What is the difference between trading income and employment income?

At Towerstone Accountants we provide specialist personal tax services, for self employed, and individuals across the UK. This article has been written to explain What is the difference between trading income and employment income, in clear practical terms, so you understand how personal tax and Self Assessment rules apply in real situations. Our aim is to help you stay compliant, avoid costly mistakes, and make confident tax decisions.

This is one of those questions that sounds simple on the surface but causes a huge amount of confusion in real life. I deal with this distinction constantly when preparing tax returns, advising new business owners, reviewing HMRC letters, or helping people who work in mixed ways across jobs, contracts, and self employment.

From experience, many people assume the difference is obvious. You are either employed or self employed. In reality, it is not always that clear cut. HMRC does not just look at what you call yourself or what your contract says. It looks at the nature of the work, how you are paid, and the level of control involved. Getting this wrong can lead to incorrect tax returns, unexpected bills, and in some cases HMRC investigations.

In this article I want to explain clearly and practically what employment income is, what trading income is, how HMRC distinguishes between the two, and why it matters so much for tax. I will also cover common grey areas, mixed income situations, and the mistakes I see most often in practice. The aim is to give you confidence in understanding how your income should be treated and when you should seek advice.

Why the distinction matters more than people realise

Before getting into definitions, it is important to understand why this distinction is so important.

Employment income and trading income are taxed differently. They involve different reporting obligations, different National Insurance rules, different expense rules, and different levels of flexibility. If income is classified incorrectly, the consequences can include underpaid tax, lost reliefs, penalties, and backdated assessments.

From experience, HMRC focuses heavily on this area because misclassification is common and often unintentional. People are rarely trying to do anything wrong. They simply do not understand the rules or assume their situation fits neatly into one category.

Understanding the difference early can save years of problems later.

What HMRC means by employment income

Employment income is income you receive from working for someone else under a contract of employment or an arrangement that looks like employment in practice.

This is the most familiar form of income for most people.

Key features of employment income

Employment income usually has several defining features.

• You work for an employer

• The employer controls how, when, and where you work

• You are paid a salary or wage

• Tax and National Insurance are deducted at source

• You have employment rights

If you are employed, you are usually paid through PAYE. Your employer deducts income tax and Class 1 National Insurance before paying you. You receive a payslip showing these deductions and your income is reported to HMRC automatically.

From experience, people often forget how much administration is handled for them when they are employed. This becomes very obvious when they move into self employment and suddenly everything is their responsibility.

What counts as employment income

Employment income includes more than just basic salary.

It can include:.

• Wages and overtime

• Bonuses and commission

• Benefits in kind such as company cars or private medical cover

• Holiday pay and sick pay

• Termination payments in some cases

All of this income is taxed under employment rules and reported through PAYE.

What HMRC means by trading income

Trading income is income you earn from running your own business or working for yourself. This is commonly referred to as self employment.

Trading income is reported differently, taxed differently, and comes with far more responsibility.

Key features of trading income

Trading income usually has the following characteristics.

• You work for yourself

• You control how the work is done

• You invoice for your work

• You bear financial risk

• You can make a profit or a loss

If you are self employed, you are responsible for registering with HMRC, keeping records, filing a Self Assessment tax return, and paying tax and National Insurance yourself.

From experience, this shift in responsibility is where many problems start. People focus on earning income but underestimate the administrative and tax obligations that come with trading.

What counts as trading income

Trading income can include:.

• Fees from clients or customers

• Sales of goods or services

• Online income from platforms or marketplaces

• Professional fees

• Contract income where you are genuinely self employed

The key point is that trading income arises from a trade, profession, or vocation carried on with the intention of making a profit.

How HMRC decides whether income is trading or employment

This is where things become less straightforward.

HMRC does not rely solely on labels. You can be called a contractor and still be treated as an employee for tax purposes. Equally, you can be paid regularly by one client and still be genuinely self employed.

HMRC looks at the reality of the relationship.

Control

Control is one of the most important factors.

HMRC asks questions such as:.

• Who decides how the work is done

• Who sets the hours

• Who decides where the work takes place

If the engager has a high level of control, the relationship looks more like employment.

From experience, control is often underestimated. Even subtle control over working hours or methods can push a relationship towards employment.

Substitution

Another key factor is whether you can send someone else to do the work.

