Loopholes in setting up a business
Leasing Assets To Your Own Corporation
The fact that the corporate form is selected as the basic means of conducting a business enterprise does not mean that all of the physical components of the enterprise need to be owned by the corporation. Indeed, there may be legal, tax, and personal financial planning reasons for not having the corporation own all the assets to be used in the business.
Whether the corporation is to be the continuation of a sole proprietorship or partnership or a wholly new enterprise, decisions can be made about which assets owned by the predecessor or acquired for use in the corporation are to be owned by the corporation and which assets are to be made available to the corporation through a leasing or other contractual arrangement.
For the assets that go to the corporation, decisions must be made about how they are to be held and on what terms they are to be made available to the corporation.
There are several possible choices. The assets may by owned by:
- An individual shareholder or some member of his family;
- A partnership, limited or general, in which family members participate; or
- A trust for the benefit of family members.
A separate corporation is still another possibility, but the risk of being considered a personal holding company and incurring penalties due to passive income (including rent and royalties) may make this impractical.
Normally a leasing arrangement is used in order for the assets to be made available for corporate use. Assuming that the rental is fair, it would be deductible by the corporation and taxable to the lessor. Against the rental income, the lessor would have possible deductions for interest paid on loans financing the acquisition of the asset, depreciation, maintenance and repairs, insurance and administrative costs.
These deductions might produce a tax-free cash flow for the lessor. When depreciation and interest deductions begin to run out, a high-tax-bracket lessor might find that he/she is being taxed at too high a rate on the rental income. At this point, he may transfer the leased property to a lower-tax-bracket family member.
He might also consider a sale of the property to his corporation. This sale would serve to extract earnings and profits from the corporation at favorable tax rates. At the same time, it would give the corporation a high tax basis for the asset than it had in the hands of the lessor, thus increasing the corporation’s depreciation deductions. This, of course, would reduce the corporation’s tax liabilities and benefit the shareholders-the lessor included, if he/she is a shareholder.
How To Deduct Start-Up Costs Sooner
Avoid being forced to capitalize and amortize start-up costs over a five-year period. The trick is to get “in business” quickly. You can claim business deductions or losses only when you’re “in business.” (You’re considered to be “in business” when you’re trying to get sales.) Any subsequent expenses you incur will be to “expand” an existing business, and you can take full deductions for those items.
For example, let’s say you want to open a sales organization. The start-up costs include getting products to sell and interviewing salespeople. If you can get one line, no matter how small, and make a few sales, you’re considered to be in business. Then you can spend time looking to expand into other products and to hire a sales force.
Incorporating A Business Tax-Free
You may have a sole proprietorship or partnership and reach a point in the growth of your business where you want to incorporate. There’s a special provision in the Internal Revenue Code (Section 351) that enables a business before the incorporation own at least 80% of the business after incorporation.
If you incorporate in this way, the IRS can’t recapture depreciation deductions or investment credits (if still applicable). If the assets are subsequently disposed of, the recaptures will take place at the corporate and not at the individual level, even though you may have initially received the benefit from the investment credit or depreciation.
How To Set Up A Hobby As A Business
You can set up a hobby as a business and deduct your losses. However, you must be able to prove that the hobby is a for-profit business. If you realize some profit in at least three out of the most recent five consecutive years, it is presumed that the business is for profit. But even if you don’t show and profit, you may be able to prove that the business is intended to make a profit.
To prove that you have a profit motive in conducting your business, keep detailed records. Present evidence of your advertising campaigns, attempts to generate new business, and sales analyses. It’s not necessary to show that you run a big business, reaping huge profits, but only that you have genuine intentions of running the business in a businesslike way.
Best Way To Set Up A Family Business
A business can be organized as a corporation, a proprietorship, a partnership, or even a trust. Use combined forms of ownership to cut taxes.
- Use a corporation to operate the business.
- Have an individual, as sole proprietor, or a partnership own the machinery and equipment and rent it to the corporation.
- Have an individual or partnership hold title to the real estate and rent it to the corporation.
