How to get tax relief for trading losses when you’re self-employed
How to get tax relief for trading losses when you’re self-employed
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Running your own business is no doubt a lot of elbow grease and resilience. Despite the best of efforts however, trading losses can still occur, and at times can be due to external factors that we have little control over. Even the most established of businesses can suffer from trading losses. If you’re self-employed and operating as a sole trader, it’s important to learn how to get tax relief for trading losses so that you can offset the loss against other income and alleviate any financial deficit.
What is trading loss?
Trading loss is when the money earned from your business is less than the money you have spent on running your business. It’ll mean that you haven’t made any profit and it has cost you to keep your business open. This can sound alarming, but trading losses are not unusual, and perhaps even expected in certain situations. For example, one of the most common times the self-employed suffer from trading loss is in the first year of starting up the business. This is because you often have to put up the initial investment of purchasing equipment or paying for advertising, and it can take some time to drum up enough customers or clients to start making a profit. In fact, on average, small businesses report taking between 2 to 3 years before they start to see a profit. Sometimes it can take even longer. In the case of Amazon, it took a decade before Jeff Bezos recorded his first profitable year for the company! So, if you are facing trading losses be sure to claim the tax relief which will help the business keep going until it can make a profit.
Why tax relief is available for trading losses and why it’s important to claim tax relief for trading losses
You may be wondering why tax relief is available for trading losses when there is no tax liability due. Whilst it’s true that you only pay tax when you make a profit, the government offer tax relief to struggling businesses in the hope that they will survive until they are more profitable. For that reason, we would argue that it’s always worthwhile claiming for tax relief available, and it can potentially make a real difference when it comes to helping you be able to run your business for longer.
How tax relief is offered when carrying forward trading losses
The default position for tax relief when there are trading losses is to carry those losses forward to offset against profit in a future year. This only applies so long as the losses are offset against the profits from the same trade. So, if you became a self-employed handyman and suffered trading losses, then switched your business to cleaning, you wouldn’t be able to claim any tax relief, even if you are profitable as a cleaner.
You are able to carry forward your trading losses indefinitely, as well as accumulate trading losses for every loss-making year, but the tax relief must be applied to the first available year in which you make a profit. If you have not made enough profit for all the trading losses to be used then any remaining amount can also be carried forward to the next available profitable year. When carrying forward trading losses for tax relief against future profits, you are able to use either the accruals accounting method or cash accounting method (see our article on how to complete your own bookkeeping if you want more information on what this means).
As an example, in the tax year 2020/21 your upholstery sole trader business makes a trading loss of £9,000 because you buy new upgraded materials. You have no other income as you are fully self-employed, so you carry forward your losses. In 2021/22, you make a profit of £5,000 and this amount is deducted from your 2020/21 losses. You have no income tax to pay for the tax year 2021/22. In 2022/23 you make a profit of £15,000 and the remaining £4,000 from your 2020/21 losses is deducted. £15,000 minus £4,000 leaves £11,000 as taxable income. However, you can then factor in your personal allowance of £12,570 which means no income tax needs to be paid (you will still need to pay Class 2 and Class 4 national insurance contributions).
How tax relief is offered when trading losses are offset against other income in the current year
One option to be able to claim tax relief faster is to offset your trading losses against other income in the current tax year in which the losses were suffered. This is known as ‘sideways relief’. It does of course rely on you to have other sources of income, so if your only income is your self-employment earnings, then you will not be able to do this. However, if you are both employed and self-employed, then you may be able to reduce the tax you have paid via PAYE from your employment by offsetting your trading losses against employment earnings. You must be using the accruals method to calculate your trading losses if you want to claim tax relief on trading losses against other income in the current tax year. We would only recommend you go down this route if you have sufficient employment income which exceeds your personal allowance.
This is because, if you do not use your full personal allowance, you will lose any remaining amount as it cannot be carried forward. For example, you have trading losses of £5,000 from your sole trader business but you are also employed part-time and earn £15,000 a year. £12,570 of your salary is tax free which means only £2,430 is liable to income tax. If you choose to claim sideways relief from your trading losses, then your earnings are reduced to £10,000 and you lose out on using £2,570 of your personal allowance. However, if your PAYE earnings are more – for example £20,000 then you could use both your full personal allowance and your tax relief for trading losses, therefore only needing to pay tax on £2,430 (which is £486 at the 20% basic rate).
If you do not have any PAYE income, but you have other income such as investment dividends or rental income, then you can still use sideways relief to offset your trading losses.
How tax relief is offered on trading losses when offset against capital gains tax for the current year
Alternatively, you can also get tax relief for trading losses by offsetting the loss against any capital gain you may have made in the current year. This option is only available to you if you have no other income in the current year that you can offset the loss against. If you do have other income, then your trading losses must be offset against that first and then any remaining amount can be offset against your capital gain. You must be using the accruals method to calculate your trading losses if you want to claim tax relief on trading losses against other income in the current tax year.
