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Colleyville Chamber of Commerce

06.02.2010

 Maximizing your after tax income

Jon Chester, MST, CPA - President

As regulations and legislation continues to change, it is becoming virtually impossible for smaller businesses to keep up with their bookkeeping, taxes, and payroll.

Here we will touch on a few changes that could impact your business and how you may take advantage of them.

Losses from Passive and Active Income and Taxes

There are three types of income; passive, active, and portfolio - dividends, interest and capital gains.

Portfolio income is self explanatory. Active means you are working or are actively running a business. Passive is when you earn money from activities, such as rental properties, or you are a limited partner in other ventures - but you are not actively involved in the business. First let’s look at losses from passive income.

Losses from Passive Income and Taxes

MYTH: You can offset losses from one “bucket” of income into another “bucket”, lowering taxable income.

TRUTH: Not necessarily - the IRS has a long history, and procedures and regulations to support the non-mingling of un-associated business activities gains/losses.

Don’t worry though, there are tax planning opportunities available to mitigate some of the tax sting. Depending on the structure of the business, there may be ways to capitalize on the losses.

One method is to shift income from the profitable business into the non-profitable business. For example, you may allocate some income as a management fee or increase an expense in the profitable business. A word of caution - careful consideration of all the facts/circumstances should be done, because if there is no real business purpose to the redirection of income, the IRS will disallow it as a sham transaction.

Now that we have covered losses from passive income let’s look at losses from active income.

Loss Limitations for Active Income

MYTH: Because a company has a loss from an active business it will be fully deductible.

TRUTH: There are limitations and requirements to attain deductions, and many of the allowances for deductions are dependent on the type of company you own and the method of operations.

Here are some guidelines to consider:

For sole proprietors there is no issue of loss limitation in the short term, meaning the losses are fully deductible in the year they occur. And, if the losses are greater than all other income on the return; the remaining loss, after eliminating income, can be carried back to obtain refunds or carried forward to reduce future income reducing the tax base.

The Downside - the IRS requires that you must have shown a net profit for at least 2 of the past 5 years for this business to be considered having a “profit motive” and not just a hobby. So, if you do not show a profit motive; the IRS can reclassify this activity as a hobby and limit the losses to the income of that year.

For legal entities, such as partnerships and corporations, your losses are limited to the amount of investment into your company. As an S corporation, the amount of loss you can take is limited to your investment in the stock of the corporation. This investment (basis) can be increased under certain circumstances, the most available are loans. But, be careful, there is a specific way to structure the loan transaction. If not done correctly, losses in excess of the basis cannot be taken in the current year but instead are deferred to future years.

For example, if you take a loan out in the company name and you guarantee the note, this is not considered as an increase in personal investment, and losses in excess of allowable amounts will be deferred at the allowable amount for future years. However, if as a partner in an S corporation, you take the loan out in your name and then loan it to the company, this is considered as an increase in your stock in the company, and excess losses can be taken. These losses will flow to your personal return and offset income or create net operating losses that can be carried back to obtain refunds or carry forward to reduce future income, reducing your tax base just like a sole proprietor.

Partnerships follow similar basis rules, but generally, all you have to do is be liable for the loan to count as basis increase, even if the loan is in the partnership’s name.

This article is intended for informational purposes only. Please do not take this as tax advice as each circumstance is different. For specific tax advice, please contact your CPA or contact:

Sterling's Bookkeeping & Tax Service
214.330.4682
email us

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