Malcolm Finney explains how to maximise cashflow by efficient trading loss usage.
No sole trader deliberately sets out to make trading losses but, typically, for many they are almost inevitable, particularly in the early years of trading.
Carry forward versus carry backwards?
Trading losses can be carried forward indefinitely and set off against future trading profits, thus reducing the income tax charge on any such profits. Unfortunately, the monetary value of the losses is in principle lessened the further in the future that they are able to be utilised.
Example 1: Trading losses carried forward
Joe Blue finds that in each of his first four tax years of operation (2014/15, 2015/16, 2016/17 and 2017/18) he makes trading losses of £15,000, £12,000, £5,000 and £1,000 respectively.
In the four following tax years, his trading profits are £3,000, £5,000, £7,000 and £10,000.
His aggregate trading losses of £33,000 can be offset against the trading profits of the succeeding four tax years of trading profits but even so, eight years after Joe started his business, he still has £8,000 of unutilised trading losses.
Thus, for those sole traders (such as Joe) who make trading losses in their early years of operation, there is perhaps little comfort knowing that income tax charges may be reduced in the future. It is at the time the losses are incurred that the sole trader would ideally like to use them, to reduce any tax bill and enhance cashflow.
Perhaps surprisingly, the tax rules go one better, and in fact allow income tax paid before commencing a sole trader business to be repaid!
Carry-back of trading losses
Where a trading loss is incurred in any of the first four tax years of trading, the loss may be carried back and offset against the trader’s ‘total income’ of any of the immediately preceding three tax years (offset against earlier years first).
‘Total income’ refers to a trader’s income for the relevant tax year comprising the aggregate of all categories of income. Such categories include employment income, rental profit, bank interest, dividend income, etc.
Such a relief offers the new sole trader significant tax savings at the earliest possible opportunity.
Example 2: Trading losses carried back
Joe Blue (see Example 1 above) prior to setting up as a sole trader was an employee with total income (most of which comprised Joe’s salary) in the tax years 2011/12, 2012/13 and 2013/14 of £15,000, £16,000 and £17,000 respectively.
Instead of carrying his trading losses forward, Joe decides to carry them back.
Accordingly, Joe offsets the £15,000 trading loss of 2014/15 against his total income of £15,000 for 2011/12. The £12,000 trading loss of 2015/16 is offset against his total income of £16,000 for 2012/13. The trading loss of £5,000 of 2016/17 is offset against the unused total income of £4,000 for 2012/13 and the balancing £1,000 against the total income of £17,000 for 2013/14.
Consequently, Joe is able to obtain a refund of income tax he paid in each of the tax years 2011/12, 2012/13 and 2013/14.
However, Joe’s trading loss of £1,000 for the tax year 2017/18 can only be carried forward for offset against future trading profits because in each of the prior three tax years (i.e. 2014/15, 2015/16 and 2016/17) there is no total income against which such losses may be offset.
For Joe, the carry back option is vastly superior to the carry forward option and, in particular, in addition to tax savings offers him significantly improved cash flow at a time when he no doubt desperately needs it.
Carry-back cap
For the tax year 2013/14 and later tax years, a cap was introduced which placed an upper limit on the extent to which relief could be claimed. The cap is the greater of £50,000 and 25% of total income. In Joe’s situation the cap is inapplicable, and for many sole traders is unlikely in practice to prove a problem.
When not to carry losses back
If marginal income tax rates are set to increase significantly in future tax years and prior tax years’ rates were relatively low, it may be more tax-efficient to simply carry forward any trading losses.
Practical Tip:
Setting up a company rather than operating initially as a sole trader means that trading losses are locked into the company, thus precluding any carry back and early tax relief. Other things being equal, consider commencing trading as a sole trader.
