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F rom telecommuting moms to vigorous early retirees, more and more Americans are starting their own businesses -- often turning to friends, relatives or venture capitalists for the money they need to get under way.
If you are putting money into a new venture -- either with a hand on the helm or as a backer -- take advantage of the loopholes in the tax laws. They can make the difference in whether you enjoy smooth sailing or run aground. Thanks to changes in the Tax Code in recent years, there are now more loopholes than ever before. Here are a half dozen key loopholes...
Loophole: Choose the right legal entity for the business. Most businesses lose money in their early days. As an investor, you will want to claim these losses on your personal tax return so that they can offset other income.
But whether you can do so depends on the choice of entity -- that is the legal structure of the business. The choices today are much broader than the venture partnerships that once offered the royal road to tax savings. The law offers these five possibilities...
C corporations are traditional corporations, used by businesses as big as General Motors or as small as a local retailer. They offer important liability protection in that shareholders can lose only what they invest -- no personal assets are at risk. And they offer easy transfer of ownership through share sales.
Problem: Still, the small-business person who incorporates as a C corporation is probably making a mistake. The reason is the double taxation of dividends, first as earnings at the corporate level and then as personal income when distributed. Also, the owner won't get the benefit of losses on his/her personal return.
S corporations are generally a better choice of entity for a small business. They offer the same legal protections as C corporations, but all income and losses flow directly to the shareholders so that income is taxed only once. Bonus: Losses may be claimed on personal tax returns.
General partnerships, like S corporations, are pass-through entities in that profits or losses flow directly to the owners, but in a partnership your other assets may be at risk.
Limited partnerships are the structure used by the old tax shelters to pass losses or other tax benefits to investors who do not actively participate in the business, the limited partners. Again, there is a possibility that other assets may be at risk for general partners.
Limited Liability Company, or LLC (or for professional firms like law or accounting firms, Limited Liability Partnership -- LLP), a relatively new entity, offers both liability protection and the advantage of flow-through profits and losses.
Best choice: Generally an LLC will be the most desirable form of ownership. However, certain states like Florida do not treat LLCs as partnerships but as C corporations, so here an S corporation would be the entity of choice. Also, there may be considerations with a particular business -- such as whether it will do business overseas or have subsidiaries -- that could affect the choice of entity. These are points to discuss with your attorney.
Caution: If you are strictly an investor -- as distinct from an active participant in the business -- any losses that flow through to you will be deemed passive losses under the Tax Code. That is, they can be taken only against passive income, such as profits from successful passive activities (there are exceptions for rental activities). If you have such income, then investing in a start-up may offer a way to reduce taxes today and produce more income in the future. If you do not, the passive losses can be carried forward until you do have passive income.
Loophole: Choose the right accounting method. The cash basis of accounting will generally be more beneficial from a personal tax standpoint than the accrual basis. Under the cash basis, costs are recognized when money is paid out and income when it is received.
The accrual basis recognizes income when goods or services are sold and costs when obligations are incurred, regardless of when money actually changes hands.
Note: If the business has inventory, it must use the accrual method.
Loophole: Set up the business so it qualifies for Section 1244 treatment. This loophole is named for the section of the Tax Code that authorizes it. If stock in a small-business investment company meets the legal requirements for Section 1244 treatment -- an important one is that total capital must be under $1 million -- the original owners of the stock who sell or exchange it or find it to be worthless will be allowed to deduct an ordinary loss of up to $50,000 on single returns and $100,000 on joint returns.
In contrast, normally only $3,000 of net capital losses on securities sales can be taken against ordinary income, with any excesses rolled forward to future years.
Trap 1: Many people, when forming a corporation, put a certain amount of money into stock and put more in a loan payable by the corporation. The problem is that if the corporation has a loss, the loan is not deductible as a 1244 loss -- it is a nonbusiness bad debt.
Trap 2: If the funds are set up as a loan, interest must be paid at the applicable federal rates, which the IRS publishes quarterly. If lower rates are used, the IRS can categorize the loan repayments as dividends. That means you would be taxed on repayments of your own money!
Loophole: Deduct research costs. The cost of looking for an investment is not deductible, even if you do make the investment. If you want to deduct the cost of your original research, start a business in the industry you're considering and get some immediate sales. Then any costs are either deductible or added to the basis when you make your investment.
Loophole: Deduct interest on borrowed money. If you borrow money to invest in a new business, the interest on the loan will be deductible as an investment interest expense, which may be taken to the extent you have investment income. So be sure you have complete records to document the deduction.
Loophole: Set up a joint venture as an LLC. If you are investing as a joint venture with a corporation, set up the entity as an LLC. Then any dividends that flow from the business to you would be taxed only once, rather than twice as for a regular corporation.
Tax Hotline interviewed Edward Mendlowitz, CPA, partner, Mendlowitz Weitsen, LLP, CPAs, Two Pennsylvania Plaza, Ste. 1500, New York 10121.
He is author of seven books, including New Tax Traps/New Opportunities (Boardroom Classics/$25).
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