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Many closely-held businesses today operate under Subchapter S corporate status. In many ways, it is the best of all worlds: Corporate liability protection combined with pass-through tax status. This tax treatment is often described as the equivalent of partnership taxation, where the owners report their proportionate share of the business income or loss on their Form 1040.

But the S corporation tax rules have some distinct differences from pass-through partnership treatment. One of those is the mandate that an S shareholder’s ability to claim losses of the S corporation is limited to that shareholder’s direct investment in the form of either capital injections or loans into the S corporation.

Example: Ken forms a new S corporation and injects $100,000 of capital in exchange for his stock. Later, as the S corporation’s need for funds increases, the S corporation borrows $200,000 of operating capital from a bank, supported by Ken’s personal guarantee of this debt. If the corporation loses $120,000 in its first year, Ken’s deduction of this loss is limited to $100,000, his direct investment in the corporation. Had Ken personally borrowed this $200,000 operating line and then loaned the funds to the corporation, his loss would not be limited.

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Many entrepreneurs with multiple business activities will use a separate S corporation for each location. In addition to providing liability protection, this also allows greater flexibility in terms of either adding additional co-owners or disposing of the business. But, when it comes to capitalizing these S corporations, the same loss limitation rule can be encountered if intercompany financing is used.

Example: Kris operates several successful stores, each organized as a separate S corporation. This year, Kris decides to open a new location, and again forms another S corporation. To capitalize this new entity, Kris has her successful S corporations make large loans to the new entity. However, at year-end when the new entity reports its first year loss to Kris for use in her Form 1040, the fact that she has not made any direct investment into the new S corporation will limit her deductible loss to zero. The unused loss will carry forward until Kris either injects capital or receives a positive net income allocation from this new S corporation.

If claiming initial losses from a new S corporation is important, there is a remedy for those who intend to capitalize the new entity using the profits of their existing businesses. If these other businesses are also organized as S corporations, a two-step process needs to occur. First, the profitable S corporation makes a tax-free shareholder distribution to the owner. Secondly, the individual then loans or contributes the capital to the new S corporation.

This simple formality of having the S shareholder personally inject funds can assure that those start-up losses produce immediate tax savings in the owner’s Form 1040!

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Marital dissolutions can get complicated. And that complexity increases when a valuable closely-held corporation is part of the marital property. In most cases, the net worth of the splitting couple will be equalized in the divorce process, with the corporate business entity going to the spouse who has primarily managed and operated the business.

But if that corporate entity represents more than half of the couple’s net worth, as is often the case with a valuable business, the spouse receiving the business will generally need to move cash to the other spouse. And often, the only source of that cash is the corporate entity itself.

Example: Bert and Ann are about to divorce. Their assets consist of a closely-held corporation valued at $2 million, a residence worth $600,000, and miscellaneous investments valued at $400,000. Bert founded the corporation and his engineering skills are critical to its ongoing success, so the couple agrees that he will take the corporation and Ann will receive the house and other assets, plus $500,000 of cash from Bert to equalize the division of assets. Because Bert has no other sources from which to secure $500,000 of cash, he proposes that the corporation buy out the shares of stock held by Ann for $500,000. Bert explains to Ann that a complete redemption of her stock will produce a favorable capital gain tax rate. They will agree to split the tax cost on this stock redemption because it is an inexpensive way to get cash out of their corporation in a manner that allows them to equally divide their assets.

In the past, when the IRS encountered a transaction such as Bert has proposed, they were quick to cast it in a different light. The IRS position would be that the corporation had assumed Bert’s personal obligation to pay Ann for a portion of her stock. Accordingly, the IRS view was that the corporation had first issued a $500,000 dividend to Bert, and that he in turn made a marital dissolution payment for the division of their property to Ann. Under this approach, the IRS converted what appeared to be a lower rate capital gain redemption into a fully taxed ordinary income dividend.

But earlier this year, the IRS reversed its position in a new favorable set of regulations.

These regulations adopted an approach that gives flexibility to spouses in structuring the division of a closely-held corporation. The spouses are given the opportunity of mutually consenting to capital gain redemption treatment if the corporation acquires the stock of one of the spouses.

Securing this favorable tax treatment requires the agreement of the spouses in the actual divorce document. If the spouse who retains the business has a primary and unconditional obligation to personally acquire the other spouse’s stock in their dissolution documents, the IRS will still assert its former position of unfavorable dividend treatment.

Example: Continuing with the preceding example, if Bert and Ann place language in their divorce instrument under which they agree that the redemption of Ann’s stock would be treated for federal income tax purposes as a complete redemption distribution to Ann, the IRS will respect this language and allow the favorable capital gain treatment.

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Back in the days when the words “tax shelter” still had meaning, equipment leasing was a common strategy. Business owners would personally invest in equipment needed by their businesses, setting up a lease arrangement that often created tax losses and deferral (i.e., the interest expense and depreciation in the early years exceeded the rental income received).

But tax laws have a way of evolving, and today there are new hazards that suggest this is an activity to avoid.

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Equipment leasing, of course, is a rental activity, and as such is subject to the passive loss restrictions. Essentially, these rules dictate that losses from rental activities must be suspended, and can only become deductible when the activity is disposed of or when used against other passive income.

Under some very limited exceptions, it is possible to combine a business owner’s equipment leasing activity with the business itself to overcome these passive rules. For example, if the ownership of the equipment being leased is exactly proportional to the ownership of the business, the passive nature of the rental activity can be ignored. Also, if the equipment rental is economically insignificant to the business, an override may be possible.

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When equipment leasing in a 1040 produces positive net income rather than a loss, a different problem arises – the self-employed social security tax (SE tax). Technically, equipment leasing is a business activity. Because the property being leased is not real estate, the normal rental exception from SE tax does not apply.

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In many states, another unwelcome tax cost rears its head in the form of the state sales tax. Many states impose their sales tax on gross rents collected on tangible personal property, and this will typically reach equipment leasing rentals.

In summary, what formerly was a solid tax strategy now has a host of problems. SE tax arises when the net result is positive and passive loss restrictions appear when the net result is negative. If you are facing any of these risks, perhaps we can be of assistance.