The tax law has a number of provisions that have different results depending on whether the subject is viewed as a business or as an investment. The words "business" and "investment" have particular meanings in tax parlance even though we look at putting money into any type of business as an investment.
Here are some situations in which distinctions matter:
If you loan money and aren't repaid, how you treat your loss depends on whether the debt is viewed in tax law as a business bad debt or a nonbusiness bad debt. A business bad debt is fully deductible and needs to become only partially worthless. A nonbusiness bad debt is treated as a short-term capital loss (regardless of how long the loan was outstanding), which can be deducted only to the extent of capital gains and a limited amount of ordinary income each year with excess losses carried forward. The debt must be fully worthless (noncollectible in any amount).
The tax law defines a business bad debt as one that arises in the context of a business (such as credit sales to customers and loans to employees). A nonbusiness bad debt is any other bad debt (such as loans related to investments).
The main challenge is properly classifying loans made by shareholder-employees. If the main reason for the loan is to protect salary from the corporation, then an unpaid loan is a business bad debt. If it's to protect the investment in the corporation, it's a nonbusiness bad debt. The determination is based on facts and circumstances.
When in a position to argue either type of bad debt, which is better? Obviously, an owner's overall tax position is the starting point for any decision. But nonbusiness bad debts usually produce a better tax result: while subject to capital loss limits, they can be carried forward and used eventually. In contrast, business bad debts of shareholder-employees are treated as miscellaneous itemized deductions, which are subject to a 2%-of-adjusted-gross-income threshold, an overall reduction for itemized deductions if such individuals are high-income taxpayers, and a disallowance for alternative minimum tax purposes. Thus, the tax benefit from any business bad debt may be nominal or none.
Passive activity losses
Business losses usually can be used to offset an owner's other income for the year. Business losses that aren't used currently may be treated as net operating losses that can be carried back and then forward to offset income in other years and save taxes.
However, if the business is viewed as a passive activity, losses are limited to the owner's passive activity income from this and any other passive activities (e.g., any rental real estate). So making an investment in a business as a "silent partner" merely creates passive income or loss. In order to escape this treatment, an owner must demonstrate that he/she materially participates in the operations of the business. There are 7 tests for material participation (limited partners may only use 3 of the 7 tests). See IRS Publication 925.
If you take a loan to buy a business, the interest on that loan may be viewed as business interest, which is fully deductible, or investment interest, which is deductible only to the extent of investment interest for the year, with any excess income carried forward. Here are some parameters:
- Interest on a loan to buy a sole proprietorship (or set the business up as a one-member limited liability company) that the owner runs is treated as business interest because the owner is buying assets, not stock. It is deductible on Schedule C.
- Interest on a loan to buy stock in a C corporation is always investment interest, even though the corporation may be closely held. The interest is deducted as an itemized deduction on the owner's Schedule A of Form 1040.
- Interest on a loan to buy into an S corporation, partnership, or limited liability company is not easily categorized. Assuming that the owner materially participates (i.e., is active in day-to-day business operations, then the IRS says to allocate the interest expense according to the business' assets, using any reasonable method. The portion allocated to the assets used in the business (as opposed to the business' investments) interest is then deducted on the owner's Schedule E.
Work with your tax advisor to make sure your business activities are conducted in a way that optimizes your tax results.