What is a business loss for tax purposes?
If the total deductible expenses for your business are greater than its income then it will have a loss for tax purposes. The business will not have to pay tax and the loss can generally be used to reduce income in future income years. The rules for using losses depend on whether the business is run through a company, trust or as a sole trader.
Loss from one or more activities
If you have a loss from:
- running a business or
- from investments, or
- from a rental property
- Then IRD will automatically exclude it from your income for Working for Families Tax Credits (WfFTC) and student loans.
This means that a loss won’t reduce your income for the purposes of working out your WfFTC entitlement or your student loan repayment obligation.
Show the net result in your individual income tax return (IR3)
If you’ve offset a loss or losses against another income and only shown the net result in your IR3, you’ll need to tell IRD the details. You only need to tell IRD the amount of a loss if you have:
- made a loss and profit from two or more unrelated businesses or investment activities, and
- have entered the net amount in only one box on your IR3
What operating at a loss means
Operating at a loss is when you’re spending more money than is coming in to the business. Businesses often operate at a loss temporarily when starting out or in periods of growth. This is okay if you’ve got enough in the bank to cover the costs of running your business until your income picks up. But if your business is frequently operating at a loss because of slow sales, you’ll need to make some changes to how your business is running. Think about consulting an advisor to help you turn things around.
You will know that you may be operating at a loss when:
- You don’t have enough money to pay your bills.
- Your bank balance is negative and you don’t know how to get it positive again.
- You’re not selling the amount you needed to in your forecast, e.g. if your business model is reliant on selling ten cups of coffee a day and you’re selling three.
What to do if you’re operating at a loss
Try these 3 steps:
- Reduce your expenses.
- Is there anything you can cut from your spending?
- Can you reduce the amount of drawings you’re taking from the business?
- Try to negotiate better deals from your suppliers.
- Sell assets you’re no longer using.
- Increase your sales.
- Can you charge more for your product or service?
- How can you sell more of your product or service?
- Can you get more customers?
- Get advice — an advisor may be able to help you turn it around.
Advice from an accountant or business advisor can help you get your business back on track and avoid trouble ahead.
Claiming losses at tax time
If you claim a loss in your tax return, you can carry it forward to lower your income in the next tax year — and therefore reduce your tax bill.
a) Sole traders and partnerships
Report the loss in your Individual tax return (IR3). Inland Revenue will then let you know the amount that can be carried forward to the next tax year. If the loss is greater than your income, the difference can be used to lower your taxable income in following years.
In most cases, companies operating at a loss don’t have to pay income tax. A company may be able to transfer its loss to another company, or carry the loss forward to future years.
To carry the tax loss forward, you’ll need to:
- report it in your company’s Income tax return (IR4)
- meet the shareholder continuity test — a group of shareholders must have combined voting interest of 49% or more from the beginning of the year the loss was incurred to the end of the year it’s offset
Companies need to calculate voting interest in a specific way. And groups of companies looking to bring losses forward may be prevented from doing so by being in a ‘market value circumstance’. If you’re considering bringing losses forward for tax purposes, you should consult a tax adviser to ensure your losses are correctly utilised.
Common mistakes when running at a loss
Avoid these common pitfalls:
- Having your head in the sand about being in a loss position.
- Not having a plan in place to get back out of it.
- Purchasing things you can’t pay for — if you go to a supplier when you know you can’t pay the invoice, you’re operating in an insolvent position and can be made bankrupt.
What is an ‘ Operating Loss?
An operating loss (OL) is a loss taken in a period where a company’s allowable tax deductions are greater than its taxable income. When more expenses than revenues are incurred during the period, the net operating loss for the company can carry forward and used to reduce future tax bills. The reasoning behind this is that companies deserve some form of tax relief when they lose money, so they may apply their current operating loss to future income tax liabilities, reducing the need to make payments in future periods.
An OL makes a company unprofitable for tax purposes. For example, in year 2016, Company A has taxable income of $500,000, expense deductions of $700,000 and a company tax rate of 28%. Its tax loss is therefore $500,000 – $700,000 = -$200,000. Because Company A does not have taxable income for 2016, it does not pay taxes in their 2016 year.
Otherwise it would have paid $200,000 x 28% = $56,000 in taxes. Because the company also had a tax loss in their previous year, it could also have put that past loss toward the current year’s tax and carry forward any balance of past losses still remaining.
When the IRD can classify your business as a hobby
If your business claims a net loss for too many years, or fails to meet other requirements, the IRD may classify it as a hobby, which would prevent you from claiming a loss related to the business. If the IRD classifies your business as a hobby, you’ll have to prove that you had a valid profit motive if you want to claim those deductions.
Inland Revenue allows you to take a tax deduction for legitimate losses incurred in the operation of your business. However, if your business claims a net loss for too many years, or fails to meet other requirements, they may conclude that you are not in your business to make genuine profit so can move to classify it as a hobby. A hobby classification would prevent you from claiming a loss related to the business. If your business is determined a hobby, you’ll have to prove to IRD that you have a valid profit motive if you wish to claim those deductions.
The IRD expects that if you start a business, you intend to make money at it. If you don’t, your business is likely to be only a hobby. To determine if your business is a hobby, the IRD looks at numerous factors, including the following:
- Do you put in the necessary time and effort to turn a profit?
- Have you made a profit in this activity in the past, or can you expect to make one in the future?
- Do you have the necessary knowledge to succeed in this field?
- Do you depend on income from this activity?
- Are your losses beyond your control?
Inland Revenue’s rule
There is no set procedure to show whether your business is not a business but a hobby. Each business is different from the next. However, your intentions and motives are important in any determination by IRD. The general rule is that if you have not turned a profit in at least 3 – 5 years, IRD will initially categorize your business as a hobby. This may be extended depending on the type of business you have.
Once IRD classifies your business as a hobby, you won’t be allowed to claim any losses except in certain limited situations. Running a hobby as a business could trigger an IRD audit. If your business is legitimate, keeping accurate and extensive records would help prevent the classification of your business as a hobby. In addition to demonstrating your professional approach to your business, records and receipts can help document your profit motive. A written business plan is often a prerequisite for indicating an intent for profit, and it can also show ways in which you are modifying your business to cope with losses.