Sub Chapter S – Stockholder vs Lender
Backing A Start Up? Insist On Being An S Corp. Shareholder
Suppose a relative asks you to help launch a new business. You decide it’s worth the risk-or you just want to keep peace in the family. Whatever your motives, you need to take action to keep your tax bill as low as possible.
Don’t make a loan to a new venture. If you lend money and can’t collect, you have a “nonbusiness bad debt”, even though the loan was to finance a new business.
To get a tax break from a new business bad debt, you must have a formal loan. If you don’t have a fixed replacement date and a market rate of interest, the IRS could argue that you mad a taxable gift.
Even if you can prove you made a loan, you have to show that you have no hope of ever collecting. In that case, a nonbusiness bad debt is treated as a capital loss. If you don’t have capital gains to offset it, your deduction is limited to $3,000 per year with the balance carried forward.
To make matters worse, a bad debt deduction can trigger an IRS audit.
Bottom Line: When you loan money to a new business, you’re risking a total loss. The interest you receive probably won’t compensate you for the risk. And, if the business goes under, you could wind up with no way to recoup your losses through tax deductions.
Insist on an equity stake: You’re better off investing as a stockholder. Have the business formed as a corporation, which is relatively easy and inexpensive. That way, you have the chance of reaping returns that are commiserate with the risk you’re taking if the new business becomes a winner. You’re more likely to get tax relief if it fails. When contributing to the new venture, write a check payable to the corporation. Be sure to receive a certificate for the appropriate number of shares in return.
Next, insist that the new venture elect S corporation status: Most small, closely held corporations qualify as S corporations and you’re in a much better position if the venture chooses this legal structure. Here’s why:
S corporation shareholders receive a flow-through of profits or losses, pro rata. For example, lets say your investment entitles you to a 25 percent stake in the company and the corporation losses $600,000 in 2000.
You will be entitled to a $150,000 deduction, provided you have sufficient basis-and direct investments in S corporation stock provide basis.
So investing as an S corporation shareholder entitles you to write off your entire investment immediately if the company fails. You don’t have to sell your stock or prove that your investment is worthless.
As a corporate shareholder your personal assets aren’t vulnerable to the company’s creditors.
Another option: Invest as a member of a limited liability company (LLC). The tax and asset protection advantages are the same for an S corp. and you don’t have to live with all the s corp. requirements.
Advisory: Don’t invest as a general partner in a partnership. It’s true that you’ll get an equity stake and a chance to write off your losses. However, you expose all your personal assets to the partnerships creditors. Limited partnerships may help with this problem, but they’re expensive to create.