- Use a trust (for the benefit of the children of the owners) as a partner in the partnership (in either the equipment partnership or the real estate partnership or both).
This arrangement reaps some important tax benefits:
- Tax losses are passed through to the high-tax-bracket owners. When partnerships begin producing income, transfer title to the low-bracket children for income-splitting purposes.
- Income from the rental goes to the owners without dilution for corporate taxes.
- Income to the children aged 14 or older benefits from income-splitting.
The possibilities for combining the above are endless. Consider such additional entities as S corporations, multiple corporations, and multiple trusts.
Caution: The “passive-loss” rules, imposed by the Tax Reform Act of 1986, severely restrict the deductibility of many partnership losses, S corporation losses, and losses from rental property. Always check with a tax professional before deciding on the structure of your business.
When To Set Up A Venture Partnership
You may be asked to help friends or relatives start up a small business by providing the capital to finance the deal. Set up the business as a partial shelter for the amounts you invest. Uncle Sam helps you reduce the amount that you’re investing by allowing you to deduct a large share of the losses. I call such a deal a venture partnership. Here’s how it works:
You become the limited partner. As such, you’re entitled to deduct a very large share of the losses, up to 99%, since you’re putting in all the money. At the point that the business turns around, the percentages drop. You might receive 50% of the profits after getting your money back, and the person you helped also received 50% of the profits. Now both of you can share in the profits as partners, but at the outset you get the benefit of a larger share of the losses. Caution: These write-offs are subject to the passive-activity-loss rules.
Best Tax Shelter In America
Tax Reform has taken dead aim at tax shelters. It’s not longer possible to offset your salary or investment income with paper losses generated by passive investments in oil wells, real estate developments, etc. Neither is it possible to cut the family’s tax bill greatly by shifting investment income to children who are under age 14.
But even under Tax Reform, the best tax shelter still remains. With it you can generate large paper losses, claim deductions for personal or hobby-like expenses, and legally shift income to your low-tax-bracket minor children.
The best tax shelter is a sideline business.
Here’s how a sideline business can be used to get the big tax-sheltering-type deductions, along with winning examples of taxpayers who have already done it…
Under Tax Reform, investment income exceeding $1,300 for a child under age 14 is taxed at the rate paid by the child’s parents. But this rule does not apply to the earned income of a child.
Result: When a child works for a parent’s sideline business, earning are taxed at the child’s own low tax rate. Since the parent deducts the salary paid to the child as a business expense, the family’s total tax bill is lowered by the difference between the parent’s high tax rate and the low or zero rate on the child’s salary.
Of course, this income-shifting technique is also available for children over age 14 and other family members. And even greater tax benefits can be obtained when family members use the salary you pay to make deductible IRA retirement contributions, or when the business pays for deductible benefits.
The only rule that governs paying salaries to family members is that they must actually earn their salaries. Salary deductions have been allowed when:
- • A doctor paid his four children, ages 13 to 16, to answer telephone calls, take messages, and prepare insurance forms.
Source: James Moriarity, TC Memo 1984-249.
- • The owner of a rental property hired his teenage sons to maintain and clean the building.
Source: Charles Tschupp, TC Memo 1963-98
- • A business owner hired his wife to act as the company’s official hostess.
Source: Clement J. Duffey, 11 AFTR2d 1317.
A part-time activity can easily qualify as a business. The only requirement is that you operate your activity with the objective of making a profit. You don’t actually have to make a profit, nor do you have to expect to make a profit in the near future. Examples:
A major benefit of running a sideline business out of your home is the possibility of claiming a home-office deduction. This entitles you to deduct expenses that were formally personal in nature, such as rent, utility, insurance, and maintenance costs attributable to the office. Even better: You can depreciate the part of your home that’s used as an office, getting large paper deductions that cost your nothing out of pocket.
To qualify for the deduction, you must have a part of your home that’s used exclusively for business and is that primary place where you conduct the sideline business. Winning examples:
- • A doctor who owned and managed rental properties to get extra income could deduct one bedroom in his two-bedroom apartment as an office.
Source: Edwin R. Cruphey, 73 TC 766.
