Hello again everyone!

With tax season now in motion, I wanted to take a bit of a break to complete Part 2 of this  blog post giving an overview of entity classification considerations for starting a new business (or looking at your ‘up and running’ business).

I hope that you found Part 1 to be insightful.
If, by chance, you missed Part 1 or simply would just like a refresher you can read that post here.

The second part will definitely continue the journey. So have a cup of coffee (or your favorite beverage) and let’s delve into Part 2 of LLCs, S-Corporations, And Partnerships – The Basics.

S Corporation Rules and Requirements

S corporations are just corporations that have elected to be taxed under special rules where the income and losses are passed through to the shareholders. Most, but not all, states recognize S corporations the same way the IRS does. There are a number of rules associated with S corporations. Violating them could result in a loss of S status. Should that occur, losses will be disallowed to the shareholders and profits will be taxed at the corporate level.

Making the S election is usually pretty straightforward. All of the shareholders must agree to make the election. In many states no separate election is necessary, filing the federal form automatically qualifies the corporation for S status in the state; in others you must file a separate state form.

Generally, the form must be filed within 2-1/2 months the corporation first has shareholders. Existing corporations can elect S status for a year by March 15 of that year (calendar-year corporations). There are exceptions to the rules, but this is not the place to make a mistake. You don’t want to find out some years down the road that you’ve been denied S-Corporation status. While the election is relatively simple, I would strongly recommend that you seek the services of a qualified professional to guide you through this process (this is not the time to be ‘penny wise and dollar foolish’).

There are several requirements associated with the shares of an S corporation:

• The maximum number of shareholders is 100;
• Shareholders can only be individuals, estates or certain trusts;
• Shareholders must be citizens or residents of the U.S.; and
• There can only be one class of stock.

The first requirement is unlikely to cause a problem for most corporations. All members of a family and their spouses are considered as a single shareholder for determining the 100-shareholder limit.

The second and third requirements can present pitfalls. Partnerships, corporations, and nonresidents cannot be shareholders. If an existing shareholder sells his or her shares to one of these persons, the S election will be terminated. An IRA cannot be a shareholder. (An inadvertent termination can often be remedied, but not without effort.)

The last requirement sounds innocent, but can often be a problem. While you’re unlikely to inadvertently issue preferred shares, the IRS has held that unequal distributions to shareholders can result in a second class of stock. For example, John Smith and Susan Jones each own 50% of SoapNSuds Inc. John takes a $50,000 salary; Susan takes only $10,000 annually. Neither takes any cash distributions. But SoapNSuds Inc. pays all the expenses of a car for Susan which Susan uses only 10 percent for business. The 90 percent of personal use is a distribution to Susan. Since Susan has gotten a preferential distribution, SoapNSuds Inc. may now have two classes of stock. Debt other than straight debt can be considered a second class of stock (e.g., convertible debt). Differences in voting rights generally won’t constitute a second class. Health or accident insurance premiums paid on behalf of a 2-percent plus shareholder aren’t considered distributions for the second class of stock requirement.

As always, the rules are far more complicated than discussed above. There are other requirements as well as exceptions.

Fringe Benefits

This is one of the drawbacks of partnerships and S corporations. Certain fringe benefits paid to any partners or more than 2-percent shareholders of an S corporation are not deductible. The fringe benefits generally include:

• health and accident insurance,
• qualified transportation fringes,
• group term life insurance premiums on the first $50,000, and
• meals and lodging furnished for the convenience of the employer.

Health insurance premiums are deductible, but only if included on the employee/shareholder’s W-2. The employee can then deduct the amount toward his or her adjusted gross income on their personal tax return. Meals and lodging furnished for the convenience of the employer include meals provided on company premises when employees can’t leave because of work requirements.

Most other fringe benefits, such as employee discounts, working condition fringes, no-additional cost services, and de minimis fringes should be deductible by the partnership or S corporation.

Attribution Rules

This is a technical area that’s beyond the scope of this blog post. However, you should be aware that stock ownership or an interest in a partnership can be attributable to a related party. For example, you own 50 percent of the stock of TicTak Inc. You pay the health insurance for your son who is an employee of TicTac Inc. Your son is deemed to be a more than 2-percent shareholder. In order for his health insurance to be deductible, you would have to include his health insurance premiums on his W-2.