An example of this is where you have self-employment trading losses of £10,000 but you also took on a zero-hour contract job and made earnings of £2,500 the same year. Although this is under the personal allowance threshold, your trading losses must be offset against income first so £2,500 is deducted from your £10,000 losses. In the same year, you also sell some shares and make capital gains of £8,000. This is reduced by your remaining £7,500 of trading losses, leaving only £500 subject to capital gains tax. However, even without the offset of trading losses, no capital gains tax would have been due as the capital gains tax allowance for the tax year 2022/23 is £12,300 (although this is due to be reduced to £6,000 in April 2023). It would therefore not be advisable to offset your trading losses against income and capital gains in this way as you would miss out on making full use of both your personal allowance and capital gains tax allowance. On the other hand, if you had no other income and made a substantial capital gain, then offsetting your trading losses in this way could be beneficial.
How tax relief is offered when trading losses are offset against income or capital gains from the previous year
One last option is available if you are unable to claim tax relief in the current year and do not want to carry your losses forwards. You are only able to use this route if you received income or had capital gains in the previous 12 months from reporting your trading losses and you must be using the accruals accounting method to record your losses. This can be the most beneficial way to realise tax relief where you have sufficient income or capital gains in the previous year and you would prefer to receive a cash rebate.
To provide an example to illustrate, you invested heavily in your business in the tax year 2022/23 but unfortunately suffered trading losses of £45,000. You have no other income in the tax year or made any disposals. In the previous year however, business was better, and you made £25,000 profit. In addition, you sold a residential investment property and made a capital gain of £35,000.
£25,000 from your 2022/23 trading losses can be offset against your 2021/22 income first which means you would receive a tax rebate of £2,486 (this is the tax you would have paid on your income as a basic rate income taxpayer).
The remaining £20,000 of trading losses can then be offset against your capital gain reducing your previous year’s gain to £15,000. You would have already paid £4,086 capital gains (£35,000 minus £12,300 which is the annual capital gain allowance, then multiplied by 18% for the basic income tax rate for residential property). The capital gain tax due on £15,000 however, is £486. You therefore receive the difference back on the capital gains tax you originally paid which would be £3,600. In total, you would receive £6,086 back in cash as tax relief for your £45,000 trading losses. It’s important to note that your actual rebate may be higher as this calculation only takes into consideration income and does not factor in NI contributions.
How tax relief is offered when trading losses occur within the first 4 years of self-employment
An exception to the carry back rule is where you are newly self-employed. As trading losses are not unusual for new start-up businesses, HMRC offer an extension on the tax relief available if you have only just begun to work as a sole trader. Again, you will need to be calculating your losses using the accrual accounting method to claim tax relief against previous years.
This method for claiming tax relief on trading losses only applies to income and does not apply to capital gains tax. To be eligible to claim for tax relief in this way, you must have been working as a new sole trader business for no more than 4 years. Any loss suffered within that time period can be carried back up to the maximum of the three years immediately after the loss-making year. Tax relief is calculated from the earliest year first.
For example, you became self-employed in the tax year 2019/20 where you managed to break even. The follow year of 2020/21, you made a small profit of £1,000. In the current tax year of 2021/22, you suffer trading losses of £4,000.
You would offset the £4,000 of trading losses against last year’s profits first, so £1,000 is deducted from your trading losses. You would not have paid any income tax on the profit last year as it is below the personal allowance threshold so will not receive any cash rebate. The year prior, you also paid no income tax because you broke even. In the tax year 2018/19 you were employed and had PAYE income of £21,000. You would be able to offset the remaining £3,000 of trading losses against this income.
You would have paid £1,830 in income tax on your PAYE earnings in 2018/19 but your income will be reduced to £18,000 once the trading losses have been applied. £1,230 in income tax should be paid on £18,000 and therefore you receive the difference of £600 back in cash as tax relief.
How tax relief is offered when trading losses occur in the year you cease trading
Similarly, if you make trading losses in the year that you end your sole trader business, HMRC also offer an extension. You are able to claim tax relief by offsetting your trading losses from the three immediate years prior to your business closing; from the latest year first. You can calculate your loss using either the cash method or accruals method.
We will use the example that you have been a self-employed carpenter but are now looking to retire. You decide to stop trading in the year 2021/22 and when completing your final accounts, you calculate that you have trading losses of £8,000. You can claim tax relief for this loss by offsetting it against your previous year’s profits of £22,000. Your tax bill for 2020/21 would therefore have been £1,886 but once you offset your trading losses against your earnings, you would recalculate that you only need to pay tax on £14,000 of earnings (£22,000 minus £8,000). The income tax due on £14,000 is £286 which means you have overpaid taxes of £1,600. By claiming tax relief on your trading losses, this amount will be repaid to you in cash. This calculation is based solely on income tax and you may receive a bigger rebate depending on your NI contributions made.
How to claim tax relief on trading losses
Once you have determined how you want to offset your trading losses, to claim the tax relief available, you will need to complete a self-assessment tax return. You can complete the SA103S short form if your earnings are under the VAT threshold, but will have to complete the SA103F full form if your earnings are over the VAT threshold. For both forms you will have to enter your figures and calculations. Make sure you read the supporting notes, as it will tell you which box to use depending on how you want to claim your tax relief.
Get help with claiming tax relief for trading losses
One of the trickiest parts of claiming tax relief for trading losses is the calculations. If you’re looking to get help with claiming trading losses relief, then why not speak to one of our tax accountants who can support you by helping you complete your tax calculation and submit your self-assessment tax return? They will also be able to advise you on which method of claiming your trading loss relief would be most beneficial for your individual circumstances. Use our online form to book in for a consultation today.
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