Trading Losses for Self Employed- How are losses treated.
PART ONE. Carry Forward Trading Losses in Self Employment.
As accountants in Hammersmith we are asked how losses in a self-employed business are treated for income tax purposes that relates to Sole Trader or Partnership income. Hammersmith Chartered Accountants will explain how the law interprets to tax losses and how they are treated in tax law. This article will describe the way tax losses are treated and how they can be offset against other income in the same tax year or backdated against previous years profits or carried forward and relieved against future income tax profits.
If a self-employed person’s adjusted trading profit for a period of account is negative or a minus figure in the accounts, then a trading loss has been incurred. This has two main consequences:
- The person’s trading income for the relevant tax year is set to nil and
- The tax relief may be claimed in respect of the loss. Several forms of tax relief are available, and each involves offsetting the loss against other income or capital gains of the personal, sole trader or partnership concerned, so reducing the amount of tax payable on that income or capital gains. This article also explains a restriction which applies to the total amount of certain tax reliefs (mainly loss reliefs) that may be claimed by an individual in any tax year.
Tax Relief for Trading Losses for Sole Traders and Partnerships
The rules which grant tax relief in relation to trading losses are to be found in the Income Tax Act 2007. This Act provides the following main reliefs:
- Carry-forward trade loss relief. A trading loss may be carried forward to future tax years and set against subsequent profits of the same trade.
- Trade loss relief against total income. A trading loss may be set against the trader’s total income of the tax year in which the loss is incurred and/or the previous tax year.
- Early trade losses relief. A trading loss incurred in any of the first four tax years in which the trade is chargeable to income tax may be carried back and set against total income of the previous three tax years.
- Terminal trade loss relief. A trading loss incurred in the final 12 months of trading
may be set against profits of the same trade in the year of cessation and the previous three tax years. Each of these forms of loss relief is described in this article written by Hammersmith Chartered Accountants who are accountants in Hammersmith specialising in small to medium sized businesses.
Each of these forms of tax relief is described in this article.
Tax Relief To be Claimed from Carrying Forward Losses in Self Employment
Carry-forward trade loss relief on a claim under section 83 Income Tax Act 2007 states a trading loss may be carried forward and relieved against future profits. It is important to note the following points.
- Carry-forward tax relief on losses is offset against future trading profits.
- Tax relief is given only against future trading profits arising from the same trade as that in which the loss incurred. Therefore, is a trader ceases one trade and commences another, the losses of the old trade cannot be carried forward and relieved against the future profits of the new self-employment trading business. Similarly, if a trader carries on two trades simultaneously, a loss incurred in one of the trades cannot be carried forward and relieved against the future profits of the other trade.
- Tax relief must be given against the first available trading profits that arise in the future. The maximum possible relief must be taken in each year until the loss is fully relieved, even if this leaves insufficient income to absorb personal allowances.
- Strictly speaking, tax relief is given by deduction from the trader’s total self-employment income when calculating his or her net income but the amount of tax relief given in any tax year cannot exceed the trading profits for that year.
- Any claim to carry forward a trading loss under section 83 must be made within four years of the end of the tax year in which the loss first arises.
Capital allowances claimed for a period of account are treated as a trading expense of that period. Therefore, capital allowances are included automatically in the calculation of a trading loss. It is important to remember that it is not mandatory to claim the maximum capital allowances available for a chargeable period. If a trading loss has been incurred it may be advisable to claim less than the maximum capital allowances or even none at all so as to avoid wasting personal allowances when the trading loss is relieved. It is important when seeking advice from an accountant in Hammersmith who has knowledge and expertise in income tax losses and how the law works around this subject. Disclaimed capital allowances are not lost permanently, since higher writing down values are carried forward than would otherwise have been the case and this results in higher capital allowances in future years.
Trade loss relief against total income carrying trading losses forward for relief against future profits of the same trade does not always provide the most satisfactory form of loss relief. Problems associated with carry-forward relief include
- Loss relief is delayed until sufficient profits arise from the same trade in future years if indeed they ever do.
- The trader has no control over the amount of tax relief given in each year and therefore personal allowances may be wasted.
- If tax rates are falling, tax relief may be given at a lower rate than the rates which were in force when the loss incurred. An alternative form of loss relief which overcomes some of these problems is “trade loss relief against total income”. If claimed, this tax relief allows trading losses to be set against the trader’s total income for a period of up to two years.
- It is important to note that there is no obligation to make a claim to set trading losses against total income. If not such claim is made, a claim may instead be made to carry the trading loss forward against future trading profits.
- Similarly, any unrelieved losses remaining after a claim has been made to set trading losses against total income may be carried forward against future trading profits.
- Trading losses may be set against the trader’s total income only if the business is being carried on “a commercial basis” and “with a view to the realisation of profits”. Furthermore trading losses may not be set against total income if they arise in consequence of tax avoidance arrangements.
- In the case of farmers and market gardeners, a loss is usually not eligible for tax relief against total income if losses have also been incurred in each of the previous five tax years.
- If a claim is made to set trading losses against total income, tax relief is given by deducting the amount of the claim from the trader’s total income when calculating his or her net income. Relief is given against non-savings income, savings income and dividends in the way which results in the lowest tax liability. Income tax Act 2007 uses the term “sideways relief” to refer to the relief of trading losses against total income. This term is also used in connection with early trade losses relief. The amount of “sideways relief which may be claimed by a “non-active” trader in relation to a trading loss is limited and there are restrictions on the total amount of certain income tax reliefs that may be claimed by an individual in a tax year.
Articles – Part two and part three are available shortly.
Article written by Hammersmith Chartered Accountants.