Excessive Salary

Excessive salary issues have generally involved C corporations. Because dividends from a C corporation are not deductible by the corporation but income to the shareholder, the best tax way to take money out of a C corporation is generally by salary. But excessive salaries can be challenged by the IRS and deemed to be, in part, dividends.

With an S corporation, partnership, or similar entity, the IRS may take issue with excessive salaries paid to relatives, claiming you’re trying to shift income to a lower bracket taxpayer. So as an example, let’s say that you are the sole shareholder of MedBuzz Inc. a highly profitable medical electronics manufacturer. You’re in the top tax bracket (i.e., 39.6%). Your son works for the business on a part-time basis. He has a college degree but no special skills, but you pay him $275,000 per year. The IRS may decide he’s only worth $35,000 and disallow a deduction for the remainder.

If there is any question as to the salary paid to a relative, you should document hours worked and be able to show the salary is not excessive.

State Taxation

Most states tax S corporations the same as the Federal government does. (There are certain exceptions.) Of more concern are S corporations, partnerships and LLCs doing business in more than one state or where you have a nonresident shareholder. The partnership, S corporation, etc. must file in each state in which it does business. (This would be a good time to  check with a tax professional on the definition of doing business.) The shareholders or partners must file a personal tax return in those states or file a composite return. So, let me give a couple of examples to help clarify the above.

Example 1–Lobster Inc. is a Massachusetts corporation owned by two Massachusetts residents, Bob and Carol. Lobster Inc. is also doing business in New Yawk New York. Lobster Inc. has to file a New York state S corporation return. Both Bob and Carol have to file New York nonresident individual income tax returns reporting Lobster Inc.’s share of New York income on their nonresident returns.

Example 2–Clams Inc. is a Massachusetts corporation owned by Ted and Alice. Clams Inc. does business only in Massachusetts. Ted is a Massachusetts resident; Alice is a New York resident. Alice has to file a Massachusetts nonresident return reporting her share of Clams Inc.’s income.

That’s the general approach. Some states allow the use of a composite return. If that’s the case the corporation can file a return for the nonresidents and pay the tax directly. While the approach is simpler, the total tax should be about the same. Some states require composite returns; in some it is optional (if available). Many states now require making installment payments for nonresident shareholders.

Converted C Corporations

Converting from a C (regular) corporation to an S corporation is generally easy and you can usually avoid any current tax consequences. But there are traps to watch out for.

The first is the built-in gains tax. It involves appreciated assets held by the corporation while it was a C corporation and sold by the S corporation. Because the sale of appreciated assets would be taxed twice to a C corporation, but not to an S corporation, were it not for the built-in gains tax, converting to an S corporation would provide a loophole.

Example–In 1996 Green Acres Inc., then a C corporation, purchased 100 acres of land for $100,000. In 2015 when the land is worth $400,000, Green Acres Inc. converts to S corporation status. Green Acres Inc. sells the land in 2017 for $650,000. Any appreciation in the land after Green Acres Inc. converted to S corporation isn’t subject to the built-in gains tax. But the $300,000 gain ($400,000 value at time of conversion less $100,000 purchase price) is subject to the special tax.

The tax rate is the highest tax rate applied to corporations. The tax does not apply to assets held by the S corporation longer than 5 years at the time of sale. Therefore, in the example above, if Green Acres Inc. had converted to S corporation status in 2010, the tax would not have applied.

As always, the rules are more complex and you may be able to avoid the tax by careful planning.

The second danger associated with a converted C corporation involves excess net passive investment income. The S corporation must first have accumulated earnings and profits as a C corporation (while the rules aren’t exactly the same, accumulated earnings and profits are similar to retained earnings). Then it must have more than 25 percent of its gross receipts from royalties, rents, dividends, interest, and annuities. An S corporation that meets these tests is subject to a separate tax at the highest corporate tax rate on the excess net passive income.

While the tax is unlikely to affect most operating corporations (an S corporation in the business of renting property enjoys a special exception to the rent rule), there is a real danger for corporations where operations have been terminated. For example, ABC Inc. has been in business for many years about half of them as a C corporation. It sells most of its operations for cash. Rather than distributing the cash, the corporation invests it and collects dividends and interest.

The third trap uses the same tests as in the second (excess net passive income and accumulated earnings and profits) but adds a third test–three years of excess passive income. Here the penalty is termination of S corporation status. Clearly something you want to avoid.

