What tax rules apply if I subcontract work as a sole trader?

What does “subcontracting” mean for a sole trader?

As a sole trader, subcontracting usually means you are taking on a piece of work for your customer (the client) and then paying another person or business to do some of that work on your behalf. You remain responsible to the client for delivery, quality, deadlines, and (often) fixing any mistakes. In practice, subcontractors can be individuals, partnerships, limited companies, agencies, or specialist trades. You might subcontract because you need extra capacity, a specific skill set, local coverage, or help meeting a deadline.

From a tax perspective, subcontracting changes the shape of your income and expenses. You still record the full amount you invoice your client as turnover, and you generally treat the amounts you pay subcontractors as business costs. But the detail matters. Some industries have special regimes, the status of the person you hire affects what records you must keep, and the way you structure agreements can influence whether payments are allowable, whether you must report them, and what evidence you need to support your figures.

This article walks through the practical tax rules and common pitfalls when you subcontract work as a sole trader. It focuses on the everyday questions: what you can deduct, what paperwork you should gather, when you might have reporting or withholding obligations, and how to keep your records clean so that your tax return reflects what actually happened.

The big picture: how subcontracting affects your taxable profit

Most sole traders are taxed on profits, not turnover. Your taxable profit is broadly your business income minus allowable business expenses for the tax year. Subcontracting typically increases both sides of that equation: you may invoice your client more because you take on larger projects, and you also incur subcontractor costs that reduce your profit.

In principle, the tax treatment is straightforward: include client invoices as income, deduct subcontractor costs as expenses (provided they are “wholly and exclusively” for business purposes), and pay tax on what remains. In practice, the complications sit in four places:

First, you must correctly classify who you are paying. Are they genuinely a subcontractor (self-employed or a business), or are they effectively your employee? Second, you need evidence. If you can’t show who you paid, why you paid them, and what you received, you risk deductions being disallowed. Third, certain sectors have additional reporting or withholding requirements. Fourth, VAT and other taxes (like payroll taxes) can bite depending on your circumstances.

Allowable expenses: when are subcontractor payments deductible?

As a sole trader, you can usually deduct subcontractor costs that are incurred wholly and exclusively for the purposes of your trade. In plain terms, this means you can deduct payments made to help you earn your business income, where the cost is not personal in nature and not a capital purchase.

Common examples of deductible subcontractor costs include:

• Paying a specialist to complete part of a job you have contracted to deliver (for example, an electrician hired by a kitchen fitter, or a designer hired by a marketing consultant).

• Labour-only subcontractors (people who provide time and skill, with you supplying materials).

• Service providers who support delivery (such as translators, copywriters, developers, editors, site labour, or installers).

• Agencies or freelancers used to meet a deadline, provided the work is for the business.

However, there are common reasons deductions can be challenged or reduced. If a payment has a dual purpose (part business, part personal), only the business portion is deductible. If you pay someone for a service that is not connected to your trade, it’s not deductible. If you pay an unusually high amount to a connected person (for example a family member) without commercial justification, you may need stronger evidence that it was a genuine business expense at a reasonable market rate.

Revenue expense vs capital expense: subcontracting can create assets

Not every subcontractor payment is a routine expense. Sometimes subcontracting produces something that lasts beyond the current year, such as building work that creates or improves a long-term asset, or development work that creates a new piece of software you will use over multiple years. In those cases, the cost might be capital rather than revenue.

Why does it matter? Revenue expenses are generally deducted in full (subject to the rules of your accounting method). Capital costs may be relieved differently, for example through capital allowances or by being taken into account when you dispose of an asset. The dividing line can be nuanced, but a practical approach is to ask: are you paying for “ongoing running costs” to generate sales, or are you buying/creating something enduring that will be used by the business for a longer period?

If you subcontract a one-off project that creates a long-term business asset, keep clear notes and invoices describing what was delivered and how it will be used. If you’re uncertain, it can be worth getting tailored advice because the correct treatment can affect your profit and tax bill in the year of spend.

Who you pay matters: subcontractor, worker, or employee?

One of the most important tax rules when subcontracting is that the legal and tax status of the person doing the work matters. If you hire a genuine subcontractor, you typically pay their invoice and treat it as an expense. If the person is actually your employee, you may have payroll obligations, and you cannot simply treat them as a subcontractor to avoid those obligations.

