Everyone dreams of becoming their own boss one day. The allure of pursuing your passion, setting your hours, and building something from the ground up is what drives many to start their own business. However, the reality is that starting a business often comes with financial challenges, and making a loss in the first year is more common than most people think. But there’s good news – UK tax laws offer relief if you made a loss in your first year of self-employment.
In fact, these rules provide an opportunity to claim back some of the tax you’ve already paid on other income, such as employment income, which many people still have when they launch their businesses.
Let’s look at how these rules worked for Paul, who took the leap into self-employment and managed to turn a difficult first year into an unexpected financial win.
Paul’s Story: From PAYE to Self-Employed
Paul had always wanted to start an online business. In 2023-24, he decided to go for it, diving into e-commerce with enthusiasm. But like many first-time business owners, Paul faced a tough first year and ended up making a trading loss of £5,000. On the surface, this might seem disheartening, but luckily for Paul, UK tax laws offer an opportunity to soften the financial blow.
You see, Paul wasn’t just relying on his new business to survive. In the tax year before he went solo, 2022-23, Paul had worked full-time in employment and paid £1,500 in PAYE tax on his salary. Now that he had made a loss, Paul was entitled to carry that £5,000 loss from his business in 2023-24 back to the previous year’s income and claim a tax refund. This helped him recover some of the taxes he had paid while he was employed.
The Basics of Loss Relief for Self-Employed Individuals
UK tax rules allow individuals to carry back trading losses to earlier years, but it’s important to understand the specifics. Loss relief can be applied to other income, such as employment income from the previous tax year. This is exactly what Paul did – he used his 2023-24 trading loss to claim a refund on tax paid during 2022-23.
Paul could have carried forward the loss to offset against future profits, but by carrying it back to the previous year, he could reclaim some of the tax he had already paid, offering an immediate cash benefit.
However, there’s a condition: the business must be carried out with the genuine purpose of making a profit. This relief won’t apply if HMRC determines that the business is simply a hobby. Paul’s business was a legitimate attempt to generate income, which made him eligible.
How Much Tax Relief Did Paul Get?
By carrying back his £5,000 trading loss to 2022-23, Paul was able to reduce his taxable income from that year. The tax he had already paid on that income, £1,500, was now due back to him in the form of a refund. Essentially, Paul could reclaim all of the £1,500 PAYE tax he paid during his last year of employment, turning his unfortunate first-year loss into a financial reprieve.
Important Deadlines and Restrictions
It’s worth noting that there are strict time limits for claiming loss relief. Paul, like any other self-employed individual, had to make his claim within one year from 31 January after the end of the loss-making year. So, because Paul made a loss in the 2023-24 tax year, he had until 31 January 2026 to submit his claim for a refund on his 2022-23 taxes.
There’s also a cap on the amount of income tax relief that individuals can claim. This cap restricts the amount of loss relief to the greater of £50,000 or 25% of their annual income. However, Paul’s losses didn’t exceed this limit, so he could fully benefit from the relief.
One more thing to keep in mind: If someone spends less than 10 hours per week working in their business, their loss relief may be further restricted to £25,000. Fortunately for Paul, he was dedicating most of his time to his new venture, so this restriction didn’t apply to him.
Key Takeaways for New Business Owners
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Losses in the first year are common: Don’t be discouraged if you make a loss – it’s a natural part of many new businesses' growth.
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Claiming loss relief: If you’ve paid tax on other income, such as employment, in previous years, you can carry your trading loss back to reclaim that tax.
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Time limits are crucial: Ensure you make your claim within one year from 31 January following the loss-making tax year.
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Business purpose matters: HMRC will only allow loss relief if the business is carried out with the intention of making a profit – it’s not designed for hobbies.
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Income tax relief cap: Be aware of the cap, which restricts the relief to the greater of £50,000 or 25% of your income. However, this doesn’t apply to losses used against future profits from the same trade.
Starting a business is a brave decision, but the UK tax system offers valuable ways to cushion the financial impact of initial losses. Like Paul, you too could turn your first-year trading loss into an unexpected tax refund. Just remember to keep track of your deadlines, ensure your business is run with profit in mind, and claim the relief you’re entitled to!
Legislation References:
- Income Tax Act 2007: Provides the framework for trading loss relief, including the carry-back provision (Section 64).
- HMRC Guidance on loss relief and the "wholly and exclusively for trade" rule to determine the purpose of the business.