Money In, Money Out (Conclusion)

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Mark E. Battersby |

Self-financing remains popular with small-business owners

ARDMORE, Pa. — Putting money into a drycleaning business, or taking money from the business, is not something to be tackled by amateurs. Admittedly, a surprising number of cleaners 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Quite simply, money invested in the business can be withdrawn with a tax bill on any profits from the sale of that capital investment.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 an operator to his or her business can, on the other hand, be repaid tax-free, but only if the ever-vigilant Internal Revenue Service 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 drycleaning 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.

LOANS GONE BAD

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.

SALE-LEASEBACKS

When attempting to take funds from the 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 may lie with the tax benefits. Are the operation’s tax benefits being wasted because of low or nonexistent profits?

A one-transaction-cures-all, all-purpose solution involves the sale-leaseback of the textile service business’ assets. Generally, the business sells its assets, the building that houses the operation, the machinery and equipment used in the business, and its furniture, fixtures, or other property it owns. The buyer of those assets, usually using borrowed funds, is often the operation’s owner, partner or shareholder.

When the owner or shareholders in a drycleaning business own the operation’s assets, 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 building or equipment, whether the business’ owner, shareholder or, perhaps, a trust established for the benefit of the owner’s children, will receive periodic lease payments. With one transaction, the operation has found a way to get money from the 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 much-needed cash.

Unfortunately, under our tax laws, specifically Section 469, which deals with passive activities and losses, income from rental real estate is generally considered “passive activity” income, regardless of the owner or operator’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 for 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 operators 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.

Navigating complex tax rules obviously requires professional guidance, especially for any dry cleaner wishing to avoid paybacks and those dreaded “accuracy-related” penalties down the road.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an attorney or tax adviser for advice regarding your particular situation.

Miss Part 1? You can read it HERE.

About the author

Mark E. Battersby

Freelance Writer

Mark E. Battersby is a freelance writer specializing in finance and tax topics. He is based in Ardmore, Pa.

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