It’s December and the last thing on your mind might be your business and its taxes. You’re busy and this year, 2020, has been especially crazy.
I get it.
But if the reason you haven’t reviewed things with your CPA is because you think it doesn’t matter. You might be very wrong.
And that could really cost you later.
It is ESPECIALLY important if your business got a PPP (Paycheck Protection Program Loan) or an EIDL (Economic Injury Disaster Loan) from your lender, fintech company and/or the SBA.
There is a very unique situation right now and it has made this question DOUBLY important.
Here’s what could go wrong.
High Income, Big Loss and Double Tax
A client of mine has several businesses that get really busy at year end. Last year was even worse. We didn’t see financial statements for the last half of the year for months. The client kept assuring us that everything was the same.
But, sadly, it wasn’t.
One company was very profitable and paid the owner a salary of almost $500,000. Another company had a loss of about $200,000, but when we looked further we saw that the company had paid the owner a salary of $300,000.
Let’s add that up:
Salary #1: $500,000
Salary #2: $300,000
Co #1 Income: -0-
Co #2 Loss: (200,000)
On the surface, it would look like there is going to be taxable income from the two companies of $600,000 ($500,000+$300,000-$200,000) for the year.
Now let’s talk about tax planning.
Right away, there’s an obvious problem. Co #1 and Co #2 are both S Corporations. An owner is required to take a salary that is reasonable for the work that he or she performs. If the income in the company is lower, we usually use a rule of thumb of 1/3 – ½ of net income.
By taking out all the profit in Co #1 in the form of salary, the owner paid more in payroll taxes than was needed. At a minimum, it should have been ½ salary and ½ distribution. That would have been a big difference already.
But then let’s look at Co #2. After a salary of $300,000, there is a loss of $200,000. That means there was only $100,000 in income. It wasn’t necessary to take that much in salary. It could have been just $50,000 in salary and the payroll taxes would have been a WHOLE lot less.
The Real Problem with a Company That Had a Loss
There is another bigger problem with Company #2. The $300,000 salary will all be taxable, but that loss that was created of $200,000 might not be deductible. The issue is basis.
In order to take a loss from a business on your tax return, you must have enough basis.
There are two ways to get basis:
Equity basis. For the S Corporation, this would be the amount that the owner paid for the stock plus the accumulated retained earnings. If the company had been around for years and running a lot of profit in the past, then there might be enough equity basis. But for most closely held companies, there isn’t enough equity basis. That’s why most closely held companies rely on the second form of basis. Debt basis.
Debt basis is the total of loans you have made to the company in the case of an S Corporation. There is one more way to get debt basis, but you have to have a partnership to use that method.
This was an S Corporation, so it only was based on how much the owner had loaned the company.
And now there was a problem.
There was no equity basis. That wasn’t unexpected, but it meant there was only one option. Debt basis.
And there had been no loans. Instead, Co #2, an S Corp, had taken out a business loan in its own name. It didn’t matter if the shareholder had personally guaranteed it. It still wouldn’t create basis.
Funding had been done by other sources (the bank in this case) and so there was no equity basis.
That mean even though the actual true profit for the year was $600,000, shown as a mix of W-2 income and the business income/loss, the taxable income was $800,000.
By taking too much salary and not having enough basis, the client CREATED tax liability that wasn’t required.
It’s like they went out of their way to pay an extra $70K in taxes.
What is the question that the taxpayer should have asked?
“Do I have a basis problem?” (or do I need more basis? Or even, I have a loss, can I deduct it?) Just something to ensure you have a conversation with your CPA before year end.
Of course, your CPA is going to want to see your financial statements. If you don’t have those, everyone will have to just give it their best guess.
Let’s do one more example for real estate losses and then I’m going to go through WHY 2020 is so much more tricky for businesses that have losses.
Don’t miss the last part of this article! It’s the one big gotcha you need to watch out for if your business got PPP and/or EIDL loans.
Real Estate Professional Loses Real Estate Losses
There are three benefits to investing in real estate:
And when it comes to tax breaks, there is nothing quite like real estate. You get a phantom deduction, depreciation.
But there’s a catch. You may end up getting on the wrong side of the passive real estate loss activities rules.
If your adjusted gross income (AGI) is under $100,000, you can take a deduction up to $25,000 in passive losses provided you have active participation and sufficient basis. If your AGI is over $150,000, you can’t deduct anything, the loss is just suspended.
Between $100K and $150K, your deduction phases out.
The exception is if you’re a real estate professional. (REP)
And that’s as far as many people get. I’m a REP! I can deduct everything.
Not so fast.
You also need two other things: active participation and sufficient basis.
Active participation is fairly easy to prove as long as you legitimately are involved in your business. The IRS has gotten fussy in audit on this part if the taxpayer can’t show that they actually did anything with their rentals. So you need to keep some kind of journal or log that shows you were actually involved in your rentals.
You can’t just rent and forget it. You can’t turn it all over to a property manager and hope for the best. You have to be actively involved in some way.
The other issue is basis.
Just like with a business, there are two ways to prove basis: equity basis or debt basis.
If you have your property inside an LLC with default taxation (Schedule E if single member or partnership if multi member), any debt that you have personally guaranteed will count as debt basis. If you have bought your real estate with a mortgage that you guaranteed, you likely have enough basis. But if you bought your real estate with debt that you didn’t guarantee or if your entity is an S Corp, you may have a problem with basis.
Talk to your CPA right away.
What is that question that is so important right now?
Do you have enough basis?
How to Solve Lack of Basis if You ACT NOW
Does your business have a loss for 2020? If so, you need to make sure you have two things:
If you have a loss of $100,000, you need at least $100,000 of basis.
The fastest way to increase your debt basis is to loan your business some money. Just make sure you do it before 12/31/2020.
Note: You can’t just pull money out of your corporation and then loan it back. This has to be private money you have, that you raise or that you borrow. You can’t just take it out of the company and put it back in.
Remember, you need to have sufficient basis before 12/31/2020 or your losses will NOT BE DEDUCTIBLE!
Why PPP and EIDL Loans Just Made This Much Harder
An EIDL loan is made to the business, not to you. That means that it does not increase your basis. Let’s say for example, your business lost $150,000 this year. And you have no cash in the business. The EIDL loan comes just in the nick of time. You can pay your bills
But unless you have basis, that $150,000 won’t be deductible for you.
And the EIDL loan does not create basis.
If the PPP loan hasn’t been forgiven yet, then it’s not going to create basis either. Once it’s forgiven, it will possibly increase your retained earnings. So it impacts STOCK basis, not DEBT basis. That’s an important distinction too.
This is tricky stuff.
Talk to your CPA NOW before it’s too late. And if you’re not sure, put some money in your corporation’s bank account before 12/31/2020. You can always pull it out in 2021. But remember you may have the same issue in 2021.
More articles on how to take deductions for your business and real estate:
Can Your Business Pass This IRS Test?
This is Still the Best Tax Break There is For Real Estate Investors