- • A woman who did economic consulting work out of a home office could deduct it, even though her husband, a famous newspaper editor, use the same office for nondeductible activities. The Tax Court did not reduce her deduction because her husband shared the office.
Source: Max Frankel, 82 TC 318.
Big Dollar Deductions
Tax Reform prohibits taxpayers from offsetting their salary and investment income with losses from businesses in whish they participate as passive investors (as shareholders or limited partners without management duties).
But if you actively manage your own sideline business, it’s still possible to claim big loss deductions. Important: Tax losses do not necessarily mean cash losses. Items such as depreciation on cars, equipment, and real estate can result in deductible tax losses while the business is earning a cash-flow profit.
A sideline business is presumed to have a profit objective if it has reported a profit in three out of five years (two out of seven year for horse breeders). But such a business may be deemed to have a profit objective, even after reporting many years of continuous losses. Winning examples:
- • A real estate operator tried to develop and market an automatic garage door opener. He was entitled to deduct $355,000 over 11 years because he had made a sincere effort to sell the door openers.
Source: Frederick A. Purdy, TC Memo 1967-82.
- • A horse farm incurred 20 straight years of losses totaling over $700,000. During the next seven years, it lost another $119,000, but in two of those years it had profits totaling $17,000. Since the two-out-of-seven-years test had been met, the farm was ruled to be a profit-motivated business, and all of its losses were deductible.
Source: Hunter Faulconer, 48 F2d 890
- • A corporate vice president and management expert ran a breeding farm as a sideline and lost $450,000 over 12 years. The loss was deductible because evidence indicated that it often takes 8 to 12 years to establish an acceptable bloodline for the animals involved.
Source: Lawrence Appley, TC Memo 1979-433
When starting a new sideline business, you can protect your deductions by electing to have the IRS postpone its examination of your business status until after you’ve been operating for four years (six years in the case of a horse farm). You’ll be able to treat your sideline as a business during that period, even if it earns continuous losses. But if you can’t demonstrate a profit objective at the end of that period, you’ll owe back taxes. Make the election by filing the IRS Form 5213, Election to Postpone Determination That Activity Is for Profit.
- • Eugene Feistman, a probation office, collected and traded stamps for many years. The Tax Court initially refused to let him deduct his costs, saying his collecting was merely a hobby. So he filed a business registration certificate with the local government, opened an account that allowed him to make sales by charge card, set up an inventory, and started keeping good business records concerning purchases and sales.
New ruling: Now Feistman could deduct his costs because he was operating in a businesslike manner. The Tax Court allowed him to deduct $9,000 over two years.
Source: Eugene Feistman, TC Memo 1982-306
- • Gloria Churchman, a housewife, admitted that she painted for pleasure, but she was also able to show that she made a serious effort to sell her works at shows and galleries. The Tax Court allowed her to deduct her expenses and losses, including the cost of a studio in her home.
Source: Gloria Churchman, 68 TC 696
- • Melvin Nickerson, an executive who lived in the city, bought a farm and began renovating it on weekends. He intended to retire to it in the future. Although Nickerson didn’t expect to make a profit from the farm for another 10 years, the Court of Appeals allowed him to deduct his renovation costs right away. It said that his expectation of future profits, combined with the real work he put in, sufficed to justify a deduction now.
Source: Melvin Nickerson, 700 F2d 402
- • Bernard Wagner, an accountant, fancied himself a songwriter and music promoter. He hired a band, rehearsed it, booked It, and copyrighted the songs he wrote. Although his chances of success were slight, he intended to succeed, so the Tax Court allowed him to deduct his costs and losses.
Source: Bernard Wagner, TC Memo 1983-606
- • J.V. Keenon bought a house, moved into it, then rented an apartment in the house to his own daughter. The Tax Court agreed that he was now in the real estate rental business, so he could deduct depreciation on the rented apartment, along with utilities, insurance, and related expenses. And this was in spite of the fact that he charged his daughter a below-market rent. The Court felt that the rent was fair because it’s safer to rent to a family member than to a stranger.
Source: J.V. Keenon, TC Memo 1982-144.
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