The fourth trap involves distributions. Generally, distributions of income from S corporations are nontaxable. The shareholders pay tax on all the income when earned, so they avoid a second tax on distributions. For converted C corporations with accumulated earnings and profits distributions out of the earnings while the entity was an S corporation are nontaxable. But once those earnings have been distributed, additional earnings will be from accumulated earnings and profits of the former C corporation and are taxed just like ordinary dividends.

There are several options to avoiding these problems, but they may depend on your specific situation.

Basis

I’ve discussed basis in other places, but a review is worthwhile. Generally, your basis in an S corporation, partnership or LLC is equal to:

Your original and any subsequent capital contributions, + your share of the income of the entity, + your share of the separately stated income (e.g., dividends, interest, etc.), – your share of the losses, – your share of the separately stated deductions (e.g., a Section 179 expense option), – your share of the distributions.

There are a number of items that can enter into the calculation (such as when property rather than cash is contributed to the entity), but the basic approach remains the same. In addition to your basis in equity capital, S corporation shareholders and partners have a basis in any money loaned to the entity. Partners can increase their basis in the partnership by partnership debts for which they are liable. Once your equity basis has been exhausted by losses, additional losses will reduce your loan basis.

Your basis is important for determining your amount at-risk, the amount up to which you’re allowed to deduct the losses of the entity. It also determines your gain or loss on the sale of the business.

Just because you can’t take the losses doesn’t mean they don’t reduce your basis. The Section 179 expense option can create a particular trap. Because of a limitation, you may not be able to use the deduction elected by the S corporation or partnership, but your share of the amount elected will reduce your basis.

Another trap arises from nondeductible expenses. Even though they don’t decrease your profit or increase your loss, they do reduce your basis. The most commonly encountered one is the 50 percent of meal and entertainment expenses that aren’t deductible.

Loss Limitations

I’ve said that income and losses of S corporations, partnerships, LLCs, etc. are passed through to the partners, shareholders, etc. That’s generally true, but in order to take the losses you have to pass some tests. The first I discussed in Part 1, material participation. (Actually the material participation test is applied first.) But you also have to have sufficient amount at-risk. That is, your economic investment in the entity must be at least as much as the losses.

What’s your amount at-risk in the entity? A complete discussion would be involved, but most taxpayers won’t get into the nuances. In most cases, your amount at-risk is very similar to your basis. And, in many cases, a shareholder or partner needs to go no further. But there can be substantial differences, particularly in the case of partnerships. Here are some points:

• You are not at risk with respect to amounts protected by nonrecourse loans, guarantees or stop-loss agreements.
• You are not at risk with respect to amounts borrowed from a person who has an interest (or than as a creditor) in the entity or a person related to a person with such an interest.
• In some cases the at-risk rules can be applied separately to separate activities.

Two examples based on simple situations should help clarify.

Example 1–Vince invests $5,000 in XYZ Inc. to start the business (he’s the only shareholder). During year 1 XYZ Inc. has income of $30,000 and Vince takes a distribution of $9,000. Vince’s basis in XYZ Inc. at the end of year 1 is $26,000 ($5,000 + $30,000 – $9,000). In year 2 XYZ Inc. has a loss of $15,000 and Vince takes a distribution of $2,000. Vince’s basis at the end of the year is $9,000. In year 3 XYZ Inc. has a loss of $16,000; Vince takes no distribution. Vince can only deduct $9,000 of the $16,000 loss. The remaining $7,000 loss can be carried forward and used in a year when he has sufficient basis.

Example 2–The facts are the same as in example 1, but in year 3 Vince loans XYZ Inc. $10,000. The loan increases his total basis in XYZ Inc. to $19,000 (the $9,000 equity basis at the end of year 2 plus the $10,000 loan basis). Viince can take the full $16,000 loss, leaving him with no equity basis (you use equity first) and only $3,000 in loan basis ($10,000 original loan basis less $7,000 loss applied to loan basis).

Here comes a trap. Assume XYZ Inc. ceases operations (just to simplify the example) when XYZ Inc. starts repaying the loan to Vince, a portion of each principal payment will be income because Vince’s basis in the loan is only $3,000.

A second trap involves loans from a party who has an interest in the entity other than as a creditor. For example, Vince and Kathy are 40-60 shareholders in XYZ Inc. Vince wants to increase his interest to 50 percent and borrows $30,000 from Kathy to make an equity investment. Vince is not at risk for the $30,000 additional investment.

