To save money on taxes you’ve got to know how to use the loopholes that are out there. Here’s a great example of how one taxpayer offset active income in one business against the passive losses in another.
A pharmacist in Texas operated a radiological service company as a side business. He created an LLC that purchased the expensive medical equipment needed to provide those services, and used a separate business structure as his operating business. The operating company leased the equipment from the LLC.,This is a great asset protection strategy, as any lawsuits would be filed against the operating company, and not the LLC, which would keep that expensive medical equipment safe.
At the end of the day the equipment LLC operated at a loss, while the operating company made a profit. Under IRS rules the pharmacist elected to treat both business activities as one for tax purposes, meaning he could take the losses from one company and use them to offset income from the other. This is allowed under the IRS Code as long as the two activities mesh together and could be considered a single economic unit, and the one of the activities is insubstantial, when compared to the other. The IRS objected, and the case wound up in court.
The court looked closely at the economic unit rule, as well as the insubstantial activity rule. With respect to the economic unit rule, it was clear that the businesses were closely connected. They had the same owner, were formed in the same state, and operated within the same city. When the court looked at the insubstantial activity rule, they looked at it from two angles: qualitatively and quantitatively.
The LLC existed only to buy medical equipment and lease it to the operating business. It had no other clients and had no income apart from what it received from the operating company. If the operating company went out of business, there would be no reason for the LLC to continue business. And if the LLC went out of business, the operating company could replace it with another equipment leasing company. So from a qualitative point of view, the LLC was an insubstantial business, when compared to the operating company.
It was the same with the quantitative perspective. When it came to earnings, the LLC earned about 3.4% of the combined gross income for it and the operating company. Even after the IRS disputed the numbers (they claimed the operating company was creating an artificial loss by paying too little to the LLC) that number was only 11%. And even though the LLC looked to be worth more on paper than the operating company, the court noted that all of the equipment was fully leveraged.
At the end of the day the Tax Court agreed with the pharmacist. There really was no reason to treat the two companies separately for the purpose of offsetting the passive loss in one company against the active income in another. The pharmacist’s deductions were allowed in full.
If this sounds like a workable strategy for your business, talk to your tax advisor first, and definitely before you put anything into place. This strategy will only work if you make sure you meet all the IRS requirements, and could backfire badly if you miscalculate. And if you don’t have a tax advisor, or aren’t sure your CPA understands your business, drop us a line. We’ve got some great folks at DKAffiliated who understand these rules inside and out and can make sure you implement this strategy correctly.