An income tax loss can occur at any stage in your business whether you’re incurring initial costs to set up your business or hit trading problems at a later stage. And, the past couple of years, as we lived through the pandemic, showed just how vulnerable self-employed people and sole traders are to changes in economic conditions.
Although a loss is not good news for your business, you can make use of the loss to reduce your income tax liability. There are a number of options, as we’ll explain in this article.
However, there are many factors to take into account when choosing one of the available options. The decision can be complex depending on the circumstances of your business, so it may be important to take professional advice before making a final decision.
An income tax loss occurs when your allowable business expenditure and capital allowances are greater than your income in your accounting period.
Your accounting period runs from 1st January to 31st December
Your income is £15,000
Your allowable business expenditure is £8,500
Your capital allowances are £9,000
You have made an income tax loss of £2500.
There are a number of reasons why this can occur, including:
Lower level of sales while allowable expenditure remains the same
Increased costs because of price rises
Additional capital expenditure, such as new or replacement equipment
Additional overheads such as advertising or larger premises to grow your business
Loss of a major customer
Reduced income because of slow-paying customers
If you have recently started your self-employed business on a part-time basis while continuing to earn income from employment, you may be able to use any losses incurred in your business to reduce your income tax bill from employment.
The same considerations apply if you do occasional work on a self-employed basis while holding down a full-time job.
For example, you might be a semi-professional musician earning occasional income from gigs. Your costs, such as instruments, travel and sound equipment, count as allowable expenses and may exceed your income in certain years. Or, you might paint in your free time and sell paintings. Again, your expenses, such as materials, exhibition costs or agents’ fees, reduce taxable income.
There are four options:
Carry back a tax loss
Claim a tax refund against other income
Set a tax loss against any capital gains
Carry forward a tax loss
Note – If you use the cash basis for your accounts, you can only use the fourth option – carry forward a tax loss.
Two different options are available, depending on the length of time you have been running your self-employed business.
If you have been in business for more than one tax year, you can carry back your tax loss to the previous tax year and use it to reduce the tax liability for any profit you made in that year.
You made a profit of £9,000 in the previous tax year
You make a loss of £3,000 in the current tax year
You can reduce your previous year’s tax liability to £6,000
You can claim a refund of the tax you paid on £3,000
If you are new to self-employment, you can use any losses you make in the first four years of trading to reduce the tax liability for any profit you made in any of the previous three years.
If you are new to self-employment and make a loss in year two and four, with profits in the other two years, the situation becomes a little more complex and it is best to seek tax advice.
As the earlier section explained, you might have both employment and self-employed income in the same tax year. You might also have additional income from investments or interest on savings.
You can use any loss you make in your self-employed business to reduce your income tax liability for other income in the same year.
You earn £25,000 from employment and interest on savings
You make a loss of £3,000 on your self-employed business
You can reduce your income tax liability for other income to £22,000
You can also use that loss to reduce any other income tax liability in the three earlier tax years, starting with the previous tax year. You can then claim an income tax refund.
However, if your other income in the current tax year or any of the previous three years was below the personal allowance, you would not be liable for income tax. In those circumstances, you could not use the self-employment loss, so you would have to consider another option.
If you make a capital gain, for example by selling equipment or a vehicle, you can use your trading loss to reduce any tax liability on the capital gain.
You make a trading loss, where allowable expenditure exceeds income, of £2,000
You make a capital gain of £3,000
You can reduce the tax liability on the capital gain to £1,000
Note – if you have employment income in the current tax year, you must use the loss against that first.
If you don’t make a capital gain in your current tax year, you can use the loss to reduce the income tax liability on any capital gains in the three earlier tax years, starting with the previous tax year. You can then claim an income tax refund.
If you don’t use any of the previous options, you can choose to carry forward an income tax loss to reduce any profits from self-employment in future tax years. The future profits must be from the same business.
This option could be useful, if you forecast a significant increase in future profits because of new contracts or lower expenses.
However, you can only use this option against future profits from self-employment, not against any other form of income, such as salary from employment or interest on savings.
The major change is that for a temporary period of two years, income tax losses can be carried back as relief on profits made in any of the previous 3 years.
This temporary facility applies to trading losses incurred during accounting periods that end between 1st April 2020 and 31st March 2022.
This means that you can carry back unused income tax losses against profits made in the previous 3 years.
You must start with claims against any profits in the most recent 12-month period. If you still have unused losses, you can carry them back to the next two 12-month periods.
You have made a loss of £10,000 in your current accounting period.
You made a profit of £5,000 in the previous 12-month period.
You can offset the entire profit of £5,000, leaving an unused loss of £5,000.
You made a profit of £3,000 in the next 12-month period.
You can offset the entire profit of £3,000, leaving an unused loss of £2,000.
You made a profit of £7,000 in the last of the 3 earlier 12-month periods.
You can offset £2,000 against the profit of £7,000, reducing your income tax liability for that period to £5,000.
This is a brief outline of the process of claiming relief on income tax losses. If you would like professional advice on any aspect of the process, or would like confirmation that you are complying with HMRC’s rules, our team of experienced tax accountants will be glad to help.