A genuine right of substitution supports self employment. If you must personally perform the work, that leans towards employment.

HMRC looks at whether substitution exists in reality, not just on paper.

Mutuality of obligation

This refers to whether the engager is obliged to provide work and whether you are obliged to accept it.

An ongoing obligation on both sides is a strong indicator of employment.

Self employed people typically have the freedom to accept or reject work and the engager does not have to keep offering it.

Financial risk

Self employed people usually bear financial risk.

This can include:.

• Paying your own costs

• Fixing mistakes at your own expense

• Risking non payment

Employees do not usually face these risks.

Integration

HMRC also looks at how integrated you are into the organisation.

If you appear to be part of the business, use their systems, represent them internally, and work like a member of staff, this points towards employment.

The problem of disguised employment

One of the biggest issues in this area is disguised employment. This is where someone is labelled as self employed but works in a way that looks like employment.

From experience, this often arises because businesses want flexibility or lower costs, not because the individual wants to avoid tax.

However, HMRC focuses on the reality, not the intention.

If income is treated as trading income when it should be employment income, HMRC can reclassify it. This can lead to backdated tax and National Insurance liabilities, often going back several years.

IR35 and off payroll working

For contractors working through limited companies, this issue becomes even more complex.

IR35 rules exist to prevent individuals from avoiding employment taxes by working through an intermediary when the underlying relationship is really one of employment.

While IR35 mainly affects limited company contractors, the principles are closely linked to the trading versus employment distinction.

From experience, many people misunderstand IR35 or assume it does not apply to them. The same tests around control, substitution, and mutuality still apply.

Mixed income situations

Many people do not fit neatly into one category.

It is very common to see individuals with both employment income and trading income in the same tax year.

Examples include:.

• Someone employed part time and self employed on the side

• A contractor with a PAYE role and freelance clients

• A director taking a salary and also earning self employed income

In these cases, each type of income is taxed under its own rules. Employment income goes through PAYE. Trading income is reported through Self Assessment.

From experience, problems arise when people assume one return or one method covers everything.

Differences in tax and National Insurance

One of the biggest practical differences between trading income and employment income is how tax and National Insurance are paid.

Employment income is taxed in real time through PAYE. National Insurance is deducted automatically.

Trading income is taxed later through Self Assessment. National Insurance is paid separately, usually as Class 2 and Class 4.

This timing difference often causes cash flow issues for new self employed people. The tax bill feels sudden because no deductions were made during the year.

Understanding this difference early is crucial for planning.

Differences in allowable expenses

Expense rules also differ significantly.

Employees can only claim limited expenses and only where they are wholly, exclusively, and necessarily incurred for the job.

Self employed people can usually claim a wider range of business expenses, provided they meet the wholly and exclusively rule.

From experience, this difference sometimes tempts people to prefer self employment classification. However, claiming expenses incorrectly can quickly undo any perceived benefit.

Common mistakes I see in practice

There are a few recurring issues I see year after year.

• People assuming invoices automatically mean self employment

• Businesses treating staff as self employed without proper review

• Individuals failing to register as self employed

• Income being reported in the wrong section of the tax return

• National Insurance being missed

These mistakes are rarely deliberate. They usually stem from misunderstanding or poor advice early on.

What I advise clients to do

When someone is unsure whether their income is trading or employment, I always suggest stepping back and looking at the facts objectively.

Ask:.

• Who controls the work

• Who bears the risk

• Can you walk away

• Can you send someone else

If the answer consistently points one way, the tax treatment usually follows.

From experience, getting this right at the start is far easier than correcting it years later.

Key points to takeaway

The difference between trading income and employment income is not just a technical tax distinction. It affects how you are taxed, what you can claim, how much responsibility you carry, and how HMRC views your situation.

From experience, the biggest problems arise when people assume rather than check. HMRC is far more interested in the reality of how work is done than the labels used.

If your working arrangements have changed or if you are unsure how your income should be treated, it is always worth reviewing it properly. Clarity here protects you far more than optimism ever will.

You may also find our guidance on What records do I need to keep for my Self Assessment, and What should I bring to my accountant for my tax return, helpful when reviewing related personal tax questions. For a broader overview of Self Assessment deadlines, reporting, and obligations, you can visit our self assessment guidance hub.