In many cases, the difference is clear: you hire a limited company to deliver a defined service, or you engage an established self-employed specialist who works for multiple clients, sets their own hours, and uses their own equipment. But sometimes the line is blurry: a person works mostly for you, uses your tools, follows your instructions closely, and is integrated into your business. That begins to look like employment.

The practical point is this: you should not rely on labels. Calling someone a subcontractor does not make them one. What matters is the reality of the working arrangement—control, substitution, financial risk, provision of equipment, and how they present themselves to the market. If you treat someone as a subcontractor but the facts point toward employment, you could face backdated payroll tax issues and penalties, and the person may have employment rights claims too.

To reduce risk, use written agreements, keep evidence that the subcontractor works independently, and ensure they invoice you for specific work. If the working arrangement resembles employment, consider whether you need to operate payroll.

Record keeping: what evidence should you keep for subcontractor costs?

Good records are the backbone of correct tax reporting. If you subcontract, your expenses are likely to grow, and so does the need to show what those expenses were for.

At a minimum, you should keep:

• Invoices from subcontractors showing their business name, address (where available), date, description of work, and amount charged.

• Proof of payment, such as bank statements, payment confirmations, or receipts.

• Contracts or purchase orders that describe what was agreed, rates, deliverables, and timelines.

• Correspondence confirming scope changes or additional work (email trails are often sufficient).

• Where relevant, timesheets, job sheets, site sign-offs, or acceptance confirmations from your client.

Keeping these items helps you support that the expense was wholly and exclusively for business. It also helps reconcile any disputes, clarifies what you received, and makes it easier to answer questions if your tax authority ever asks for more detail.

Payment methods and audit trail: why “cash in hand” is risky

Paying subcontractors in cash is not automatically prohibited, but it creates risk. Cash payments are harder to evidence, easier to dispute, and can raise suspicion if the amounts are large or frequent. If you pay cash, you should insist on a signed receipt that includes the subcontractor’s details, date, amount, what the payment relates to, and ideally an invoice reference. Better still, pay by bank transfer or card so the payment trail is automatic.

From a business standpoint, bank payments also help with budgeting, proving your expenses, and keeping your accounts tidy. If you later need to demonstrate that a payment was for business, a clear bank record plus an invoice is much stronger than a vague cash withdrawal and a handwritten note.

Withholding and reporting: industries with special rules

In some industries, subcontracting comes with additional compliance. A common example is the construction sector, where a specific scheme may require contractors to verify subcontractors, make deductions at set rates, and report payments periodically. If your trade operates in an industry with those kinds of rules, you may have obligations even if you are “just” a sole trader.

The key point is that “sole trader” status does not exempt you from sector-specific withholding or reporting regimes. If you take on work as the main provider and pay others to help you deliver, you may be treated as a contractor for those purposes.

If you think your business falls into a regulated subcontracting regime, don’t ignore it. Failures here can lead to penalties and to deductions being disallowed or delayed. In many cases, you must register, carry out checks on subcontractors, and keep specific records or submit returns on a schedule.

VAT considerations: when subcontracting affects your VAT position

Subcontracting affects VAT in two main ways: how you handle VAT on your sales to clients and how you recover VAT on subcontractor invoices (if you are VAT-registered). If you are not VAT-registered, VAT still matters because it affects your costs: you generally cannot reclaim VAT paid on subcontractor invoices.

If you are VAT-registered, you will typically charge VAT on your invoices to clients where the supply is taxable, and you can usually reclaim input VAT on subcontractor invoices that include VAT, provided the expense relates to your taxable business activities and you hold proper VAT invoices. If a subcontractor is not VAT-registered, their invoice will not include VAT, and there will be no input VAT to reclaim.

Subcontracting can also push you toward VAT registration by increasing turnover. Even if your profit margin stays similar, taking on bigger projects can increase gross sales. VAT thresholds and rules depend on jurisdiction, so it’s important to track turnover and anticipate whether subcontracting will move you closer to compulsory registration. If you register late when you should have registered earlier, you could owe VAT backdated from the effective date, which can be painful if you can’t recover it from clients.

Finally, some supplies have specific VAT rules (for example, certain construction-related supplies in some jurisdictions may be subject to special VAT accounting methods). If you work in a sector where VAT is complex, treat subcontracting arrangements as a trigger to double-check how VAT should be applied.

Domestic reverse charge and other special VAT mechanisms

Depending on your jurisdiction and industry, you may run into VAT mechanisms that shift responsibility for accounting for VAT from supplier to customer (often referred to as reverse charge rules). These are common in certain cross-border services and can also apply domestically in specific sectors.

