Running a Business at a Loss? What the Non-Commercial Loss Rules Mean for You
Many people run a business alongside a job or other income. A small farm, a consulting side hustle, a weekend market stall, a hobby that has grown into something more. In the early years, or in a tough season, that business may well make a loss.
A common assumption is that a business loss can simply be offset against your salary or other income to reduce the tax you pay. Sometimes it can. But often it can't, at least not straight away, because of a set of rules in the tax law called the non-commercial loss rules.
Here's a plain-English guide to how they work.
Who do the rules apply to?
The non-commercial loss rules apply to individuals, including individuals who carry on a business in partnership. They don't apply to companies or trusts, which have their own loss rules.
They also only apply to business losses. If your activity is a hobby rather than a business, the rules don't come into play, but then the loss isn't deductible at all. Whether an activity is a business depends on things like its size and scale, whether it's run in a commercial way, and whether there is a genuine intention to make a profit.
The starting point: losses are deferred
The default position is that a loss from a business activity cannot be offset against your other income in the year it arises. Instead, the loss is quarantined and carried forward. It can only be used in a later year against a profit from that same business activity (or a similar one), or in a year when you pass one of the tests below.
The good news is the loss is not lost. It's just parked until it can be used.
When can you claim the loss now?
There are three ways a loss can be claimed against your other income in the year it arises
1. The primary production and professional arts exception
If your business is a primary production activity (farming, grazing, cropping, horticulture and so on) or a professional arts activity, and your other income for the year is less than $40,000, the loss can be claimed immediately. "Other income" here means your assessable income from sources outside the business, ignoring any net capital gain.
This exception is a big one for many farming families, particularly where a spouse has a modest off-farm income.
2. Meeting the income requirement and one of the four tests
If your adjusted taxable income for the year is less than $250,000, you can claim the loss provided the business passes at least one of these four tests:
• Assessable income test – the business produces assessable income of at least $20,000 in the year.
• Profits test – the business made a tax profit in at least three of the past five years, including the current year.
• Real property test – real property used in the business (land and buildings, but not your home) is worth at least $500,000.
• Other assets test – other assets used in the business (plant, equipment, trading stock, motor vehicles and similar) are worth at least $100,000.
Adjusted taxable income is your taxable income before deducting the business loss, plus reportable fringe benefits, reportable super contributions and any total net investment loss. So a high earner with negatively geared property may find themselves over the $250,000 line even if their taxable income looks lower.
If your adjusted taxable income is $250,000 or more, the four tests are not available. You will need the Commissioner's discretion.
3. The Commissioner's discretion
If you can't use the exception or the tests, you can apply to the ATO to exercise its discretion to let you claim the loss. There are two main grounds:
• Special circumstances – something outside your control, such as drought, flood, bushfire or a serious illness, stopped the business from meeting a test in that year.
• Lead time – the nature of the business means there is an inherent period before it can be expected to make a profit or pass a test. Think of a new vineyard, an orchard, or a cattle breeding program. You will need objective evidence, such as industry data or an independent business plan, that the activity is expected to become commercially viable within the accepted period for that industry.
The discretion is applied year by year and must be applied for. It's not automatic.
A worked example
Sarah works as a nurse earning $95,000 a year. She and her husband also run a small beef cattle operation on 40 hectares they bought two years ago. This year the farm made a $30,000 loss, sold $12,000 of cattle, and the land is valued at $650,000.
• Sarah's other income is above $40,000, so the primary production exception doesn't help her.
• Her adjusted taxable income is under $250,000, so the four tests are available.
• Sales of $12,000 don't meet the $20,000 assessable income test, and the farm hasn't yet been profitable, so the profits test fails.
• But the land is worth more than $500,000, so the real property test is passed.
Sarah can claim her share of the farm loss against her nursing income this year.
If Sarah had instead been running the farm on leased land with $60,000 of plant and equipment, none of the tests would be met and her share of the loss would be deferred, unless she could make a case for the Commissioner's discretion.
Practical tips
• Keep good records. Valuations, asset registers and sales records are what let you demonstrate a test has been met.
• Plan ahead. If you are close to a threshold, timing of sales or asset purchases can matter.
• Don't forget deferred losses. They are tracked at the individual activity level and need to be recorded each year so they can be used later.
• Get advice early on a new venture. If you are setting up something with a long lead time, an independent business plan prepared at the outset makes a discretion application far stronger down the track.
The bottom line
A business loss is not always an immediate tax deduction. Whether you can use it this year depends on the type of business, your other income, and the size and performance of the activity. Understanding where you sit against these rules before the end of the financial year gives you the best chance of a good outcome.
If you are running a business at a loss and want to know how the rules apply to your situation, get in touch with our team.
This article is general information only and does not take into account your personal circumstances. Please seek advice specific to your situation.
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