Investing in a small business can be a great opportunity. It can provide you with the chance to earn extra income, to diversify your investment portfolio, and it can be rewarding to help bring another person’s idea to fruition. But of course, with these rewards also come risks, so it is important to fully understand the tax implications of your investment before you dive in.
Step 1: Understand the Business’s Tax Structure
How a business is taxed will be determined by its tax structure. Today, most small businesses organize themselves as pass-through entities so that the business income gets “passed through” to the owners. Pass-through entities, such as S corporations and partnerships, are simple to administer and are often more flexible than C corporations. However, the Tax Cuts and Jobs Act may change this trend going forward. The recent tax reform reduced the corporate tax rate from 37% to 21% – the lowest it has been in decades. Only time will tell if this rate reduction, combined with other changes to corporate tax law that we discussed in this article, will impact how small businesses choose to structure their organizations.
Step 2: Be Familiar with the Tax Outcomes
Once you know how the business is structured, you should familiarize yourself with how you will be taxed. To get your feet wet, let’s discuss how common business activities may trigger a tax bill for you as the investor.
In most situations, there are no tax consequences for investing in a small business. There are, however, tax consequences for almost everything that follows.
During the Course of Business
Investors of pass-through entities must report their share of the income (and expense, gain, loss, and credits) on their own individual income tax returns, even if the income was reinvested into the business. In other words, they may be required to pay taxes on earnings that never made it into their pockets. A corporation, on the other hand, pays tax as a separate entity. Typically, shareholders of a C corporation would only personally owe taxes on corporate income when they see it in the form of a dividend.
As the business becomes profitable, investors of pass-through entities will need to pay quarterly estimated taxes for their share of annual income to avoid paying a penalty. C corporation shareholders may also need to pay quarterly estimated taxes depending on how their dividends are structured and whether or not taxes are withheld.
If the business takes a downturn, investors may not be able to recognize the full loss on their returns. A pass-through investor’s business losses will be limited thanks to both the passive loss rules and the at-risk loss limitations.
The investor’s level of involvement in the business can affect how they are taxed. Partners in a partnership who are materially involved in the business may be subject to self-employment tax on their entire proportionate share of net income, not just on guaranteed payments for services rendered. Shareholders in a C or S corporation who materially participate are required by the IRS to receive a reasonable salary for which both the shareholder and company would owe employment taxes. No self-employment taxes are owed on the net income from a S corporation passed through to the investor.
Having an exit strategy is necessary for all investors, no matter how promising the business idea appears to be. The sales of both C and S corporation stock is fairly straightforward; the taxpayers would recognize a gain if the sales price of their shares of stock exceed the basis they had in those shares. Similarly, investors in a partnership would recognize a gain from the sale of their interest by comparing what they receive (cash, debt forgiveness, etc.) to the basis they have in their partnership interest.
Step 3: Make the Right Choice
Choosing the right time to invest in a small business will not be an easy decision. However, if you enter into the decision with reasonable expectations and good background knowledge of how small businesses are taxed, you will be better prepared to make that final call. If you need a guide to help you through the process, our Spire professionals can help you assess whether a business opportunity is best for you and your individual tax plan.