ποΈ Weekly emails ποΈ Accounting Basics π° Tax Strategy and Structuring Basics π Internal Controls for Small Business π Lessons learned as a partner and running CPA Firms
Tax Planning for Debt
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One of the first questions to answer when advising entity selection is how the business will be capitalized. π° Whether you should run your operations as a S-Corp, C-Corp, or Partnership depends heavily on:
We'll be focusing mainly on the second bullet point today - more specifically the tax impacts that being a partnership versus a S-Corp has on the ability to "access" debt-financed losses. But first, let's walk through two real life examples. Example 1: Stay at home mom decides she wants to open up a cycle bar (like a place where people go to ride stationary bikes together). π΄ββοΈ
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Her full-time W2 husband does some googling and confirms with his neighbor that being a S-Corp would save $7,000 on self-employment taxes for the cycle bar - so that's the type of entity they select. It's a start up so they do the filing themselves (correctly!) and are locked in. π
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Mom opens the bank account, pays the franchise fee, and takes out a loan to purchase all the bikes and cost to build-out the location in the closest strip mall. π¬
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Year 1 starts out slow, but the tax benefits to all that depreciation will at least be a consolation prize - right? π€
β Example 2: CPA who has only worked in the audit department and in corporate accounting decides to invest with his buddy in a restaurant. π£
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He also does some googling and confirms with a tax senior he's buddies with that being an S-Corp will save a ton on self-employment tax too, because this concept is going to crush.
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First location does well, so they decide to expand. π
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Second location, also an S-Corp, needs some help in addition to traditional financing - so money is lent from Location 1 to Location 2.
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Location 2 runs a big loss, while Location 1 crushes it. But at least they'll offset each other come tax time - right? π€
β The main concept to cover here is how debt (liabilities) are treated differently between Partnerships and S-Corps. Partners in a partnership are treated as "personally" incurring business liabilities. These liabilities give them additional "basis" in their partnership interest. π Shareholders in a S-Corp are NOT treated as "personally" incurring business liabilities. The only liabilities that increase S-Corp shareholder basis are loans made by that shareholder individually. π Basis matters for a few reasons:
β If you don't have basis in your ownership interest, and are allocated a loss, then that loss is "suspended" β due to lack of basis. It will get unsuspended when you get more basis (contributions of assets, income allocated to you, etc). Equally problematic is when you receive distributions in excess of basis. These can be taxable - which is why S-Corp debt-financed distributions don't work. π€¦ββοΈ β Applying this concept to our examples, we can see that both of the shareholders of the S-Corps will be limited in how much in losses they will be able to utilize to offset other income. π§ Cycle bar mom doesn't have basis in the S-Corp for the amount of bank debt - so losses generated by all that depreciation won't be usable to offset husbands W2 income. Which sucks because she otherwise materially participated. π€¬ And because the intercompany loan from restaurant Location 1 to Location 2 is not a shareholder loan, it does not meet the criteria for shareholder basis (without significant backdating of documents, which isn't advisable). Meaning shareholders will be stuck picking up all the income from Location 1 but not being able to utilize the losses from Location 2 due to lack of basis. π€’ β In both of these cases, a partnership would have been more practical and could have helped increase the owners basis in the underlying interest - freeing up those suspended losses. π¨βπ« It's worth noting that S-Corps do have a purpose and role to play in tax structuring. But if the business will be asset heavy and / or using debt to finance operations, a partnership should be considered somewhere along the way. πΊοΈ β Interestingly, or not maybe, is that within a partnership there are different classifications of debt that also impact how much loss can be taken by that partner - and even how much loss is allocated to them. But that's for another time. β π«‘ π Reminder that I offer one-off paid consultations. Reply to this email to set up a call. π
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The Plug: Tax & Accounting for Real Estate and Small Business
ποΈ Weekly emails ποΈ Accounting Basics π° Tax Strategy and Structuring Basics π Internal Controls for Small Business π Lessons learned as a partner and running CPA Firms
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