October - 2002 - issue > Personal Finance

Under current tax laws, the taxable income of a business entity is computed by deducting “ordinary and necessary” business expenses and other allowable expenses from gross revenues. Deductible expenses can also include most operating costs of another partnership or a limited liability company (LLC) owned by the entity, or the operating costs of another corporation controlled by the entity and electing to file consolidated returns. Costs of organizing the venture and the initial costs incurred before the venture commences generally cannot be deducted, but have to be amortized and deducted over five years. The taxable income of a newly formed venture is similarly determined but, as is frequently the case, a newly formed enterprise does not generate taxable income for several years, and has to carry-forward its losses, to the extent permitted by law, until it generates enough income to be able to deduct its current and accumulated expenses or losses. In many cases, a new business venture never becomes profitable and, thus, can never deduct its expenses-or it changes ownership before becoming profitable and loses the ability to deduct a large portion of its accumulated losses because of restrictions imposed by the “change of ownership” rules.

Astonishingly, most owners of an established, profitable business prefer to organize their subsequent venture as a stand-alone entity, relinquishing their privilege to deduct business expenses, undoubtedly one of the most significant tax benefits available to businesses. Instead, if the new venture is organized as a partnership, an LLC, or a subsidiary controlled by the established company—from now on referred to as “related entity" or "new venture"—the current tax burden of the established entity could be substantially reduced because it could reduce its taxable income by deducting the operating expenses of the new venture from its gross income.

The magnitude of the tax savings is best illustrated with an example. Let us assume that the newly formed venture incurs deductible expenses of $1,000,000 each year for the first five years of its existence. Also assume that during the first five years, the venture does not generate revenues in excess of expenditures and is in a net operating loss position. Finally, we assume that another entity owned by the promoters of the new venture is well established, has enough income to be able to currently deduct the allowable expenses of the new venture from its revenues, and pays 40 percent of its net income to the federal and state governments as taxes. Under these assumptions, the new venture incurs total expenses of $5,000,000 over the five year period which it is unable to deduct currently but is required to carry-over for fifteen years or until the venture generates taxable income, whichever is shorter. In an ideal scenario, the venture becomes profitable before its ability to deduct the expenses expires and it is able to reduce its taxable income in future years by deducting expenses incurred in prior years. However, if the new venture was organized as a related entity, the established entity could potentially reduce its current tax liability by $2,000,000 over the five-year period or by $40,000 each year. Stated differently, for each dollar in expenses incurred by the new venture, the established entity reduces its current tax burden by forty cents. This translates into the government subsidizing the expenses of the new venture by 40 percent.

Some may argue that the subsidy is only temporary, to be repaid when the new venture becomes profitable. It is still advantageous to organize the new venture as suggested. Inflation causes the purchasing power of money to erode over time. Assuming a 3 percent rate of inflation, a dollar that has to be repaid in five years is roughly worth eighty-five cents today. Thus, taking into consideration the time value of money, it does not hurt to save taxes now. However, as stated earlier, many new ventures never become profitable, or change ownership by the time they become profitable and lose the ability to deduct a large portion of accumulated losses. The “change of ownership” rules, briefly, restrict the ability of a company to offset income after the change in ownership by utilizing losses accumulated prior to the change.

Organizing a subsequent venture as a subsidiary of an existing, profitable business is particularly beneficial for companies engaged in “research & development.” Most expenses associated with developing a new technological product or process-including salaries, rents, supplies, and even equipment-may be deducted. By contrast, capital investments made for other purposes generally must be capitalized and deducted over the expected life of the investment. The benefits of organizing a new venture as a related entity of an established company are not likely to last forever. Once the new venture itself becomes profitable, it may be desirable to reorganize as separate entities to benefit from graduated levels of tax rates. However, like any other strategy, this approach should be periodically monitored to ensure that it is serving the intended purpose.

Sushil Rungta is an attorney-at-law, whose expertise lies in tax and business laws.