Are Those Pesky “At-Risk Rules” Blocking You from Tax Savings?

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Saving taxes with innovative and IRS approved tax plans is the pathway to wealth.

The client never sees it.  He/she merely pays more than his/her fair share. More than is legally required.  His CPA did not want to take the time to tell him what happen.  

The best business structure for the entrepreneur must avoid the “at risk” rules (I’ll tell you how this done at the end of the blog) and here is why

Take Jim.  During the great recession, one of his businesses was booming; but another was losing money.  The successful business loaned money to the losing business.  Both businesses were an S-corporation.

The successful business earned a $100,000.  The other company lost a $100,000. Jim can’t offset the $100,000 income by the $100,000 loss.  Here is why.  The successful corporation loaned money to the losing corporation.   Jim’s corporation was at risk.  Jim was not.  To deduct the loss, Jim had to be at risk.  

“At-risk rules” in the tax code limit the amount you’re allowed to claim as deductible loss from your business. Section 465 limits those losses to a) the amount of money and other property contributed by the taxpayer to the activity, and b) borrowed amounts that fit certain criteria.  Money from another corporation or partnership does not increase the amount you are “at risk.”

Unfortunately for taxpayers, Section 465 has an at-risk rule that discredits operating losses “borrowed from any person who has an interest in such activity or from a related person to a person (other than the taxpayer) having such an interest.” In other words, when a business loses money borrowed from a related entity, they can’t claim it as a tax deduction.

Small businesses that have more than one business entity, whether S-corporations or LLCs fall into this tax trap.  For example, let’s say a holding company (or parent company) named SoCal Tech Brains has a service provider as one business entity and online sales as another business entity.

They’re attracting a ton of customers needing service, but their products aren’t selling. The savvy CEO at SoCal Tech Brains decides to have her team focus on creating a new product after learning the customers’ needs. To fund product development, the owner borrows money from the profitable entity—in this case, the service provider—to give the struggling business a boost.

Sounds like a perfectly rational decision for the business owner to make, right? Well, based on the IRS’s at-risk rules, that would be a bad idea. The sales entity of SoCal Tech Brains wouldn’t be allowed to deduct the loss of that loan.

For many years, the pesky rule left me in a conundrum when creating tax savings strategies for my business clients. “If only there were a business entity exempt from the at-risk rules,” I often thought. How could a business owner run more than one entity saved on taxes when one company was making money, while the other was barely holding on to dear life?

My Latest IRS Discovery

On May 19, 2014, I found a written letter from the IRS that answered my question. (In the P.S. section mind you!)

Here is the excerpt in blue verbatim minus one name blocked out for confidentiality:

“P.S. At risk under section 465 does not apply to partnerships. Hambrose v. Commissioner. These would require affected item stat notices following the proceeding to the partners of ***.”

Hurray, a solution!

Based on the notice, here’s my advice for creating a small business tax structure: Form a holding company LLC with two owners, so that you’ll be legally classified as a partnership. If you’re married, you might consider forming a husband and wife partnership. If you’re unmarried without a family, here’s another idea to form a partnership: create a trust to be your partner.

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Best small business tax planning strategy is the two member LLC as a holding company.   A husband and wife or you and a trust can be the two members.

The LLC holding company owns each business as a single member LLC, which enjoys the same creditor protection as the S-corporation.

S-Corp Owners: Use Caution

I encourage S-corp owners to consider this business structure, however, keep in mind, that moving a profitable business from an S-corp to an LLC can be tricky. If it’s not done right, you’ll incur income tax. You’ll have to assess your assets such as goodwill to determine the best tax plan.

During the Great Recession, I witnessed many small business owners become insolvent because of the IRS’s burdensome at-risk rules. Don’t let this happen to you.

If you want to take your tax planning to the next level, then contact me, Brian Dooley, CPA, MBT  at [email protected]