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Trading losses and how to plan for them – sole traders

Most businesses, particularly in their early development, experience years when they lose money. However, it’s possible to use these losses to reduce your future income tax bills or to receive a refund from HMRC based on income tax you’ve paid across in previous years.

This week, TWP Accounting looks at how sole traders can use their trading losses to their advantage and the options that are open to you if you choose to do so.

Accruals versus cash accounting

There are many different ways to explain what the differences are between accruals-based accounting and cash-based accounting but the simplest way to do so would be:

  • accruals accounting records transactions when an invoice is issued to or from you regardless of when you receive or make payment
  • cash-based accounting records transactions when you make or receive payment regardless of when an invoice is issued to or from you.

For the purposes of using trading losses in your particular business, all of the methods we outline below can be utilised by you if you use accruals-based accounting. If you use cash-based accounting, you’re only allowed to use the “carry forward” method.

Trading loss – a definition

A trading loss is when the amount of money you’ve spent on your expenses and on your capital allowances is greater than the turnover you’ve brought in.

TWP tip – sole traders are allowed to spend up to £150,000 on equipment, machinery, and business vehicles which can then be included as general trading costs for profit and loss purposes. In other words, you can deduct these items as expenses to lower your tax liability when you’re in profit.

For this article, we’re going to look at the example of a sole trader whose turnover was £20,000 but who spent £17,500 on expenses and £10,000 on capital allowance items. This would mean that our sole trader would show a loss of £7,500 for the year.

Please bear in mind that HMRC will want you to prove that you are actually a sole trader. They do this by examining your personal situation against their “badges of trade” tests. The taxman uses these badges to determine whether what you’re doing is actually a business or a hobby.

If it’s a business, you will be able to claim against your losses but you will have to pay tax when you make a profit above certain thresholds. If it’s a hobby, you won’t be able to claim back your losses but you won’t have to pay taxes on any gains you make.

What to do with a trading loss

There are five things you can choose to do with any trading loss that you make. If you want help choosing the best one for you, please do give us a call.

Please bear in mind that there is a maximum amount that you can claim back equivalent to whichever is greater of 25% of your annual income or £50,000. For sole traders spending less than 10 hours a week on their business, that maximum loss you can reclaim goes down to £25,000.

Claim a loss this year if you are on a salary as well

Every taxpayer earning less than £100,000 gets a personal tax-free allowance of £11,850 per annum.

Therefore, if our sole trader lost £7,500 that year and they earned £11,850 from their job, there would be no benefit in claiming the loss because they would have paid no tax that year.

However, if our sole trader earned £25,000 in a year at their job, they would pay 20% tax on the amount over £11,850. So that’s 20% of (£25,000-£11,850 which equals) £13,150 = £2,630. They could claim that £7,500 loss to bring the £13,150 down to £5,650. 20% of £5,650 is £1,130. That means that a refund of £1,500 would be due to them (£2,630 minus £1,130).

Get in touch with your TWP accountant to find out how to make that claim.

New business losses if you were salaried in previous years

You can claim back up to the last four years against any business losses. You have to use the earliest years first when you’re making a claim.

Tax Year Self-employed profit or loss Income from employment
2015-2016 £30,000
2016-2017 £30,000
2017-2018 £15,000
2018-2019 -£15,000

In this example, our sole trader has lost £15,000 in their first full year of trading. They can carry back that loss however they must begin with the 2015/2016 year in which they earned £30,000 from their job.

In the 2015/2016 tax year, they would have paid £3,880 in tax on their earnings of £30,000. Had they earned £15,000 (that’s the £30,000 wage from 2015/2016 minus their 2018/2019 self-employed tax loss), they would have paid £880 in tax. Our sole trader will therefore be due a refund of £3,000 in income tax.

Claiming losses in your final 12 months of trading

If a sole trader suffers a loss in their last twelve months of trading, they can use that loss to offset against profits made from the same trade in the last three years. These rules can be quite complicated so please do get in touch with your TWP accountant for assistance.

Carrying forward losses

If there is no financial advantage to you in claiming for tax losses against previous years, you can carry losses forward to the future.

For example, for our sole trader who lost £7,500, he or she can carry that forward to this year if they expect to make a profit. Let’s say that they expect to make a £40,000 profit this year. £40,000 would result in an income tax payment of £5,630. However, if they chose to round the £40,000 down to £32,500 by using their £7,500 loss in the previous year, income tax due drops to £4,130, meaning they pay £1,500 less in income tax by using that loss.

We can help

If you’d like help on how to use trading losses to offset against past or future profits, please call us today on 01932 704700.

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