We have been asked this question many times and want to address the key issues it touches. The people asking this question would normally fall into two categories:
- People running a business on a self-employed basis, but the business is making a loss and they are concerned that the loss-making venture would be interpreted as not being a “serious business” or indeed raise a flag with the tax authorities.
- People involved in multiple activities, some running as businesses and some running as hobbies, but there is a blurring of the lines or a crossover of related activities so that it is not always clear which income or expenses relate to the business and which belong to the hobby.
In self- employment, the individual is the taxable legal entity and all their business activity must be reported on a self-assessment tax return. As a self-employed person, it can sometimes be challenging to distinguish between what is a business and what is a hobby. The indicator lies in the primary motive of the activity. The main difference is that a business is an activity carried out with a view to making a profit, while a hobby is carried out for pleasure.
Why is it important to know the difference?
There must be complete clarity as to what is a hobby and what is a business. This is because when running a business, you can off set the costs related to the business before arriving at the taxable profit, while costs for a hobby cannot be offset against business income.
The biggest challenge for some self-employed people, however, is in keeping proper records to clearly determine whether a cost relates to the hobby or the business, especially when the two are closely related.
Two tax cases, heard together, that highlight this issue were Earl of Jersey’s Executors v Bassom and Earl of Derby v Bassom (1926) 10 TC 357. In these cases, a taxpayer bred racehorses and raced them, but also hired out stallions for stud. In each case, the stud part of the business made a considerable profit, which was eaten up by the costs of other activities. The taxpayers argued that these activities constituted one loss-making business, therefore it was not trading.
The court ruled that there were three separate activities. The breeding and racing activities were not capable of making a profit and, therefore, were hobbies. However, the stud businesses were run with a view to profit and hence taxable.
How do you know if a venture is a hobby or a trading activity?
The chief indicators used to decide whether a transaction or series of transactions constitutes trading transactions are known as the ‘badges of trade’. HM Revenue & Customs (HMRC) lists nine badges of trade which are collectively used to give an indication as whether there was trading activity.
The Badges of trade:
- Profit-seeking motive – An intention to make a profit supports trading, but by itself is not conclusive.
- The number of transactions – Systematic and repeated transactions will support ‘trade’.
- The nature of the asset – Is the asset of such a type or amount that it can only be turned to advantage by a sale? Or did it yield an income or give ‘pride of possession’, for example, a picture for personal enjoyment?
- Existence of similar trading transactions or interests – Transactions that are similar to those of an existing trade may themselves be trading.
- Changes to the asset – Was the asset repaired, modified or improved to make it more easily saleable or saleable at a greater profit?
- The way the sale was carried out – Was the asset sold in a way that was typical of trading organisations? Alternatively, did it have to be sold to raise cash for an emergency?
- The source of finance – Was money borrowed to buy the asset? Could the funds only be repaid by selling the asset?
- Interval of time between purchase and sale – Assets that are the subject of trade will normally, but not always, be sold quickly. Therefore, an intention to resell an asset shortly after purchase will support trading. However, an asset, which is to be held indefinitely, is much less likely to be a subject of trade.
- Method of acquisition – An asset that is acquired by inheritance, or as a gift, is less likely to be the subject of trade.
Please note there is not a set criterion e.g. that a transaction must meet a specific number of “badges of trade” before it can be deemed to be trading activity. Where there is doubt as to the nature of a transaction, the courts will result to reviewing existing case law.
Implications of being in trade
If there is deemed to be trading activity, then the related profit must be reported in the Self-Assessment Tax Return and is subject to income tax and class 2 and 4 National Insurance contributions. Capital Gains tax will apply where the transactions are capital in nature.
Has my business made profit?
Profit is the surplus made after expenses have been deducted from income earned. Therefore, if income is more than expenses, then your business has made a profit. If however expenses are more than income, then the business has made a loss.
To determine whether your business has made a profit or a loss you need to have proper records for all income and expenses relating to the business.
HMRC guidance is that expenses must be “wholly and exclusively for business. The legislation disallows any expenditure not incurred wholly and exclusively for the purposes of the trade, profession or vocation. This means that the rule is only satisfied if the taxpayer’s sole purpose for incurring the expense is for the purposes of their trade, profession or vocation. If there is a non-trade purpose, then the expenditure is not allowable.
So, let’s go back to the original question: When do I have to show that my business has made a profit? The answer is: As soon as the business makes a profit.
You must keep proper records and prepare a profit and loss account and balance sheet for your business. Review all transactions to determine if they are genuinely ‘wholly and exclusively” for business and categorise them correctly. Non-trading related expenses cannot be offset against trading income.
If in doubt, please speak to your accountant for professional advice or get in touch with us.