Tax laws can help or hurt new and expanding businesses.
By Mark E. Battersby
In today’s economy, it’s not unusual for an existing fabrication business to branch out, or for the owner or self-employed canvas professional to start another business in the same or a different field. Few realize, however, that Uncle Sam stands ready to become a partner in these efforts in the form of U.S. tax laws.
The tax laws allow the government to not only pick up part of the expense of branching out or starting up a new venture, but often allow the losses from a secondary activity to be used to reduce the tax bills generated by income from self-employment, wages, investments or the primary business.
Startup cost write-offs
In most cases, the ordinary and necessary expenses of carrying on a trade or business are tax deductible. Naturally, if there is no business, there are no tax deductions for business expenses. Special rules exist for the expenses incurred in starting a business.
Anyone who pays or incurs business startup costs and who subsequently enters the trade or business can choose to expense and immediately write off up to $5,000 of those costs. However, that $5,000 deduction is reduced dollar-for-dollar when the startup expenses exceed $50,000.
The so-called organizational costs of business entities are a separate class of expense from startup expenses, although subject to similar rules. An incorporated business can, for instance, choose to deduct up to $5,000 of any organizational expenses incurred in the tax year business begins.
The balance of startup or organizational expenses, if any, are amortized (written off) over a period of not less than 180 months, starting with the month in which the business begins.
Business owners and self-employed professionals often have multiple business activities. Common to almost every situation is the question of whether the new activity is merely a branch or subsidiary of the existing fabrication business—or will the Internal Revenue Service (IRS) view it as a separate activity?
If the new operation is really an extension of the original business, a significant write-off is available. To illustrate, suppose John Doe operates a marine upholstery business and an online store. The operation is profitable, and he decides to build a shop at the same location that specializes in custom boat covers. John Doe’s startup expenses amount to $70,000 and include the cost of hiring employees, setting up bookkeeping, creating an operations manual and advertising and promoting the operation.
If this were an integrated operation, John Doe’s primary business could immediately deduct the startup costs. If not, the rules require they be capitalized and amortized.
Losses—hobby vs. business
Not surprisingly, all income from a business activity is usually taxable. Fortunately, the losses from a money-losing activity—either from an existing business or a startup—can be used to offset the income from other sources. However, for a hobby that is not aimed at generating profit, the expenses are generally deductible only to the extent of the activity’s income.
Even after the 2017 Tax Cuts and Jobs Act (TCJA) eliminated many personal itemized deductions, some expenses incurred in connection with a hobby are still tax deductible. The general rule is an activity is presumed not to be a hobby if profits (more income than expenses) result in any three of five consecutive tax years. Fortunately, even without profitable years, if someone operating a business activity can prove there is “intent” to show a profit using the IRS’s guidelines, many activity-related expenses are legitimately deductible, even those in excess of the activity’s income. The amount by which the activity’s expenses exceed its income, its losses, can offset all income from other sources.
It’s logical for canvas professionals to consider using many of the TCJA’s tax breaks to start or grow their business. Be aware, however, that the TCJA’s tax breaks can both help and hinder those expansion plans, as many of the potential pitfalls in our basic tax rules still exist.
Although there is the 100 percent write-off of equipment and other business asset costs, there must be taxable income that can be reduced by that write-off. Additionally, to make those purchases, money must be borrowed or the equipment must be leased. Larger businesses attempting to borrow expansion funding are now limited to an interest expense deduction that cannot exceed 30 percent of the operation’s income.
Leasing, long a staple of cash-starved businesses and startups, faces new accounting rules that require most leases to be reported on the operation’s financial statements. Publicly traded businesses must already treat leases as a liability, while smaller businesses are required to begin similar reporting in 2020. Also, don’t forget that the tax deduction for startup expenses remains limited.
Formalize entities for protection
Whether you’re starting a new venture or expanding an existing one, it may be wise to formalize the operation by incorporating or forming a limited liability company (LLC). Doing this can provide personal liability protection and give the new operation an edge when it comes to sales, financing and taxes. Keep in mind that the LLC or incorporated new branch or startup won’t escape IRS scrutiny under the hobby rules.
Corporations, LLCs and limited partnerships do offer protection to their owners or shareholders for any debts of the entity. But the entity’s corporate veil can be pierced if a creditor can show the entity was the alter ego of the owners. Sometimes it is enough that the owners are majority shareholders, exercise substantial control over the incorporated operation, or regularly use corporate funds to finance personal expenses.
The right funding
In good times or bad, one of the hardest questions to answer is what kind of funding should a startup or expanding fabrication business seek? Any quest for business funding begins with an understanding of the various types of financing, where that funding may be found, and at what cost. Generally, there are two basic ways to fund a business: debt financing or equity financing. With equity financing, capital is received in exchange for part ownership in the operation or business. With debt financing, capital is received in the form of a loan, which must be paid back.
Putting money into the fabrication business or taking money from the business is not something to be tackled by amateurs. In simplified terms, money invested in the business can be withdrawn with a tax bill on any profits from the sale of that capital investment. On the other hand, a loan made by a canvas professional to his or her business can be repaid tax-free if the ever-vigilant IRS accepts it as a bona fide, arm’s-length transaction.
The passive trap
So-called material participation rules limit the deduction of losses from so-called passive activities, ventures where the taxpayer does not “materially participate” in the activity. Generally, losses from passive activities may not be deducted from non-passive income (for example, wages, interest or dividends).
Usually, someone is said to materially participate in an activity if he or she participates in the activity on a regular, continuous and substantial basis during the year, or the individual participates in the activity for more than 500 hours during the year.
Having access to legal expertise is extremely important when creating or expanding a business to help the business survive and grow as rapidly and efficiently as possible. In addition to legal advice, accounting advice such as setting up the operation’s books, auditing, payroll services, taxes and retirement planning might benefit both new and expanding fabrication operations.
The first step in finding the right professional requires an inventory of what you and the business or startup need in the way of services and advice and how much you can afford to pay for them. It’s also important to determine beforehand just how much of the work you and your business will do and how much of it will be done by professionals.
Mark E. Battersby writes extensively on business, financial and tax-related topics.
The IRS uses many factors to determine whether an activity is a hobby or a business. These include:
- Do you keep complete and accurate books and records?
- Do you depend on income from the activity for your livelihood?
- Are losses normal in the startup phase of your type of business?
- Did you make a profit in similar activities in the past?
- Does the activity makes a profit in some years?
For a complete list, visit www.irs.gov/faqs/small-business-self-employed-other-business/income-expenses.