When an unincorporated business makes a trading loss, there may be some consolation to the sole trader or partner, if for tax purposes he or she may be able to claim relief for that loss by deducting it against other income and possibly obtain a tax refund. The tax legislation allows some flexibility over how that loss may be relieved, including the following possibilities:
- against any income of the same or the previous tax year;
- against future profits of the same trade;
- losses incurred in the first four years of trade may be relieved against income of the previous three years;
- where losses arose on the cessation of a trade, a claim may be made to deduct those losses from any profits from the same trade during the previous three years.
- if no or insufficient income in the year, trade losses may be claimed against capital gains of the same year;
- as there may be more than one way in which a loss can be relieved, care is required to make the most efficient use of the loss.
There are however certain restrictions to the amount of losses which may be relieved:
- If the trade is not being conducted on a commercial basis, i.e. with little likelihood of ever making a profit, there is a risk that none of the losses will be allowed. A recent tax case has demonstrated the importance of business plans to demonstrate viability.
- A “non-active” member of an LLP can deduct no more than £25,000 of his share of losses against his other income. Unrelieved losses may be carried forward for relief against future profits from the same LLP. Non-active for this purpose means spending less than 10 hours a week on the partnership’s business. HMRC have particularly queried whether members film partnerships are non-active.
- A sole trader who spends less than 10 hours a week on his business will also have each year’s losses capped at £25,000.
- Where the loss exceeds the amount of capital contributed by a member of an LLP, tax relief for the loss is restricted.
- From 6th April 2014 a further restriction limits the amount of losses or loan interest which qualify for tax relief to the higher of £50,000 and 25% of taxable income. This is of particular concern to investors in film partnerships where partnership profits often roughly match the interest paid on loans used to finance investment in the LLP. Unless the member has total income in excess of £200,000, the amount of loan interest which can be relieved for tax purposes will be limited to £50,000.
- Farmers have a special restriction which is designed to avoid giving relief to “hobby” farmers. The general rule is that the restriction denies relief for the current year’s loss to be set against other income if the farmer has made losses (before capital allowances) in each of the previous five years. However exceptions are made if either:
- the farming trade forms part of a larger trading undertaking;
- that a competent farmer would pass the test of a “reasonable expectation of profit” or
- the trade was started at any time within the previous five tax years.