Second-business benefits

If you’re considering a start-up business in the same industry or in a different field, understand that Uncle Sam stands ready to become a partner — although not always a helpful or inexpensive one.

Play your cards right and Uncle Sam, in the form of our tax laws, will not only pick-up part of the expense of branching out or starting up that new venture, but will often allow the losses from a secondary activity to be used to reduce the tax bills generated by income from self-employment, wages, investments or the primary business.
 

Expanding business write-offs

In most cases, the ordinary and necessary expenses of carrying on a trade or business are tax deductible. Funny thing though, if there is no business, there can be no tax deductions for business expenses. Don’t despair because special rules exist for the expenses incurred in starting a business.

Anyone who pays or incurs business start-up costs and who subsequently enters the trade or business can choose to expense and immediately write-off up to $5,000 of those costs. However, the $5,000 deduction amount is reduced, dollar-for-dollar when the start-up expenses exceed $50,000.

The so-called “organizational” costs of incorporated businesses are a separate class of expense from start-up expenses although subject to similar rules and the $5,000 deduction. The balance of start-up or organizational expenses, if any, are amortized (written off) over a period of not less than 180 months, starting with the month in which the business begins.
 

Branching out

It is quite common for business owners or self-employed professionals to have multiple business activities. Common to almost every situation is the question of whether the new activity is merely a branch or subsidiary of the existing nursery or garden center business or will the IRS view it as a separate activity?

If it can be argued that the new operation is really an extension of the original business, a significant write-off is available. To illustrate, suppose John Doe operates a nursery business. The operation is profitable and he decides to add landscaping services operating from the same location using a newly constructed shop building. John Doe’s startup expenses amount to $70,000 and include the cost of hiring landscapers, mechanics and other help, setting up bookkeeping and an operations manual, as well as advertising and promoting the operation.

If this were an integrated operation, John Doe could immediately deduct the startup costs. If not, the rules require they be capitalized and amortized.
 

Losses

Not so surprisingly, all income from any activity is usually taxable. Fortunately, the losses from a money-losing activity — existing or start-up — can be used to offset the income from other sources. Of course with an activity that is a hobby, that is an activity not engaged in for profit, the expenses are generally deductible only to the extent of income produced by the activity.

Obviously, some expenses are tax deductible whether or not they are incurred in connection with a hobby (such as taxes, interest and casualty losses). If, however, the activity is engaged in for profit, not if it actually made a profit, but rather that it is operated with the “intent” of making a profit, many activity-related expenses are legitimately deductible — even if they exceed the income from that activity. The amount by which a for-profit activity’s expenses exceed its income, its losses, can offset all income from other sources.

The general rule is that an activity is presumed not to be a hobby if profits (more income than expenses) result in any three of five consecutive tax years. Fortunately, without profitable years anyone operating an activity can, if asked, prove there is “intent” to show a profit using the IRS’s guidelines. It should be noted that an activity involving the breeding, training, showing, or racing of horses is presumed not to be a hobby if profits result in two out of seven consecutive years.
 

Business entities for fun, protection

Whether starting a new venture or expanding an existing one, it may be wise to formalize the operation by incorporating or forming a limited liability company (LLC) to provide personal liability protection and give the new operation an edge when it comes to sales, financing and, of course, taxes. And no, the incorporated startup or branching out enterprise or LLC won’t escape IRS scrutiny under the hobby rules.

Corporations (both S and C), LLCs, and limited partnerships do offer protection to owners for the debts of the corporation. But the corporate veil can be pierced if the creditor can show that the entity was the alter ego of the owners. Sometimes it is enough that the owners are majority shareholders, exercise substantial control over the incorporated operation, or regularly use corporate funds to finance personal expenses.
 

The right funding

Good times or bad, the hardest question to answer is often what kind of funding should a startup or an expanding nursery business seek? Any quest for business funding begins with an understanding of the various types of financing, where that funding may be found, and at what cost? Or, put another way, what type of funding can best help the new or expanding garden center or nursery business?

Generally, there are two basic ways to fund the business: debt financing or equity financing. With equity financing, capital is received in exchange for part ownership in the growing business. With debt financing, capital is received in the form of a loan which must be paid back.

Putting money into the nursery business, or taking money from the business, is not something to be tackled by amateurs. Quite simply, money invested in the business can be withdrawn with a tax bill on any profits from the sale of that capital investment. On the other hand, a loan made by a nurseryman to his or her business can be repaid tax-free — if the ever-vigilant IRS accepts it as a bona fide, arm’s length transaction.
 

Accounting methods

There is no “right” accounting method for all businesses. Both the cash accounting method and the accrual accounting methods have their pros and cons. The basic difference between the cash and accrual methods of accounting lies in the timing of revenue and expenses.

The cash basis method of accounting recognizes revenues when money comes into the nursery business and recognizes expenses when money is paid out. Cash basis doesn’t recognize accounts receivable or payable. Only when a bill is paid does an operation using the cash method of accounting recognize an expense.

Naturally, the nursery business must use the same accounting method to figure the taxable income used to keep their books or to operate the venture it is branching out from. Also, the accounting method must clearly show income.
 

The passive trap

So-called “material participation” rules limit the deduction of losses from so-called “passive activities,” activities where the taxpayer does not “materially participate” in the activity. Generally, losses from passive activities may not be deducted from non-passive income (for example, wages, interest or dividends).

Generally, an individual materially participates in an activity if, based on all of the facts and circumstances, he or she participates in the activity on a regular, continuous and substantial basis during the year (the facts and circumstance test), or the individual participates in the activity for more than 500 hours during the year (the 500-hour test).
 

Ask an expert

Having access to legal, accounting and other expertise is extremely important when creating or expanding a business as well as helping the business survive and to grow as rapidly or efficiently as possible. In addition to legal advice, accounting advice such as setting up the operation’s books, auditing, payroll services, taxes and retirement planning might benefit the garden center or nursery operation.

Remember, however, the first step to finding the right professional requires an inventory of what you and your nursery business or start-up actually need in the way of services and advice and, most importantly, how much you can afford to pay for that advice or services. It is also important to determine beforehand just how much of the work you and your business will do and how much of it will be done by the professional.

The IRS can both tax and help underwrite the expansion costs of a nursery business or the startup expenses of a new activity. On the one hand, they stand ready to tax all income. On the other hand, many of the expenses incurred by the venture may be used to offset “hobby” income. If the activity is an expansion of an on-going business or a startup venture operated as “business,” the amount by which the activity’s expenses exceed its income, its “losses,” can be used to offset income from other sources. Will the IRS view your nursery’s new or expanding activity a tax business?

Mark Battersby is a freelance writer in Ardmore, Pa. His tax and financial features have appeared in leading business magazines and trade journals for more than 25 years.