Tax laws can help or hurt new and expanding businesses.
In today’s economy, it’s not unusual for an existing event business to branch out, or for an owner or self-employed 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.
Tax laws allow the government to not only pick up part of the expense of branching out or starting up a new venture, but they 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.
Start-up 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 start-up 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 start-up expenses exceed $50,000.
The so-called organizational costs of business entities are a separate class of expense from start-up 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 start-up 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 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 Jane Doe operates an event planning company. The operation is profitable, and she decides to establish a business at the same location that specializes in vintage decor rental. Jane Doe’s start-up expenses amount to $70,000 and include the cost of hiring employees, setting up bookkeeping, creating an operations manual and advertising and promoting.
If this were an integrated operation, Jane Doe’s primary business could immediately deduct the start-up 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 start-up—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. Other factors the IRS considers are whether you keep complete and accurate books and records and depend on income for your livelihood, and whether losses are normal in the startup phase for this type of business. 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 to consider using many of the TCJA’s tax breaks to start or grow a 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 start-ups, 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 start-up expenses remains limited.
The right funding
One of the hardest questions to answer is what kind of funding should a start-up or expanding business seek. This quest 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 business. With debt financing, capital is received in the form of a loan.
Putting money into the 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 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.
Having access to legal expertise is extremely important when creating or expanding a business. In addition, accounting advice such as setting
up the operation’s books, auditing, payroll services, taxes and retirement planning might benefit both new and expanding operations.
The first step in finding the right professional requires an inventory of what you and the business or start-up need in the way of services and advice and how much you can afford to pay for them. It’s also important to determine how much of the work you and your business will do and how much of it will be done by professionals
By Mark E. Battersby. Battersby writes extensively on business, financial and tax-related topics.