A new client asked me, “Why can’t I write off my business losses?” Here’s the story, as recounted in my new book, “Taxmaggedon.” Want to know how to use the brand new Tax Act to put money in your pocket? Look for this book coming in April!
I like to do a lot of preparation before consultations with new clients. You’ll get asked a lot of questions about the businesses you have now, what businesses you plan to start, what your income currently is and what you project it will be. Tell me about your dreams and your goals. Tell me about your challenges with those businesses and investments. And then I ask you how I can best help you.
A new client was concerned that he had a lot of carry forward NOL that wasn’t being used. His main questions all revolved about how to use those. He’d read what I, and others, had said about NOL and he wanted to know why he wasn’t getting the deduction.
“That seems strange,” I thought. NOLs are deductible against income.
As I looked at his last tax return, I spotted a few things that I wanted to investigate. Before we even had our consultation, I asked for more information and in this case it meant more years’ worth of tax returns.
The answer was in the past tax returns.
My new client actually had several carry forward losses on his return. He had some suspended real estate losses. That likely wasn’t going to change, but we wanted to stop the bleeding so I recommended he stop taking depreciation. Depreciation is a strange type of deduction. You can take it, or not. You can catch it up. You can accelerate it with a cost segregation study. And you can just stop it, after you’ve already started it.
Since depreciation has to be recaptured when you sell and he got no benefit from the additional loss it created, he in effect was exchanging capital gains tax (maximum of 20%) for depreciation recapture tax (25%). Not a smart strategy.
He also had capital loss carry forward. In case of this type of carry forward, your deduction is limited to the amount of capital gains in that year plus $3,000. Sometimes I see clients with losses of $100,000 or more. Recently, a new client had a loss of $300,000. It would take 100 years to get the tax benefit of that loss. That needed a whole different strategy. He needed to turn ordinary income into capital gains income. Not hard, if you have enough time to plan and are willing to do things a little differently. (For more details on this strategy, please go to https://www.ustaxaid.com/register-your-book/ to register your book and listen to Insider Tax Strategies, a free bonus as a thank you for your purchase of Taxmaggedon 2018.)
And then we got to the net operating loss. He was absolutely right. He had net operating losses that were carried forward and he was not showing those losses against his other income.
In this case, the issue was that he did not have sufficient basis. There are actually two requirements for net operating losses before you can even consider using those to offset other income. These are:
- You need to have active participation in the business, and
- You need to have basis.
Active participation is a pretty low standard, as tax rules go. It means you have to be active in the business. You could go over the financials with the CFO and talk to the manager a few times a week as way to stay in touch and help focus on what the company can do better. That is enough for you to have active participation!
Basis, though, is a little trickier. There are two types of basis that can qualify. One is equity basis. Equity is comprised of the money you put in the company that isn’t debt. If you make a loan, it’s not equity, it’s a liability for the company. But if you fund it with $10,000, you have $10,000 in equity. Over time, there is income the company will make. Your share of the income increases your basis. If there is a company loss, your share of the loss decreases your basis. If you take out a distribution, it decreases the basis.
If the business has a flow through loss to you, you need to tally up the equity basis you have. If you don’t have enough equity basis, you may not be able to take a deduction for the loss.
You do have one more shot, though. You may have enough debt basis. If you have loaned your business money, that adds to the debt basis. In the case of a partnership, or an LLC that has elected to be taxed as a partnership, if you have personally guaranteed partnership debt then it will count as well.
However, in the case of an S Corporation or an LLC that elects to be taxed as an S Corporation, if you personally guarantee the debt, that will not count toward the debt basis.
That’s an important difference to keep in mind.
In this case, my new client didn’t have enough basis. He had a lot of debt, but he had not personally contributed the money and because it was an S Corporation, the fact that he had signed for the debt didn’t count.
Over the next year, the company paid off that debt and he personally loaned money to the corporation so that he had the needed debt basis.
The corporation didn’t have enough cash to pay off the debt without getting a loan. This time, though, they got the loan through the owner so he could get basis. That meant he could take advantage of the net operating losses he had carried over.
The lesson to take away from this real-life story is to first understand what kind of carry forward loss you have and then secondly, figure out what needs to change in order for you use that loss to offset other income. “
Keep tuned to USTaxAid.com for the launch of “Taxmaggedon.”