Explaining Non-Commercial Losses: Understanding the 5 Essential Rules
It’s quite common for new businesses operated by sole traders or partnerships to incur losses during their initial growth phase. To support their business’s development, these individuals often rely on income from other sources, typically in the form of a salary. (Essentially, they’re running a side business while earning income elsewhere).
To aid such burgeoning businesses during this crucial phase, the ATO permits sole traders and partnerships to offset their non-commercial losses against their other sources of income, provided they meet specific eligibility criteria. This practice often results in a substantial reduction in taxable income, leading to larger tax refunds.
There are several prerequisites outlined by the ATO that you should be aware of before attempting to offset your non-commercial loss.
Distinguishing Between a Hobby and a Business
The ATO emphasises the importance of differentiating between income-generating activities considered a “business” for tax purposes and those regarded as hobbies. If you’ve incurred losses from engaging in activities like selling artwork to friends or sporadic family photography, these losses won’t qualify as non-commercial losses. Similarly, investments generating passive income aren’t classified as business activities and cannot be offset.
According to the ATO, “if it is unlikely to ever make a profit and doesn’t have a significant commercial purpose or character, you can’t offset the loss against your other income.” You can, however, defer the loss for use in a future year when you eventually generate a profit. While there aren’t hard-and-fast rules distinguishing hobbies from businesses, you can use the following criteria as a guide:
- Engaging in business-like activities to generate income
- Organising and planning activities in a business-like manner
- Performing similar activities consistently as part of your operations, with a comparable scale and size to established businesses in the industry.
The Assessable Income Test
Meeting the criteria of being a business is not enough; sole traders and partnership members must also meet the income requirement test to offset their non-commercial losses. According to this test, you can offset such losses against other income only if your adjusted taxable income is less than $250,000. Calculating your adjusted taxable income involves the following components:
- Taxable Income
- Total reportable fringe benefits
- Reportable superannuation contributions
- Total net investment losses
The Four Non-Commercial Loss Tests
Simply satisfying the income and business criteria does not automatically qualify you for non-commercial loss offset. You must also meet at least one of the four non-commercial loss tests:
- The assessable income test: Your business activity’s assessable income (gross earnings and capital gains) must be at least $20,000. In cases where the business operates for less than a year or ceases during the income year, you can estimate the income for the entire financial year reasonably.
- The profit test: If your business operates for over five years, it must have generated a profit in at least three of those years, including the current one.
- The real property test: Using real property valued at a minimum of $500,000 as part of your business activity satisfies this test. Real property includes land, leases, and fixed buildings but excludes tenant-owned fixtures and private-use dwellings.
- The other assets test: Owning assets, excluding real property and motor vehicles, worth $100,000 or more that are continuously used in your business activity satisfies this test. Assets can encompass plant and equipment, intangible assets (like trademarks and copyrights), trading stock, and leased assets from other entities.
The Commissioner’s Discretion
In situations where you meet the income test but not the four non-commercial loss tests, you can request the Commissioner of Taxation to use their discretion to allow you to offset your non-commercial losses.
However, certain conditions must be met:
- There is a likelihood that your business activity would have satisfied one of the four non-commercial loss tests, but circumstances beyond your control prevented this.
- Due to the inherent nature of your business activity, there’s a substantiated expectation that you’ll eventually meet one of the four tests or make a tax profit within a reasonable period, given the industry’s characteristics.
Other Income: Exceptions to Non-Commercial Loss Rules
The ATO provides exemptions from non-commercial loss tests for sole traders and partnership businesses classified under primary production or professional arts, provided that their assessable income from non-business sources is less than $40,000, excluding net capital gains.
Primary Production Business Activity includes activities such as tree farming, felling, fishing, pearling, plant cultivation, and animal cultivation.
Professional Arts Businesses cover performing artists, production associates, and authors of literature, dramatic, musical, or other artistic works.
Conclusion
In summary, operating a sole trader or partnership business may involve running at a loss during the growth phase. However, by generating other income sources to support these losses, you may qualify to offset non-commercial losses. To determine eligibility, consult a business advisor or accountant, as navigating these rules can be complex. Freshwater Taxation has been assisting clients in benefiting from the ATO’s non-commercial loss tax refund for years and can guide you through the options available. For more information, don’t hesitate to get in touch with our team.
