It's common for small businesses, any business for that matter, to run at a loss in the first few years of operation as the business is established, staff are trained up, customers are found, etc. The question is, can you claim a tax deduction for these losses at some stage, or are they lost forever?
The treatment of losses is a little different depending on the structure through which the business is run, here we'll take a look at two popular choices.
Can you claim the loss straight away against your other income, or does it need to be quarantined and only used against future income from the business? A common question asked by people with a day job is whether or not they can claim the loss from a side-gig against their wage income to, hopefully, generate a tax refund at year end. The answer to this question is, sometimes. In the words of the ATO: "You can't claim a loss for a business that is little more than a hobby or lifestyle choice. Even if it has business-like characteristics, if it is unlikely to ever make a profit and doesn't have a significant commercial purpose or character, you can't offset the loss against your other income. In this case, you can defer the loss until you make a profit from the business."
How can they tell if it is "little more than a hobby or lifestyle choice"? That's where the non-commercial loss rules come into play which outline the following criteria which dictate whether you can claim the loss against other income in the year the loss was incurred, or whether the loss will need to be quarantined and carried forward to only be used against future profits generated by the business.
- Are you carrying on a business? This means that hobbies do not count.
- Similar business activities. If you're running more than one business and they are similar they can be grouped together when applying these rules, but if they are different in nature they will need to be considered separately.
- Excepted activity. If your business is in primary production or the professional arts and your assessable income from other sources (e.g. your day job, investment income, etc.) is under $40,000 you can claim the business loss against this other income without needing to satisfy the other tests. Create for creative industry businesses that start as a side hustle.
- You must be earning less than $250,000 - this is known as the income test and looks and not just income, but fringe benefits and a few other things.
- Tests - if you've satisfied the above criteria, you just need to pass one of these:
- Your business earned at least $20,000 in assessable income during the year.
- Your business has made a profit in at least three of the last five years (including the current year).
- Real property, worth at least $500,000, is being used in the business on a continuing basis.
- Other assets, worth at least $100,000, are being used in the business on a continuing basis.
- If all else fails, you could apply for the Commissioners discretion to get the deduction (though I wouldn't hold your breath).
So, if you can meet the criteria you can claim a tax deduction for the business losses against any other income you may have earned in that year. If there is an amount left over it will be carried forward as a tax loss that can be used as a tax deduction against any income you may earn in a future year.
If you can't meet the criteria then you'll need to carry the losses forward into future years with them being quarantined so they can only be used as a deduction against your business activities, and not any other income being earned. As you can see, having them as tax losses, rather than quarantined losses, is preferable as you can claim them against any income, rather than being restricted to business profits only.
Whether or not carried forward losses can be used as a tax deduction in a company will depend on meeting one of two tests. Those tests are ...
- Same ownership and control - if the business is under the same ownership and control this year (i.e. the year you want to claim the deduction) as it was when the loss was originally incurred, then this test is passed and the losses can be deducted to reduce the current year profit. Control can be shared and is met when an owner, or group of owners, have more than 50% of the voting power in the company. There is an alternative to this test for when it's reasonable to assume that a person, or group of persons, have control of 50% of the voting power in the company regardless of who owns what.
- Same business test - if the business is carrying on substantially the same business this year (i.e. the year you want to claim the deduction) as it was in the year the loss was originally incurred, then the test is passed and you can claim a tax deduction.
To answer the question in the title of this post - sure, most of the time small businesses can claim a tax deduction for losses incurred in their business, however, it's not always clear cut especially when it comes to the timing of the deduction. If you'd like to have a chat to someone about the taxing issues facing your business, why not get in touch today? We'd love to help.