Ask the Expert - Peter LaChance: The tax effects of your business decisions
Decisions whether your company should be a limited liability company or a corporation can seem like they aren't all that important early on, but the consequences of not thinking ahead and making the wrong choice can be costly.
Here's an example. Two individuals chose S-corporation status for their startup company. The individual with the technological know-how received 80 percent of the S-corporation's stock while contributing no capital. The other individual received the remaining 20 percent of the company's stock and funded the company in the very early stages by contributing 100 percent of the capital.
Like many startup companies in the first two years, they operated at a loss. In the third year, an event occurred that required them to change their entity structure to a C-corporation (they received venture capital).
For tax purposes, the income and losses of an S-corporation pass through to the owners based on their share of the company's stock. So in this case 80 percent of the losses went to the individual who had contributed no capital.
However, shareholders cannot deduct losses that are passed through to them from the S-corporation until they have created basis in the S-corporation. Methods of creating basis include contributing capital, leaving prior earnings in the company, and personally assuming the debt of the company (also note that losses passed through will decrease basis).
Additionally, when an S-corporation converts to a C-corporation, any losses that have not been taken by the shareholders are lost (some exceptions apply).
To put it in perspective, if the company had losses of $100,000 in each of its first two years, then the 80 percent owner would have had $160,000 in losses that could not be deducted (due to a lack of basis), and those losses would be lost when the company converted to a C-corporation.
On the other hand, the 20 percent owner who had funded the company during the early stages with a cash contribution of $200,000 to keep the company operating was allocated $40,000 of those losses, which were deductible because the individual had basis.
As the saying goes, hindsight is 20/20. The better choice would have been to create an LLC, not an S-corporation. This is because an LLC has tremendous flexibility. An LLC is taxed as a partnership by default and it provides the flexibility to allocate income and losses in any manner deemed appropriate by the owners. If the situation above occurred in an LLC, the owners could have chosen to allocate 100 percent of the losses to the owner that had been contributing cash to keep the business operating.
That owner contributed $200,000 and would have been allocated the entire $200,000 of losses and would have had sufficient basis to deduct those losses. Assuming a tax rate of 35 percent, that is a $70,000 savings. Additionally, being an LLC isn't permanent; one can always convert to an S- or a C-corporation later. The bottom line is that an LLC provides more flexibility to allocate income and losses and to change to other forms of taxable entities if it turns out to be more beneficial later on.
Boot Camp for Startups
Please join me on Nov.
20 from noon to 1 p.m. at the abi Innovation Hub where I will be expanding on this and other topics in a seminar titled "Thinking Ahead: Making Legal and Tax Decisions for Early and Growth Stage Ventures."
This will be the second of nine monthly seminars in the abi's "Launch Series: A Boot Camp for Startups."
Visit http://www.eventbrite. com/event/8835115067 to register.
If you're unable to attend the Nov. 20 presentation, I'm happy to answer your posted questions at http://unionleader.com/expert.
Peter C. Lachance is a CPA and Partner at Howe, Riley, and Howe. As one of New Hampshire's largest and oldest accounting firms, HRH provides tax, audit and consulting services to a wide range of industries including technology, real estate, manufacturing, non-profit and professional service companies. Pete also serves on the board of directors of the abi Innovation Hub. He can be reached at firstname.lastname@example.org or 627-3838.