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June 2003 Deducting S corporation losses Direct investment is the key to turning those business losses into personal tax deductions Many closely held businesses today operate under subchapter S corporate status. In some ways, that form of entity is the best of both worlds: corporate liability protection combined with pass-through tax status. This tax treatment is often described as the equivalent of partnership taxation, where the owners report their proportionate share of the business income or loss on their Form 1040. But the S corporation tax rules have some distinct differences from pass-through partnership treatment. For instance, a shareholder's ability to claim losses of the S corporation is limited to that shareholder's direct investment, through loans or capital contributions, and it's important that you understand what is and is not a direct investment. Let's say you form an S corporation and contribute $100,000 in exchange for stock. When your new corporation needs operating capital, it borrows $200,000 from a bank, supported by your personal guarantee. In its first year, the corporation loses $120,000. Your deduction of this loss is limited to $100,000 - the amount you directly invested. If you had personally borrowed the $200,000 and re-loaned it to the corporation, you could have deducted the entire $120,000. Intercompany loans. Many entrepreneurs with multiple business activities will use a separate S corporation for each operation. In addition to providing liability protection, this allows greater flexibility in adding co-owners or disposing of a business. But if you use inter-company financing to capitalize a new S corporation, you may encounter the same loss limitation rule. For instance, you operate several profitable retail businesses, each organized as a separate S corporation. This year, you open a new location and form another S corporation. To provide it with needed capital, you have your other S corporations make large loans to the new entity. However, when that new entity experiences the likely first-year loss, you cannot deduct any part of that loss on your Form 1040, since you didn't make a direct investment. The unused loss will carry forward until (a) you make a direct investment or (b) you receive a positive net income allocation from the new S corporation. To claim initial losses from a new S corporation that you capitalized with profits from your other S corporations, a two-step process needs to occur:
This simple formality of having the S shareholder personally inject funds can assure that those start-up losses produce immediate tax savings in the owner's Form 1040. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |