When you're in the market for a new business, you can spend thousands of dollars running ads, traveling around the country to look at companies, and hiring auditors to evaluate several prospects. Yet if your search is unsuccessful, the Internal Revenue Service says that you cannot deduct expenses for a general search or a preliminary investigation.
Say that you do find the company of your dreams, and you incur further costs, such as legal fees -- and then the deal falls through. You can deduct the legal and other expenses that are specific to the negotiation, but you still get no deduction for those general search expenses.
But there is a way to assure a 100% deduction for all expenses. The answer is to incorporate. Then buy stock from your new corporation equal to the amount of the anticipated search; have the corporation, instead of you personally, incur the expenses of looking for the new business. If you find what you want and buy the operating assets, you have a corporation set up and ready to go. If you don't find what you want, you will be able to get a personal deduction for the expenses incurred by the corporation. How? Liquidate the corporation. A little-known section of the Internal Revenue Code, Section 1244, allows you an ordinary deduction, rather than a capital loss, on your stock loss in amounts up to $50,000 for a single taxpayer or $100,000 for a husband and wife filing a joint return. (For another use of 1244 stock, see "Attracting Capital," below.)
There are any number of ways to transfer stock ownership, but a stock bonus has particularly interesting tax benefits. It's a technique you can use to shift shares of stock from you to your successor -- an employed relative, say, or a key employee.
As an example, let's assume that you eventually plan to turn your business over to your daughter, who now works with you. So you give her a bonus in shares of stock -- but not so much as to cause an "unreasonable" compensation problem with the IRS.
These are the tax consequences of the tax bonus:
* Your employed daughter must pay income tax on the fair market value of the stock she receives.
* The corporation can deduct the fair market value of the stock it gives as compensation.
* The corporation does not pay income tax on the benefit (the tax deduction) it receives.
This combination is advantageous all around. The corporation gets a full tax deduction for the fair market value of the stock. You've decreased your ownership, and your daughter's share has increased. It is as if you had sold her some of your shares -- except the stock bonus is tax free to you.
If you're looking for ways to entice friends and relatives to help capitalize your small company, you should know about Section 1244 of the Internal Revenue Code. The idea behind the legislation is to give a kind of investment insurance to anyone investing in a small, incorporated business.
The way it works is this: an investor who buys Section 1244 stock gets the best of all tax breaks: capital gains, which can be offset against capital losses if he sells the stock at a profit; and ordinary loss treatment if he sells at a loss or if the business fails and the stock becomes worthless. Ordinary losses are limited to $50,000 for single taxpayers and $100,000 for married taxpayers filing a joint return. But compare those numbers with the tax law's capital losses, which can be deducted only at the rate of $3,000 a year.
If you're incorporated, you can issue Section 1244 stock, provided the following four requirements are met at the time the time the stock is issued:
* Your company has received 50% of its gross receipt from operations -- as opposed to passive income such as interest and dividends -- for as long as it has been in business over the past five years.
* You issue the stock for cash or property, not stock or securities.
* Your company has received $1 million or less for its stock, including the Section 1244 stock, you're planning to sell.
* The stock is newly issued.
You can issue and sell Section 1244 stock to yourself as well as to outside investors. (For another use of 1244 stock, see "Costs of Business Searches," above.)
A Quick Loan
Certain restrictions go along with an individual retirement account, and one is that you can't borrow from it. You can't even pledge it as collateral for a loan. In either case the amount would be included in your current income, and if you're under 59 1/2 years old, you'd have to pay penalties as well.
But if you need money for only a short period, you can in effect borrow from your IRA.
The law allows you to remove money without triggering current income or penalties if you roll the exact amount removed into another IRA within 60 days. And there you have it: interest-free use of the funds for a short-term need. Still, you can't make a habit of this: you can use the 60-day maneuver only once a year.
Corporate Tax Returns Audited In 1986 (by Size Of Assets)
Balance sheet 1985 returns Number Percent
assets filed audited audited
$ 0-50,000 803,200 5,988 0.75%
50,000-250,000 865,400 12,733 1.47
250,000-1 million 507,100 7,922 1.56
1 million-5 million 198,700 9,349 4.71
5 million-10 million 28,400 3,639 12.81
10 million-50 million 31,000 7,400 23.87
50 million and more 15,700 9,892 63.00
Source: Internal Revenue Service Highlights of 1986, U.S. Government Printing Office, 1987.
If you play by the percentages, the smaller your assets, the lower your chances of getting audited by the Internal Revenue Service. But don't overlook the numbers.