It sounds like I have spent a considerable amount of time explaining what may sound like a fine point. However, many small businesses are financed with only a minimal amount of equity and a large amount of debt.

Partnerships, LLCs and sole proprietorships can get more complicated. The basic rules are the same. But your amount at-risk in a partnership or sole proprietorship is increased by any loans for which you are personally liable and decreased by the relief of any debt for which you are liable. For example, Bonnie and Clyde are 50-percent partners in Green2Go Co., a general partnership. Each contributed $5,000 to start the business. Green2Go Co. borrows $20,000 from Ketchum Bank to purchase inventory. Bonnie and Clyde are considered to have increased their amount at risk by their share of the loan, $10,000 each.

But that increase is elusive. Assume Green2Go Co. has losses of $30,000 ($15,000 for each) in the first year. Bonnie and Clyde can deduct all the losses because their amount at risk is $15,000 each. That decreases the at risk amount to zero. Assume in year two Green2Go Co. has cash flow but no profit for the partners. Green2Go Co. uses $10,000 of the cash generated to pay off the bank loan. Bonnie and Clyde will have $5,000 of taxable gain because of the reduction in the bank loan. A similar situation could occur if the partner is no longer at-risk with respect to the loan or investment.

Sale of Interest

Selling your interest in an S corporation can be as simple as signing over the shares of stock. More than likely you’ll draft a purchase and sale agreement providing for a noncompete clause, payment terms, etc. Some of the proceeds will be outside the gain or loss on the business. For example, the noncompete agreement is usually between the owner of the business and the buyer. The corporation isn’t involved. It’s more complicated in the case of a partnership, since there are a number of special issues to be dealt with and that’s beyond the scope of this blog post. However, the starting point for computing gain or loss is similar.

Whether you have a gain or loss on the sale of an asset is determined by your selling price and the basis. That can be good news or bad news, depending on your basis. Keep in mind that your basis in an S corporation or partnership depends on your equity investment plus any income less losses and distributions. For example, Vince started XYZ Inc. with $5,000. Over the years XYZ Inc. has had income of $85,000; Vince takes no distributions. He sells his stock for $160,000; he has a $70,000 gain (selling price of $160,000 less $90,000 basis). Katlin started World Inc. with a $100,000 investment. World Inc. has losses of $90,000; her basis is $10,000 ($100,000 investment less $90,000 in losses). Katlin sells her stock for $160,000. She has a gain of $150,000 ($160,000 selling price less $10,000 basis).

As always, things can be more complicated. The point to remember here is that your gain or loss is based on more than just your original investment.

Distributions

In our Part 1 of this article I said it really doesn’t matter if you take a distribution or not, the income from an S corporation, partnership, etc. is taxable to you. But what about the distribution? Is that taxable? This is another time when the answer depends on your basis.

Generally, distributions up to your basis are nontaxable. Distributions in excess of your basis are taxed as a capital gain.

Example–Chris invested $5,000 to start LMN Inc. LMN Inc. has had earnings of $23,000. Chris takes a distribution from the company of $35,000. At the time of the distribution, Chris’ basis in LMN Inc. was $28,000. Of the $35,000 distribution, $28,000 is nontaxable, the remaining $7,000 is treated as a capital gain and, assuming the required holding period is met, taxed at long-term capital gain rates.

The rules for partnerships are similar. How can you distribute more money than you put in? Simple. If you financed the business with debt or even have accounts payable, you could have cash available for distribution.

In the discussion above I assumed that only cash is distributed. Distributing property (e.g., a truck used in the business given to your son) will complicate the issue. A distribution of appreciated property by an S corporation could result in a taxable gain. And the amount of the distribution will be the fair market value of the property. A distribution of property by a partnership won’t result in gain until it’s sold by the partner. But a distribution of property encumbered by a liability (a truck with a loan outstanding on it) can trigger an overall decrease in partnership liabilities. The reduction in the partners’ liability will result in a deemed distribution to the partners.

In Conclusion:

As I wrap up this two-part post I will say that I know that this post was a long read (in addition to Part 1) but the length just reflects how intricate choosing an entity classification can be for your business. The decision is not to be taken lightly.

But, keep in mind, what I covered in these two posts only scratched the surface. So, if you are starting a business or even if you are already ‘in business’, give Solid Tax Solutions
(SolidTaxSolutions.com) a call so that we can help you make informed and smart decisions for your business.

We can be reached at (845) 344-1040 year round.

