One of the first steps in starting your own business is determining the type of business entity you intend to create. There are several different business entities, and the type you choose will have an effect on the tax consequences your business will face. Possible business entities include sole proprietorships, partnerships, corporations, S corporations, and Limited Liability Companies (LLCs). If you are considering establishing a C corporation, which could possibly be treated as a “closely held corporation” by the IRS, it is a good idea to be familiar with the tax implications of a closely held corporation. That way you will be able to make an informed decision about which type of business entity to create.
What does it mean to be “closely held?”
When you have a business with a limited number of shareholders, all with a common interest in the business, it is typically considered a closely held corporation. The most common types are owned by family members. The stocks in these companies are generally not traded in the public stock market, as opposed to publicly traded companies that have a preexisting market for the types of shares that are traded. A closely held business entity does not necessarily have to be a corporation. Sole proprietorships can also be closely held, as long as there are a limited number of shareholders and the stocks are not publicly traded.
Tax implications for businesses subject to the At Risk Rules
You may not be familiar with the “At Risk” rules that relate to businesses and tax deductions. The At Risk rules limit the amount of losses an investor can claim as a tax deduction. The investors claiming the deduction are typically limited partners. The rule basically means, only the amount actually at risk can be deducted. If your C corporation is a closely held business entity, then it is subject to the At Risk Rules. For example, if you are a sole shareholder, and you contributed $10,000 to your business, then your at risk amount would be $10,000. This means, you can only claim up to $10,000 in losses, in order to reduce your businesses taxable income.
Tax Implications of Passive Activity
When a business owner does not participate substantially in the corporation’s activities, there are limitations that will be imposed on, what is considered, “passive activity loss.” This is also true when a the corporation earns income from rental property, for example. The Passive Activity rule says that, a corporation is only allowed to offset income from passive activities with the losses that come from those same passive activities. In other words, if your business owns rental property, but its primary business operation is retail, any losses from the rental property cannot be claimed to offset profits from the retail business.
Indirect Stock Ownership
In cases where a business owner owns stock in a corporation, that owns stock in another corporation, the ownership in the second corporation is considered “indirect.” To determine whether the second corporation can be considered closely held, the owner will be treated as having indirect stock ownership, in proportion to his ownership percentage in the first corporation.
If you have questions regarding closely held businesses, or any other small business planning needs, please contact the Schomer Law Group either online or by calling us at (310) 337-7696.