Putting money into a woodworking business — or taking money from the business — is not something to be tackled by amateurs. Admittedly, a surprising number of woodworking professionals do depend on themselves when it comes to financing their businesses. Thanks to our complex tax rules, however, getting money invested out of the business can be expensive.
Quite simply, money invested in the business can be withdrawn — with a tax bill on any profits from the sale of that capital investment. A loan made by a shop owner to his or her woodworking business can, on the other hand, be repaid tax-free only if the ever-vigilant IRS accepts it as a bona fide arm’s-length transaction.
On a similar note, it can also be expensive for any owner, partner or officer who attempts to take money from their woodworking business. Once again, there is the risk the IRS might view the movement of funds from the business to the owner, partner, officer or shareholder as a taxable event.
It should be increasingly obvious that something as apparently simple as taking money from the woodworking business or even putting funds into the business can be painfully expensive under our tax rules. Those tax rules are quite clear — only bona fide loans and contributed/invested funds qualify for any sort of tax break. When either lending to or borrowing from the shop or business, every woodworking professional should keep in mind that in order to count in the eyes of the IRS, any transaction must be a legitimate, interest-bearing loan. Under our tax rules, an owner, partner or shareholder borrowing from his or her business can face a hefty tax bill should the IRS view the transaction as a dividend payout rather than a loan.
All too often, it is below-market interest rates or the lack of evidence of an arm’s-length transaction that draws the attention of an IRS examiner. The IRS is particularly interested in (1) gift loans, (2) corporation-shareholder loans, (3) compensation loans between employer and employee or (4) loans between independent contractor and client and (5) any below-market interest loan in which the interest arrangement has significant effect on either the lender’s or borrower’s tax liability.
Should the IRS re-characterize or re-label a transaction, the result is an interest-expense deduction when none was previously claimed by the borrower and the addition of unexpected taxable interest income for the lender. The lender’s higher tax bills — tax bills that can date back several years — are usually accompanied by penalties and interest on the underpaid amounts.
Always a borrower be
For many woodworking businesses, borrowing means a loan from the owner or shareholder. In some cases, it is the owner or shareholder who borrows funds from the woodworking operation. Loans and advances between these so-called “related parties” are quite common in closely-held shop or businesses. Corporate loans to shareholders are probably the most commonly seen by IRS auditors, with advances from shareholders to the incorporated woodworking business running a close second, particularly in the early years of closely-held but thinly capitalized corporations.
The IRS’s interest in these transactions stems from the tremendous potential for tax avoidance — inadvertent or intentional. When an incorporated woodworking business makes an interest-free (or low-interest) loan to its shareholder, in the eyes of the IRS, the shareholder is deemed to have received a non-deductible dividend equal to the amount of the foregone interest. The incorporated woodworking business is, at the same time, deemed to have received a like amount of interest income.
Fortunately, there is a $10,000 de minimis exception for compensation-related and corporate/shareholder loans, at least those transactions that do not have tax avoidance as one of the principal purposes.
Although this transfer of taxable income between entities might appear to be offsetting, there can be a significant tax impact on the reallocation, depending on the relative tax benefits to the borrower and to the lender and the deductibility of the expense deemed paid.
Downside: Stock or loan
When IRS examiners review loans from shareholders and the common stock accounts of a woodworking business, they often encounter what can only be called “thin capitalization, which occurs when there is little or no common stock and there is a large loan from the shareholder. A special section of the tax law, Section 385, Treatment of Certain Interests in Corporations as Stock or Indebtedness, governs whether a loan is one to an incorporated business or treated as debt.
The IRS’s objective when it encounters thin capitalization is to convert a portion, if not all, of the loans made by the shareholders into capital stock in the business. Naturally, this conversion requires an adjustment to the interest expense account because at this point the loans are considered non-existent. The interest paid by the incorporated business on these disallowed loans becomes a dividend paid to the shareholder in an amount equal to the operation’s earnings and profits.
Recovering from bad loans
Under our tax laws, a business bad-debt deduction is not available to shareholders who have advanced money to a corporation where those advances were labeled as contributions to capital. However, a business owner or shareholder who incurs a loss arising from his guaranty of a loan is entitled to deduct that loss — but only where the guaranty arose out of his trade or business or in a transaction entered into for profit. If the guaranty relates to a trade or business, the resulting loss is an ordinary loss for a business bad debt.
When attempting to take funds from the woodshop business, one option involves taking tax benefits instead, especially where the business might profit from an infusion of badly needed cash. If the business is in need of an infusion of cash and the owner is reluctant to invest additional money, an answer could lie with the tax benefits. Are the operation’s tax benefits being wasted because of low or non-existent profits?
A one-transaction-cures-all, all-purpose solution involves the sale-leaseback of the woodshop business’s assets. Generally, the business sells its assets, the building that houses the operation, the equipment used in the business, its furniture, fixtures or other property it owns. The buyer of those assets, usually using borrowed funds, is often the owner, partner or shareholder.
When the owner or shareholders in a woodworking business own the assets of the operation, the business makes fully tax-deductible lease payments for the right to use those assets in its operation. The business is exchanging depreciable equipment or its building for badly-needed capital and immediate deductions for the lease payments it is now required to make.
The new owner of that shop or equipment, whether the business’s owner, shareholder or, perhaps, a trust established for the benefit of the woodworking professional’s children, will receive periodic lease payments. With one transaction, the shop owner has found a way to get money from the woodworking business without the double-tax bite imposed on dividends and a tax write-off as the owner of the property or equipment. Even more importantly, the business receives an infusion of badly-needed cash.
Unfortunately, under our tax laws, specifically Section 469, that deals with passive activities and losses, income from rental real estate is generally considered “passive activity” income, regardless of the woodworking professional’s level of management involvement. The tax rules clearly state that a taxpayer can use losses from a passive activity only to offset passive activity income.
In other words, passive losses cannot shelter other income including profits, salaries, wages or portfolio income such as interest, dividend or annuity income.
A loophole built into the rules states that rental realty income is not passive activity income if the property is rented for use in a trade or business in which the taxpayer materially participates. This rule prevents taxpayers with passive activity losses from artificially creating passive activity income to absorb the losses.
The cost of self-financing
With conventional financing still difficult to obtain, it is little wonder that “self-financing” remains a popular form of financing and is used by small-business owners. It’s quick, doesn’t require a lot of paperwork and is often less expensive than conventional financing.
Unfortunately, when investing in their businesses, many shop owners overlook the cost of self-financing. The cost everyone using his or her funds should consider is the so-called “lost opportunity” cost, the amount that could have, or might have, been earned had those funds remained in savings or invested elsewhere.
However, in the current topsy-turvy economic climate, doing it yourself or keeping financing within the family frequently produces the fastest and best results. Unfortunately, our tax laws create obstacles that must be overcome to avoid penalties and corresponding higher tax bills.
The complexity of the tax rules obviously requires professional guidance especially for any woodworking professional wishing to avoid paybacks and those dreaded “accuracy-related” penalties down the road.
This article originally appeared in the March 2015 issue.