__________________________________________________________________________________________________

Bruce – Your Host at The Tax Nook

Our Firm’s Website: SolidTaxSolutions.com (or just click on the icon on right sidebar of this page).

Other Social Media Outlets: Facebook.com/SolidTaxSolutions (or just click on the icon on right sidebar of this page).

Twitter: Twitter.com/@SolidTax1040 (BTW, We Follow-Back).

Hello All!

Over the past year a number of people who have started a business or contemplated starting a business, have asked me various questions about LLCs, S-Corporations, and Partnerships and which of these forms of ownership is best.

These questions have come to me by way of visits to our office, through this blog, facebook (facebook.com/solidtaxsolutions), or even through twitter (twitter.com/@SolidTax1040). But there was a common denominator among these questions. A lack of understanding of what these entities represent and the responsibilities required by each.

So, I’ve decided to put pen to paper (so to speak) to give a foundation on which business formation and operation decisions can be made.

I’ve decided to break this up into two parts so as not to overwhelm. But keep in mind that the two parts do not represent all that needs to be considered when forming a business or contemplating changing the ‘entity type’ for the business.

So, here we go…………

CAUTION

While it’s too early to predict what effect any tax legislation in 2017 will have on S corporations and partnerships, you should be aware that significant changes are possible.

An Introduction

LLCs, S corporations, and partnerships, have been around for some time and are very popular with small businesses. But despite their extensive use, there are still a number of misconceptions among business owners and the entities have their own particular traps. This blog post is not a detailed treatise, and certainly won’t make you an expert. That would take way to many pages. Rather, I’ve tried to assemble a list of misconceptions and traps that I’ve encountered over the years. Many of the basic rules are the same for LLCs, S corporations, partnerships . I’ll point out important differences as I discuss the topic.

Notes:

• The Middletown company used in the examples below is always assumed to be an S corporation or a partnership or LLC.
• References to owners can mean either shareholders or partners.
• LLCs are generally treated as partnerships (Note: An LLC can also have only one member in which there would be a different tax treatment. But for now I will talk about the LLC as if there is more that one ‘owner’, hence partnership treatment).

Basic Operation of a Pass-Through Entity

S corporations, LLCs and partnerships are known as pass-through entities. The idea behind a pass-through entity is that the entity doesn’t pay any taxes. Instead, the income and losses and certain separately stated items are passed through to the shareholders or partners and reported on their personal tax returns. That’s the big advantage of a pass-through. If a business operates as a C (regular) corporation, it pays a corporate level tax. Any payments made to the shareholders are taxed again on the shareholder’s personal tax return (therefore a double tax for C corporation shareholders. But I digress). Avoiding the corporate tax can produce substantial savings, depending on the tax level of the corporation. An additional advantage is that accidental constructive dividends (e.g., when the corporation pays for a shareholder’s personal expenses) avoid the double tax. Instead, in the case of a pass-through entity, the deduction is simply disallowed and considered a distribution.

In the simplest situation, the income or losses are passed through to the shareholders/partners. For example, Middletown, LLC has two equal partners, Darren and Fred. For the year it (the partnership) has gross receipts of $250,000 and expenses of $140,000. Of the total net income of $110,000, $55,000 is reported on Darren’s K-1 and the same amount reported on Fred’s K-1. Darren and Fred report the income on their respective Form 1040s.

Separately Stated Items

But, it’s often more complicated. Some items are considered to be “separately stated”. Instead of affecting the income or expense of the entity, they’re passed through to the owners separately. For example, Middletown, LLC makes a charitable contribution of $200. Instead of deducting that amount from Middletown, LLC’s income, it’s reported separately on the K-1 to the owners. The owners can take their share of the contribution on Schedule A of their 1040, but only if they itemize. Similarly, interest and dividend income isn’t included in the entity’s gross income, but passed through to the owners and reported on their Form 1040.

Unfortunately, a number of items that you might consider to be business income and expenses are also passed through to the shareholder/partners separately. They include the -Section 179- expense option (writing off equipment purchases), capital gains and losses, gains and losses on the sale of equipment, all credits including the work opportunity, disabled access, energy, foreign taxes, certain special expenses such reforestation expense deduction. Investment expenses, such as portfolio management fees, must also be separately stated.

Rental activities must also be passed through separately. For example, Middletown, LLC’s business is providing advice to manufacturers. Because the partners saw an opportunity to buy a building containing five small offices at an attractive price, they did so. The income and expenses of the rental property are reported on a specific tax form and the net income (or loss) is not reported on Middletown LLC’s return but passed through to the owners.

