In the early years of many businesses, it can be difficult to make a profit. It takes time to build up a customer base and whilst you’re doing that, outgoings can often exceed receipts.
If you trade through a company, any losses you accrue in the early years can generally be carried forward and used against profits arising once the business starts making money.
If you trade as a sole trader or partnership, losses can in theory be offset against your other income for that year, with only the excess needing to be carried forward.
In many cases, however, the ATO will restrict sole traders and partnerships from offsetting business losses against other income. Although intended primarily as an anti-avoidance tool to prevent people claiming losses from “hobby” or “lifestyle” businesses, these rules can also impact business start-ups.
If the anti-avoidance (“non-commercial loss”) rules apply, losses can only be carried forward and used against future profits of the same business. In some cases, that could mean that the losses are not absorbed for years. The cash flow disadvantages for affected businesses – which are effectively funding a loss-making business without tax relief – can be severe so it’s worth taking the time to ensure you aren’t caught by these rules.
There are two aspects to the rules.
The first, you can’t offset losses from your business against your other income if your other income for a year is $250,000 or more (unless the business is in the arts or primary production, in which case you can’t offset the less if your earn $40,000 or more). Your other income includes:
- Your taxable income (ignoring any business losses)total reportable fringe benefits amountsreportable superannuation contributions
- total net investment loss (from negatively geared properties for instance).
The second, you can offset the losses from your business against your other income if your other income is less than $250,000 but only if you pass any ONE of the following tests:
- The assessable income from your business is greater than $20,000 in the year of the loss
- The business uses real property (such as an office or warehouse) valued at greater than $500,000 as part of its activity
- The business has made a profit in at least 3 of the last 5 years, up to and including the current year
- The total value of other assets used in the business (excluding real property and motor vehicles but including trading stock, plant and equipment) is greater than $100,000 in the year of the loss.
If your business is in the arts or primary production, you can offset the losses from your business against your other income if your other income is less than $40,000 and you don’t need to pass any of the four tests.
You’ll see that all of these tests are geared towards weeding out businesses which are not genuinely run on a commercial basis, such as hobby businesses. The danger however is that businesses in the early stages of their existence (particularly where the owner has to hold down a job in order to keep the family finances afloat) can also find themselves failing the tests.
If that happens, there is a possible solution. You can apply to the Commissioner of Taxation for a special dispensation to disregard the non-commercial loss rules where special circumstances apply.
The most common situation in which the Commissioner would provide such a dispensation is where a business is affected by factors such as a natural disaster, or where the business is in its infancy and there is an expectation that the business will meet one of the four tests within a reasonable timeframe in the context of the norms for that industry.
You’d need to substantiate your case to the Commissioner, which might involve analysing your business compared to other comparable businesses to show that the lead time between start-up and profit is not unusual for that type of activity. If the Commissioner gives a dispensation, the losses can be offset against your other income.
Mark Chapman is director of tax communications at H&R Block.