If you start a business in your own name (or partnership) you may not be able to claim losses you make against other income. There are special rules called non-commercial loss rules or tests.
How the non-commercial rules work
If your business loss is allowed (i.e. you pass the non-commercial loss tests), you claim a loss from your business which will reduce your taxable income.
If you don’t pass the tests your loss from the business is deferred (added back in your tax return) until you make a profit from that business (or never if you don’t make a profit from that business).
What are the non-commercial loss tests?
The tests (which you only have to pass one of) are:
- $20,000 of income (or sales)
- Profit in the last 3 of 5 years (not possible if you have only started a business)
- Assets of $500,000 used to run your business (including your home)
- Assets of $100,000 used to run your business
High income earners
From 2010, the government has disallowed those with salary over $250,000 to claim business losses, regardless of whether they pass the non-commercial loss rules.
Example: The $20,000 assessable income test
E.g. Sam earns $60,000 working full time, but decides to start a business selling Coffee beans he has purchased from Colombia in his spare time.
In Year 1 – Sam makes sales of $2,000 and a loss of $10,000 in his first year. However, because Sam hasn’t passed one of the tests he can’t claim the loss against his other income. ($20,000 sales, profit in the last 3 of 5 years, $500,000 assets business assets including a home or $100,000 other assets).
Year 2 – Sam makes $13,000 sales, but a loss of $3,000 – so he can’t claim his losses again (he now has $13,000 deferred losses).
Year 3 – Sam makes $17,000 sales and a profit of $4,000. He can reduce this to zero against previous losses. However, because Sam hasn’t passed a non-commercial test he will still have deferred losses of $9,000.
Year 4 – Sam makes $21,500 sales (excluding GST) and a loss of $1,000. Despite Sam’s loss, he has now passed a non-commercial test and can claim all losses. So he can claim $1,000 loss from this year plus $9,000 from previous years (being $10,000 year one, $3,000 year two less $4,000 profit in year three).
Implications and ideas:
If you will make a profit – no need to worry
If your business will make a profit, you don’t need to worry about these tests. Your business income will be included in your tax return.
Try to get to $22,000 sales (including GST)
The $20,000 sales (or $22,000 including GST) may be the only test that you can pass when you start your business.
A sale is a sale
If you are close to the $20,000 mark and June is approaching, you may wish to sell items at a discount to meet $20,000 sales. I.e. Losing an extra $500 on the sale of an item, might be worth it if to you if you can get a $2,000 tax refund if you have losses.
Register a company
Companies do not need to apply the non-commercial loss tests, which means that any losses can usually be carried forward and used later (provided the company shareholders stay substantially the same).
Although this means higher setup and ongoing costs, at least the losses can be carried forward until you use them (rather than potentially be lost if you don’t make enough money/profits on that type of business).