Tax Tip 1–Problems can arise if the entity has more than one owner and the owners have different tax situations. For example, Middletown, LLC bought raw land as an investment three years ago. Sue and Fred each own 50% of Middletown, LLC. Fred has a large capital gain this year; Sue rarely has investment activity. The land has declined significantly in value and Fred wants to sell it. His share of the loss could be used to offset his gain. Sue can only take $3,000 of the loss this year and carry the remainder forward indefinitely. Passive losses resulting from rentals might be limited by the phase-out of the $25,000 exception for one or more owners, but not for other owners, depending on their individual tax situation. There are other examples.

Tax Tip 2–Using the S corporation or partnership to hold investments, make contributions, etc. can increase the complexity of a return. That will add to preparation cost and make tracking certain items more difficult. While often a minor concern, before complicating your business, make sure there’s a valid reason for doing so. That may be particularly true with respect to rental properties in the business. It is often smarter to hold them in your own name or a separate LLC for both tax and non-tax reasons.

Salaries, Distributions, and Business Income

This, unfortunately, could be one of the most misunderstood areas of pass-through entities. More than once I’ve heard a taxpayer say “How could I owe so much money? I didn’t take a salary last year.” Or “I won’t take a salary so I’ll save on taxes”. Here’s were the rules on S corporations and partnerships and LLCs separate.

Basically, whether or not you take anything out of your pass-through entity, the owners will be taxed on all the income. In the case of a partnership or LLC, all the income is taxable as self-employment income. That means you’ll owe the self-employment tax on your share of the income.

An S corporation is just a ‘wee bit’ more complicated. Let us first assume that you take no salary from the corporation. In that case, like a partnership or LLC, all the income of the corporation is still taxable to the owners, but is not subject to the self-employment tax. Before you think you’ve spotted a loophole, you should be aware that the IRS requires corporate officers/employee/shareholders to take a salary. The salary you take will be subject to the usual FICA and Medicare taxes (as well as state and federal unemployment). Your share of the FICA/Medicare is withheld from your salary; the business pays the other half, just as if you were an employee at an unrelated employer.

A couple of examples should make it clearer.

Example 1–Fred is the sole shareholder of Middletown, Inc., an S corporation. Middletown, Inc. needs the cash, so Fred decides not to take a salary during 2016. He takes no distributions from the corporation of any kind. At the end of the year, Middletown, Inc. has a profit of $250,000. On his Form 1040, Fred reports the entire $250,000 of corporate profit as income. Fred has no other items of income, so his adjusted gross income is $250,000. (I assumed no other income to make the examples easier.) Example 2–Sue is the sole shareholder of Chester Inc., an S corporation. Chester, Inc. has excess cash. Sue takes her regular salary $100,000 and a distribution of $60,000. At the end of the year, Chester, Inc. has a profit of $150,000 (after accounting for Sue’s salary). On her Form 1040, Sue reports the corporation’s profit of $150,000 as income and the $100,000 salary as income. The distribution of $60,000 doesn’t enter into the computation. She has no other items of income, so her adjusted gross income is $250,000 ($100,000 in salary plus the $150,000 of Chatham’s profit).

Clearly, either way, the total income from the entities reported by the shareholders are the same. It doesn’t matter how you take the money out, or even if you take it out. The only difference will show up in FICA and Medicare taxes. By taking less of a salary, you can avoid some of these taxes. The flip side is that you’ll have less earned income for funding a pension plan or for other purposes.

There is a situation where you can end up disadvantaged from a tax standpoint.

Example 3–Middletown, Inc. has net income of $20,000 through late December. Fred, a 100% shareholder takes a $50,000 salary that creates a net loss of $30,000 for Middletown, Inc. Fred’s basis (I’ll discuss that later; for now assume it’s his investment in the corporation) is $5,000. Fred can only deduct losses up to his basis. On his personal return he’ll report $50,000 of salary, but can only deduct $5,000 of his loss.

With a partnership or LLC, the results are similar. Leave the money in or take it all out. You’re still taxed on the full amount earned. In addition, you’ll pay the self-employment tax on the full amount either way.

There may be reasons for not taking the money out, such as loan covenants, avoiding contributing funds back to the business for cash flow purposes, etc., but there are no real tax advantages or disadvantages.