From a practical perspective, this affects what your subcontractor invoice should say, how you account for VAT on your VAT return (if registered), and how you price work. If you handle this incorrectly, you might underpay VAT or lose the ability to reclaim input VAT, both of which can lead to assessments and cashflow issues.

If your subcontracting involves cross-border work, digital services, or regulated sectors, review whether reverse charge or similar rules apply to your purchases or sales.

Timing: when can you claim the expense?

When you can deduct subcontractor costs depends on your accounting method and the rules of your tax system. Many sole traders use a straightforward cash basis where income and expenses are recorded when money is received or paid. Others use accrual accounting where income and expenses are matched to when the work is done and invoices are raised, regardless of payment date.

If you use the cash basis, subcontractor costs usually become deductible when you pay them. That makes the timing easy, but it also means late payments can shift deductions into a later tax year. If you use accrual accounting, you may deduct the cost when you incur it, typically when you receive an invoice and the work relates to that period, even if you pay later.

Whichever method you use, consistency matters. Mixing methods without a valid reason can create errors and make your results hard to reconcile. Keep a clear system for tracking unpaid subcontractor invoices at year-end if you use accruals, and keep a clear record of payment dates if you use the cash basis.

Retention, snagging, and disputes: what if the subcontractor work is faulty?

Subcontracting sometimes leads to costs that don’t neatly match the original invoice. You might withhold retention until work is completed, you might pay for remedial work, or you might recover costs from the subcontractor if they have to fix defects. Tax-wise, you still want your accounts to reflect reality: what you paid, what you recovered, and what your net cost was.

If you pay a subcontractor and later receive a refund or compensation for defective work, that refund is generally business income (or a reduction of expense) because it offsets a previously deducted cost. If you incur additional costs to put things right, those may be deductible if they are part of the cost of delivering the job for your client, provided they are not capital improvements.

Keep documentation of disputes and resolutions. If you simply reduce what you pay, make sure the invoice or credit note reflects the reduction. If you recover money later, keep evidence of the settlement and the payment received.

Subcontractor expenses beyond labour: materials, travel, and tools

Subcontracting is not only about paying for labour. Sometimes you reimburse materials, travel, accommodation, or tool hire. The tax treatment depends on what exactly is being paid and who is responsible for it.

If the subcontractor bills you for materials used on the job, that is typically part of the cost of goods or job costs and can be deductible as a normal business expense. If you reimburse travel or accommodation, you should be careful: reimbursements can be legitimate job costs, but they can also trigger questions about whether the travel was necessary, whether it was personal, or whether you are effectively providing employee-like benefits.

As a practical rule, aim for clarity: either the subcontractor prices the job to include their costs (so you pay one amount for delivery), or they itemize expenses with receipts. If they itemize, keep those receipts and ensure the expenses are clearly connected to your client project.

Expense restrictions and “not allowable” items

While most genuine subcontracting costs are deductible, there are areas where deductions can be restricted. Examples can include:

• Fines and penalties: if you pay penalties (for example for non-compliance or breaches), these are often not deductible even if they arise in business.

• Excessive or non-commercial payments to connected persons: you may be limited to a reasonable amount that reflects the market value of the work.

• Personal elements: if you pay for something that includes personal benefit, you may need to apportion and claim only the business portion.

• Entertainment: if subcontracting involves meals or hospitality, there may be specific limits depending on local rules. A working meal necessary for travel might be treated differently from entertaining someone.

When in doubt, keep the scope of subcontractor payments tightly linked to deliverables and maintain a clean paper trail.

Subcontracting and payroll taxes: when you might need to operate PAYE (or equivalent)

If the person you engage is effectively your employee, you may need to run payroll, withhold income tax, and pay employer social contributions (depending on your jurisdiction). This is not purely a “tax return” issue; it changes your responsibilities as a business. Misclassification is one of the most common and costly mistakes in subcontracting.

Warning signs that a “subcontractor” might be an employee include: working exclusively for you over a long period, having set hours, being directed and supervised like staff, being unable to send a substitute, using your equipment, and being paid a fixed wage-like amount regardless of results. None of these are definitive on their own, but together they can point to employment.

If you engage workers frequently, especially labour-only, it may be worth creating a standard onboarding process: collect their business details, confirm how they operate, sign a contract that reflects genuine independence, and review the working arrangement periodically.

