In reviewing a new client’s tax situation, I had the unpleasant task of informing them that the losses they were incurring would not be deductible. In setting up their business they decided to become a S-Corporation because they had heard, through message boards, that was the best way to go. It’s hard to argue because, for many of our established clients, the S-Corporation is the most tax efficient option. However, if you are just starting a business or you just purchased one, it may make sense to wait before you make the election. Here’s why:
Losses Might Not Be Deductible
In order to deduct losses in a business you typically have to have two things:
1. You must be active in the business
2. You must have basis to take the loss
Most business owners will meet the “active in business” requirement, but the basis requirement can be a stumbling block. Basis is created by two events. First, the business has to have previously taxed income. Second, the owner has to have money at risk. One of the strange rules of a S-Corporation is that loans obtained through a bank or outside party do not create at-risk basis. Sure, you’ve got money at risk, but for whatever reason that does not help. Only money that you personally loan the corporation creates basis.
So if you have not created basis, the loss becomes suspended and can only be deducted against future income or the future creation of basis. The problem here is that most new owners are tight on cash and could’ve used the refunds these losses would have provided.
If the owner had been taxed as a sole proprietor, the losses likely would have been deductible as third party loans from banks/lenders are considered to be “at-risk” and create basis to take losses.
Of course this makes no sense, but neither does much of the tax code.
In short, you cannot take more money out of a S-Corporation than your taxable income or else you create capital gains with the excess distributions. As most new owners struggle to turn a profit out of the gates this can be an issue as well.
Entity selection is an often-overlooked issues for new business owners and entrepreneurs. It is an important facet to your business and you should be talking with your CPA about to determine the right fit. Yes, S-Corporation are eventually the best choice for many, but most times it’s not the best choice in the initial years of a business.