates to a formal review or tribunal process if you continue to challenge an upheld decision.

In practice, many sole trader penalty situations are resolved at the early stages once evidence is provided and the issue is clarified.

Special situations: VAT-registered sole traders

If you’re VAT-registered, penalties can arise from late VAT returns, late VAT payments, or errors in VAT reporting. VAT can be particularly unforgiving because the deadlines are frequent and the amounts can be significant.

To reduce VAT-related risk:

- Reconcile VAT records monthly, not just at quarter end.

- Keep VAT invoices and check that input VAT claims are supported.

- Be careful with mixed-use items and partial exemption rules if relevant.

- Don’t treat the VAT you collect as “your money.” Put it aside so you can pay on time.

If you receive a VAT penalty notice, identify whether it relates to filing, payment, or accuracy, then follow the same structured approach: verify, understand, gather evidence, and respond promptly.

Special situations: sole traders with employees

If you run payroll, penalties can relate to RTI submissions, late PAYE payments, or incorrect payroll reporting. Payroll penalties can snowball if submissions are repeatedly late.

Practical prevention tips include:

- Use payroll software that prompts for RTI submissions.

- Pay PAYE on time and confirm the payment reference and period.

- Keep a payroll calendar (pay dates, submission dates, payment deadlines).

- Consider outsourcing payroll if it’s a recurring stress point.

A simple action plan checklist

If you’re staring at a penalty notice right now, here’s a straightforward sequence you can follow:

1) Read the notice carefully and identify the type of penalty and the period it relates to.

2) Note the appeal deadline and the payment deadline.

3) Check your HMRC online account for messages, statements, and submission history.

4) Gather evidence: submission receipts, bank confirmations, records, and a timeline.

5) Decide: pay, request a payment plan, appeal, or correct an error (or a combination).

6) If appealing, write a clear evidence-led appeal and submit it within the deadline.

7) Keep a communication log and copies of everything.

8) After resolution, build a small system to prevent the same issue next year.

Final thoughts: treat it as a solvable admin problem

A penalty notice is unpleasant, but it’s usually manageable if you act promptly and stay organised. As a sole trader, it’s easy to feel like you’re carrying everything alone, and that’s why structure matters: verify the facts, gather evidence, respond within deadlines, and choose the right route—pay, appeal, or arrange time to pay.

Most importantly, don’t let a penalty notice become a cycle. Once you’ve handled it, put simple safeguards in place: calendar reminders, regular bookkeeping, and a habit of setting money aside for tax. Those small steps can reduce stress dramatically and help you keep your focus where it belongs—on running and growing your business.