Hobby Loss Rules

Just because you incorporated or set up an LLC or partnership doesn’t mean you’re immune from the hobby loss rules. The rules prevent taxpayers from deducting losses from activities that are not real businesses. This is rarely an issue if you’ve got an operating business with employees, a storefront, you have one or more years of income despite losses, etc. But if you run the business as a sideline, there are significant recreational elements (e.g., horse boarding, dog breeding), you have consistent losses that are unlikely to be reversed and you don’t carry on the activity in a business like manner (e.g., don’t keep good records, don’t attempt to reverse losses, don’t have professional advisers) you could be in trouble.

If you fall into the latter category (e.g., it’s a sideline) there are a number of steps you can take to insure you won’t have a problem with the IRS.

Separate Activities

Tax law requires S corporations, partnerships and LLCs (and sole proprietorships) to break down their businesses into separate activities for purposes of the passive activity rules. (See next.) This could mean that if your S corporation, etc. has more than one activity, you may not be able to use losses from one to offset profits from another. For example, Middletown, Inc. has two businesses. Fred manages and operates a machine shop that rebuilds aircraft engines in Albany, NY. Sue runs Middletown Inc.’s two stores selling kayaks on Cape Cod. Neither Fred nor Sue interfere in the operation of each other’s respective activities. They get together a few hours monthly to review the combined financial statements and provide each other with business advice. Middletown Inc. must account for the businesses separately and losses from the kayak sales can’t be used to offset profits from engine rebuilding.

While this may be an extreme example, the message here is that you should not assume that you can put two completely diverse businesses together so that the losses may be utilized. When do you have to split the business into separate activities? That’s a difficult question that depends on the facts. The IRS will look at five factors–similarities or differences in the types of businesses; extent of common control; extent of common ownership; geographical location; and interdependence between the activities. There’s a good chance you won’t run into the situation. And, fortunately, even if you do, the answer is often obvious. In the example above, there’s no chance this is a single activity. But the operation of a chain of auto repair shops would be a single activity, as would rebuilding aircraft engines and operating an airport.

Passive Activities and Material Participation

One of the reasons for the complexity of the rules surrounding S corporations and partnerships stems from the ability to pass through losses to the owners. The uncontrolled use of partnerships (and S corporations to a lesser extent) in the early 1980’s led to restrictions on the use of the losses. Congress wanted to deny losses to passive investors while allowing them to owners who were active in the business. They arrived at the concept of “material participation”. If the owner materially participated in the business (as most small business owners do), the losses could be used to offset other income such as dividends, interest, salaries, etc. On the other hand, owners who did not materially participate (passive investors) could not use these losses to offset other income. They could be used to offset other passive income or used to offset other income when the investment was completed disposed of.

What’s material participation? There are seven tests. Pass any one and you’re in. Most business owners will pass one of these three tests:

1. You participate in the activity for more than 500 hours during the tax year.
2. Your participation constitutes substantially all of the participation in the activity of all individuals (including non owners) for the tax year.
3. You significantly participate in the activity and your total participation in all significant participation activities during the year exceeds 500 hours. The threshold for significant participation is 100 hours.

Most small business owners will pass the first test. But participation counts only if it’s actually managing or working in the business. The second test is available for sidelines or very small businesses. So for example, let’s say that you’re a flight instructor and on trips to various airports you try and sell a line of aviation electronics. You’re the only employee and spend about 300 hours a year at the business. Test 3 is for owners who own a number of businesses and significantly participate in each of them for more than 100 hours a year, but don’t make the 500 hour test for any one business.

Keep in mind that there are four other tests. I’ve found that most small business owners qualify under the three listed above.

If you don’t materially participate in the activity, you can’t currently deduct the losses. The losses are passive and can only be used to offset current or future passive income or on the disposition of the activity. And that’s the reason for the definition of activity. In our example above, Sue can deduct her losses in the kayak activity. Fred can’t. He can only deduct losses incurred in his aircraft engine operation.

What does it all mean? Before you agree to part with a bunch of cash and join your buddies in a new venture, you should thoroughly understand the rules. While it still may be a good deal even if you can’t take any losses currently, you may want to reconsider.

Don’t get hung out to dry with your business, contact Solid Tax Solutions
(SolidTaxSolutions.com). It will be worth it.

We can be reached at: (845) 344-1040.

Are you ready for Part 2? Well you can read it right here.

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Bruce – Your Host at The Tax Nook

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