If you are setting up a new business, you may discover that establishing a profitable base takes time. If your pre-trading planning discloses an initial loss making period, you may want to take advice about the business structure you adopt.
For example, if you set up the business as a company, the early year’s losses can only be carried forward to set off against future profits.
Alternatively, if you set up the business as a sole trader (or certain partnerships) there is a possibility of setting the initial trading losses against your other earnings. In this way you could recover the tax relief much faster than waiting for a company to become profitable.
This would be especially beneficial if you have paid income tax on other earnings at the higher rates as the early trading losses would create tax refunds at your marginal rates (40%, 45%, or perhaps 60% if your other income exceeds £100,000). Losses carried forward in a company would only reduce any future liability at corporation tax rates, currently 19%.
Deciding on the optimal structure for a new business is not a process that you should contemplate without taking professional advice. There are many pitfalls waiting for the unwary entrepreneur. We have listed below a few examples of the restrictions you would need to consider. It is unlikely that you could claim to set losses against other income if you:
use the cash basis for working out your tax
don’t run your trade commercially and for profit, for example if your trade is run as a hobby
are a farmer or market gardener and you also made a loss (worked out for this purpose only before capital allowances are considered) in each of the previous 5 tax years
The amount of loss relief you claim against income or capital gains may be restricted or limited for example if you:
worked for less than 10 hours a week on average on commercial activities of the trade
are a Limited Partner or a member of a Limited Liability Partnership
have a trade which is carried out wholly overseas
have claimed certain capital allowances
have income from oil extraction activities or oil rights.
However, there is some merit in the strategy outlined in this article. If you are thinking about a new business, and you are more than likely to make losses in the early years, then you may be able to make best use of any tax losses by being a sole trader in this early period. You will need to consider other commercial factors, such as the exposure to your personal assets of business risks.
We can help you explore your options.