National insurance and social contributions: implications of hiring people vs businesses

Subcontracting to an incorporated business (such as a limited company) often feels administratively clean: you receive an invoice, you pay it, and the company handles its own taxes. Hiring individuals can be more complicated because the line between contractor and employee can be less clear, and because individuals may not have the same level of formal business documentation.

Where social contributions exist (for example, national insurance), the treatment depends on the employment status. As a sole trader, your own social contributions are typically calculated on your profits. But if you have employees, you may owe employer contributions as well. Subcontracting can become an unintended route into payroll obligations if you rely on individuals who function like employees.

To protect yourself, align your practices with the status you intend: true subcontractors should have control over how they deliver, bear some financial risk, and operate their own business. If your business model requires direct control, fixed schedules, and ongoing integration, it may be more appropriate to hire employees or use an agency with clear compliance structures.

Tax deductions for the subcontractor: why your paperwork still matters

Even though the subcontractor is responsible for their own taxes, what you do can still affect them. If you pay them without a clear invoice, if you misdescribe the work, or if you don’t provide basic information they need, it can create disputes and reduce trust. Clean paperwork helps both sides: it clarifies scope, reduces misunderstandings, and makes it easier for the subcontractor to maintain their own records.

From your perspective, well-structured subcontractor invoices and contracts also help show that the relationship is business-to-business rather than employment. That can be valuable if your arrangements are ever questioned.

Managing cashflow: tax is paid on profit, not on whether your client paid you yet

A common trap for sole traders who subcontract is cashflow mismatch. You may need to pay subcontractors before your client pays you, especially if your client has long payment terms. If you operate on an accrual basis, you may recognize income when you invoice the client even if payment hasn’t arrived, while also recognizing subcontractor expenses when invoices come in. That can create a profit figure (and tax liability) that doesn’t reflect the cash sitting in your bank.

Even under a cash basis, you can run into problems if clients pay late because you still have to meet subcontractor payroll-like expectations to maintain relationships. The practical solution is operational rather than purely tax: build deposits, staged payments, or milestone billing into your client contracts; agree payment terms with subcontractors that mirror your client terms where possible; and maintain a buffer for tax and VAT if relevant.

Many sole traders find it helpful to set aside a percentage of each client payment into a separate account for tax. Subcontracting tends to increase turnover and may increase the absolute tax amounts you’ll need to pay, even if your margins stay stable.

Pricing and profit: subcontracting doesn’t reduce your turnover

It is easy to think of subcontracting as “passing on” part of the job, but for tax and accounting purposes you still book the full sale you made to your client. That means your turnover can rise significantly when you subcontract, even if your net profit does not rise as much.

This matters because turnover often drives other thresholds and obligations (for example VAT registration thresholds in some jurisdictions, or requirements to change accounting method). It can also affect how lenders and landlords view your business and how you assess affordability.

When you scale through subcontracting, track both turnover and margin. Make sure your prices include a clear markup for your time spent managing, coordinating, quality checking, and taking on risk. If you subcontract at cost and do not build in margin, you can end up increasing workload and responsibility while barely improving profit.

Subcontracting agreements: clauses that protect your tax position

While tax is mostly determined by facts, your written agreement supports those facts. A good subcontractor agreement can help demonstrate that the subcontractor is independent, clarify what they are responsible for, and reduce confusion about expenses and invoicing.

Clauses that often help include:

• Scope and deliverables: what work is included, what is excluded, and how changes are handled.

• Pricing and invoicing: day rate, fixed price, milestone payments, and when invoices are issued.

• Responsibility for materials and expenses: whether costs are included or reimbursed, and what evidence is required.

• Substitution: whether the subcontractor can send someone else (subject to reasonable approval) which supports independent status.

• Insurance: requirements for public liability, professional indemnity, or other cover where relevant.

• Confidentiality and data protection: important in service businesses and often expected by clients.

• Quality standards and rectification: what happens if work is defective and who pays for fixes.

A written agreement won’t “prove” status by itself, but it reduces ambiguity and makes it easier to show that the arrangement is commercial and business-to-business.

Using agencies and platforms: are they subcontractors or suppliers?

Sometimes you hire labour through an agency or platform rather than directly engaging an individual. In that case, your contract and invoice might be with the agency, and the agency handles the worker’s pay and compliance. Tax-wise, you typically treat the agency fee as an expense, and you keep the agency invoice and proof of payment.

