A surprising number of rural building business owners depend on themselves for financing. With conventional financing increasingly more difficult to obtain, self-financing is the number one method used by small business owners. It’s quick, doesn’t require a lot of paper work and is often less expensive than conventional financing.
That is not to say that self-financing is without cost. The cost every building business owner using his or her own funds must consider is the “lost opportunity” cost — the amount that might have been earned had funds remained in savings or invested elsewhere.
However, in a current topsy-turvy economic climate, doing it yourself or keeping financing within the family frequently produces fastest and best results. Unfortunately, tax laws create a number of obstacles that must be overcome to avoid penalties and higher tax bills.
Reversing the bottomless pit
Although many business owners ordinarily think only of cash savings, other assets can be turned into cash. Unfortunately, there are drawbacks, including risk of running-afoul of tax laws and the Internal Revenue Service.
Consider a few strategies that can either put the owner at risk or provide the needed funding — or both:
• Liquidate savings. If you’ve got it, consider giving it up.
• Get a home-equity loan. However, there is a limit to the amount of qualified residence interest that is tax deductible. The aggregate amount of acquisition indebtedness may not exceed $1 million and the aggregate amount of home equity indebtedness may not exceed $100,000; interest attributable to debt over these limits is non-deductible personal interest.
• Get a bank loan. Banks usually will require a personal guarantee or the guarantee of friends or relatives.
• Sell a vacation home.
• Take out a margin loan against your stock holdings.
When lending to or borrowing from the building business, it must be a legitimate, interest-bearing loan. Often, it is below-market interest rates or the lack of evidence of an arm’s length transaction that draw the attention of the IRS.
The IRS is particularly interested in (1) gift loans, (2) corporation-shareholder loans, (3) compensation loans, between employer and employee or 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.
If the IRS re-characterizes or re-labels a transaction, the result is an interest expense deduction when none was previously claimed by the borrower, and unexpected taxable interest income on the lender’s tax bill. The lender’s higher tax bills, often dating back several years, are usually accompanied by penalties and interest on underpaid amounts.
Always a borrower be
Loans and advances between so-called “related parties” are quite common in closely-held building businesses. Corporate loans to shareholders are probably most commonly seen by IRS auditors, with advances from shareholders to the incorporated building operation running a close second.
The IRS’s interest in this stems from the tremendous potential for tax avoidance, either inadvertent or intentional. When an incorporated builder 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 nondeductible dividend equal to the amount of the foregone interest; the corporation receives a like amount of interest income.
Fortunately, there is a $10,000 de minimis exception for compensation-related and corporate/shareholder loans that do not have tax avoidance as one of the principal purposes.
Downside: stock or loan
When IRS examiners review loans from shareholders and common stock accounts of many building businesses, they frequently encounter “thin capitalization.” That’s what occurs when there is little or no common stock and a large loan from the shareholder. Section 385 of the tax law specifically considers whether an ownership interest in a corporation is stock or as indebtedness.
The IRS’s objective when it encounters thin capitalization is to convert all or a portion of loans from shareholders into capital stock. Naturally, this conversion requires an adjustment to the interest expense account because, at this point, loans are considered nonexistent. The interest paid by the incorporated building business on these disallowed loans becomes a dividend at the shareholder level, equal to the operation’s earnings and profits.
The downside: Loans gone bad
Under tax laws, a business bad debt deduction is not available to shareholders who have advanced money to a corporation as so-called “contributions to capital.” A business owner or shareholder who incurs a loss from guaranty of a loan is, however, entitled to deduct the loss, but only if the guaranty arose out of his trade or business or in a transaction entered for profit. If the guaranty relates to a trade or business, the resulting loss is an ordinary loss for a business bad debt.
If your building business is in need of cash, are the business’s tax benefits being wasted because of low or nonexistent profits? As a result, does the business find itself in a low tax bracket?
An all-purpose, one-transaction-cures-all solution involves the sale-leaseback of business assets. Generally, the building business sells its assets, the building that houses the operation, equipment used in that operation, etc. In return, the business receives an infusion of working capital. The buyer of those assets, usually using borrowed funds, is often the operation’s owner or principal shareholder — you.
When the owners or principal shareholders own the assets of the operation, the business pays fully tax-deductible lease payments for the right to use those assets. An unprofitable building business is exchanging its assets for capital and immediate deductions for the lease payments it is required to make.
The new owner of that equipment, whether the business’s owner, chief shareholder or, perhaps, a trust established for the owner’s children, receives periodic lease payments. With one transaction, the owner has found around the double-tax bite imposed on dividends, giving the operation an infusion of badly-needed cash.
“Me-” or self-financing is often the only option. Drawing on assets, selling assets for cash or using them as loan collateral are options, too. Other “me-” or self-financing options are available and should be studied, too, by any building business or builder in need of funding.
Mark Battersby is a tax and financial consultant, lecturer and writer with more than 30 years experience with small business issues. Contact him at (610) 789-2480 or MEBatt12@Earthlink.net