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Tax Implications of Investing in a Business

tax implications of owning a business

Tax Implications of Investing in a Business

Investing in a new business can be a great opportunity. Business investments — when done successfully — can help you:

  • Generate new streams of income
  • Influence the trajectory of an organization
  • Build equity
  • Support initiatives you believe in
  • Diversify your investment portfolio

But a business investment shouldn’t be entered into lightly. There are both positive and negative consequences to every investment, and if you pursue a new opportunity without the proper tax planning, those consequences are more likely to skew negative.

Are you considering making a small business investment? Here are a few things to think about.

Goals

What are your goals for the business investment?

If you can’t articulate what your goals are, your investment is unlikely to be a success, and here’s why: as negotiations get under way, there is no compass to show you if things are veering off track. Only with well-defined goals can you ascertain if a business investment would be beneficial.

If you don’t yet have your goals clearly outlined, that’s OK. Ask yourself the following questions to start working through what you would ultimately want out of a new venture:

  • What types of investments excite you? Why?
  • Do you want to be holding this same investment in 5 years? 10 years? 30 years?
  • How much involvement do you want to have in the business, and how much time can you devote to it?
  • How long can you afford to go without this money, and what will you do if the business goes under?
  • What level of risk are you willing to accept?

For example, investing in a start-up can be great for one taxpayer but bad for another. If you’re excited by challenges, comfortable with risk and can support yourself without an immediate return on your investment, a start-up might be the perfect company to back. But if you have little interest in influencing a business or want to start seeing returns in the next three or four years, you may want to invest in a business that is already running smoothly.

Tax Structure

With your goals clearly defined, it’s much easier to consider specific investments. One of the first things you should note about each investment opportunity is the business’s tax structure.

If you’re going to own any significant portion of the business, the tax structure is important because it dictates how business income is taxed, who is liable for the tax and how much tax is levied.

But tax structure goes deeper than that. It also determines:

How profits and losses are allocated

S corporations must split net income, gains, losses and credits in proportion to each investor’s ownership percentage. Partnerships don’t have to be allocated this way. There must be a rhyme or reason to why partners choose to allocate tax attributes the way they do, but it is possible for one partner to report more items of gain than another, or for one partner to report more of the earnings than would be dictated by their ownership percentage. If your venture is structured this way, get a tax lawyer involved to make sure the partnership agreement is sound.

How ownership is transferred

Buying into a C or S corporation is simple; you can simply purchase an exiting shareholder’s shares or purchase newly issued shares from the corporation. Getting into a partnership is more complicated. In most cases, each change in partner makeup necessitates a new partnership agreement (i.e., a new entity), so all existing partners must agree to dissolve the partnership before they can bring anyone new on board.

If you choose to invest in a partnership, be sure to look into how future partner changes will affect your tax returns, too. At a minimum, a mid-year change in partners will generate two tax returns, one for each entity. This can be more cumbersome and costly from a tax preparation perspective, and partnership allocations might change, which may require you to reformulate your tax plans.

How the entity’s liabilities affect the owners

Is investing in a business tax deductible? It all depends on tax basis.

The liabilities of S corporations do not generally affect tax basis, but the those of a partnership might.

Tax basis is an important figure to small business owners because basis dictates the deductibility of company losses. If you have tax basis to absorb your share of company losses, you can deduct those losses on your individual tax return. If your tax basis is insufficient, you must carry those losses to future tax years. This means that partners in a highly leveraged partnership may be at a disadvantage compared to an S corporation shareholder in the same situation.

Another Investment Option

Purchasing equity isn’t the only way to invest in a business. If equity investment seems too complicated or risky, you could invest by way of debt instead.

Depending on your financial circumstances, you can consider working alone or with the help of a venture capital or equity investment firm to provide debt financing to small businesses. The return on the investment is dictated by the debt agreement. If the venture is risky, you can demand a higher interest rate on the loan. If the venture is more straightforward, you won’t be able to demand such a high return, but the risk of default will be lower.

Tax Planning Is Key

Even if you aren’t looking to invest now, keep the implications of small business investment in mind. It’s crucial to understand how important the tax aspect of business investment can be. And when in doubt? Consult with a tax professional for advice before making a business decision that could impact your tax return.

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