However, agencies can charge differently: some charge a margin on top of wages, some bill an all-in rate, and some add separate fees. Make sure you understand what you are paying for and whether VAT is included. If the agency supplies workers who act under your day-to-day control, that may still have implications for your health and safety responsibilities and for how you manage risk, even if payroll is handled elsewhere.

From a record-keeping standpoint, agencies can simplify documentation because invoices are often standardized and easier to reconcile. The downside is cost: you may pay a premium compared to engaging a subcontractor directly.

Cross-border subcontractors: withholding tax and reporting risks

If you subcontract to someone based in another country, additional rules can apply. Depending on where you and the subcontractor are located, there may be withholding tax on certain services, VAT or sales tax issues, and reporting obligations. Even if there is no withholding requirement, you may need to gather evidence of where the service is performed and the supplier’s location.

Cross-border subcontracting is an area where it is easy to make mistakes because the rules can be technical and vary widely by country and by service type. If you regularly engage overseas subcontractors, treat it as a compliance project: keep clear contracts, document supplier details, and ensure invoices include the information needed for your tax reporting.

Subcontracting to family members: extra scrutiny and how to do it properly

Paying a family member as a subcontractor is not automatically a problem, but it often attracts extra scrutiny because it can be used (intentionally or unintentionally) to shift profits within a family. The safest approach is to treat it like any other commercial arrangement: define the work, agree a reasonable market rate, ensure they actually do the work, and pay via traceable methods.

Keep the same evidence you would for any subcontractor: invoices, proof of payment, and documentation of deliverables. If the family member is not operating as a business and the arrangement looks like employment (for example regular hours, ongoing work, close control), you may need to consider payroll obligations rather than treating them as a subcontractor.

Common mistakes sole traders make when subcontracting

Subcontracting can be a powerful way to grow, but the same issues show up again and again. Here are some of the most common mistakes and why they matter:

• Treating subcontractors as “off the books”: failing to keep invoices and payment records can lead to disallowed expenses and compliance risk.

• Confusing turnover and profit: scaling turnover via subcontracting can trigger thresholds even if profits remain modest.

• Misclassifying workers: paying someone as a subcontractor when they are effectively an employee can trigger backdated payroll taxes and penalties.

• Ignoring sector-specific rules: some industries require verification, reporting, or withholding on subcontractor payments.

• Poor contract management: unclear scope leads to disputes, rework, and extra costs that are hard to evidence.

• Not tracking VAT properly: reclaiming VAT without valid invoices, or failing to register when turnover rises, can be expensive to fix later.

• Weak pricing: not including a management margin or contingency can increase workload without increasing profit.

By addressing these points early, you make subcontracting smoother and reduce unpleasant surprises at tax time.

Practical checklist: staying compliant when you subcontract

To bring everything together, here is a practical checklist you can use when you start subcontracting or when you want to tighten up your current process:

• Confirm who you are hiring: individual, sole trader, partnership, or company, and keep their trading details on file.

• Use a written agreement that matches the reality of the working relationship.

• Collect and file invoices for every payment, and pay through traceable methods.

• Keep a clear link between each subcontractor cost and a client job or business activity.

• Track turnover as well as profit so you can anticipate VAT registration and other threshold-driven obligations.

• Review employment status risk regularly, especially for long-term or near full-time “subcontractors.”

• Keep notes on any unusual payments, refunds, or disputes, and record credit notes and reimbursements properly.

• Reconcile your accounts periodically so job costs, invoices, and payments match your bank records.

Final thoughts: subcontracting can be simple if you build good habits

For most sole traders, subcontracting is tax-efficient in the sense that genuine subcontractor costs reduce taxable profit in the same way as other business expenses. The real challenges are not about finding a clever tax trick; they are about getting the fundamentals right: correct classification, solid documentation, and awareness of any special industry rules.

If you build a routine—onboard subcontractors properly, insist on invoices, keep clean payment trails, and track thresholds—subcontracting becomes a predictable part of your business rather than a compliance headache. It can help you take on larger jobs, deliver better quality, and grow your reputation, while keeping your tax reporting accurate and defensible.

When your subcontracting becomes regular, high value, or complex (especially with cross-border work or regulated sectors), it may be worth getting professional advice specific to your circumstances. But even then, the basics remain the same: record what you earned, record what you paid to deliver it, and keep enough evidence to show that your figures reflect real business activity.