Negative Basis in Business – Tax Shelters

Almost one third of all the small businesses I’ve consulted with in my career had negative basis. Most of the owners, actually almost every one of them did not understand what I meant by negative basis. In private, I would lower my head and shake it in disbelief.  

Negative basis in business refers to the value of the equity investment in the company. It literally means you have no actual equity investment and worse you owe somebody money because other parties have fronted the necessary capital to make the business viable. Often it is loans from either the owner or others. In many situations I’ve seen where the vendors have all fronted the capital to provide for inventory for the business. 

Negative basis in business has significant tax ramifications and other issues. Basically, the Internal Revenue Service frowns upon this and in some situations they will penalize you for having negative basis. There are some business situations where not only has Congress authorized negative basis but they actually encourage this investment relationship. These types of investments are commonly referred to as ‘Tax Shelters’. 

This article explains the basic concept of negative basis and how it is generated. Then I’ll explain where it is commonly found and why. Finally I’ll identify the tax issues involved in some of your more common types of business situations. The following cover these three areas of negative basis: 

Negative Basis – How is it Generated? 

In a good business model the owner of the company puts up the necessary capital to make the company operate. Over time, the earnings from the company allow for the company to expand and flourish. But many business owners have an idea and know how to make the company operate; they just don’t have the necessary financial capital to make it work. 

Essentially they cheat by borrowing money off their credit cards or getting vendors to front the necessary goods for sale in the store. The vendors are promised payment in 30 days and the owner is basically hoping the goods sell within 30 days and he’ll have the money to pay the vendor. Then the cycle begins anew. The problem is that this is referred to as insolvency because the pressures of dealing with the cash and the respective timing of payments can overwhelm even the best accountants. For those of you not familiar with the term insolvency, it basically means your current ratio is lower than 1:1. A good example is when your total current assets are less than your total current liabilities. 

For you to truly understand this basic concept you need to understand the equity section of the balance sheet. Furthermore, you need to understand the terms insolvency and bankruptcy so if you are not aware of these subjects and their real definitions, please read the following articles: 

For those of you not familiar with the concept of basis, please read Basis for Tax Purposes.

With your legitimate business operations, the owner has a tax basis because as the company grows and makes even more money, the income tax is paid on these earnings and the basis continues to increase from year to year.  In a negative basis scenario the owner loses money or doesn’t earn enough money to offset the existing negative basis in the company. Every one of them believes that they are allowed to take these losses to their personal tax return to offset other sources of income like their spouse’s wages or other earnings. 

The answer is that you cannot do this unless you pass the At-Risk tests associated with this negative loss. The at-risk rules determine the value the taxpayer places in jeopardy related to the business activity. In almost every case I’ve experienced, the business owner fails to pass the tests and therefore is denied the business loss as an ordinary loss on their personal Form 1040. Therefore the ability to save on taxes associated with the business loss is deferred to another year. 

But not all negative basis situations exist due to improper capitalization; many are purposely designed this way and often are very financially productive. 

Common Negative Basis Businesses 

Through the years Congress strives to achieve certain social goals or economic goals. To achieve these goals, they will authorize businesses to take as a deduction the negative basis reported contingent on certain conditions. As an example, back in the 70’s and early 80’s Congress desired to increase the low-income housing conditions nationwide. To accomplish this task, Congress authorized the concept of Qualified Non-Recourse Debt as justifiable basis in an investment. I know most of you are looking dumb founded.  Allow me to explain. 

Qualified non-recourse debt is basically a loan from a qualified financial institution such as banks or brokerages. These loans are typically made on real estate as real estate is considered excellent collateral. 

Almost every financial institution requires a ratio of the debt to the fair market value of the underlying asset in the range of 75% or less. To build a $2,000,000 apartment complex the business operation needs to front $500,000 and borrow the remaining $1,500,000 from a qualified institution. Now you have a $2,000,000 investment.  

With apartment complexes, they generally do not make money during the first 20 years of operations due to market rents matching the current market rates therefore which basically covers the cost of operations. The actual cost of operations usually matches the actual rents collected. In this accounting format, the complex’s financial reports include depreciation of $75,000 per year. In effect the financial report shows a loss each year for around $75,000. This $75,000 is passed to the investors as a passive loss and because these investors put up $500,000 they are entitled to take this $75,000 each year until completely depleting the $500,000; about 6.67 years.  

In the 7th year the apartment complex is still losing money on paper due to this depreciation. Well, because the debt is qualified non-recourse, these investors are allowed to take this $75,000 as a loss in year seven and in reality all the way until the entire $1.5M of the loan value is fully utilized.  

The investor puts up $500,000 but is allowed to take as a loss the entire $2,000,000 of costs associated with the complex. In effect, the investor has a $1,500,000 negative basis. Shocking isn’t it? 

For accounting purposes we track the investor’s capital account to identify exactly how much is their respective negative basis. 

Other negative basis businesses that commonly operate include mining operations and oil drilling operations. The term most of us understand related to these is ‘Tax Shelter’. The key is that a tax shelter reduces the tax obligation of the investor beyond their actual investment basis thereby reducing their overall tax significantly. 

These shelters are encouraged by Congress in order to improve economic activity in the United States or promote a social goal such as low income housing. But for those that generate negative basis in your small business, the tax implications can be punitive. 

Tax Implications 

For the tax shelters described above the Internal Revenue Service uses Code Section 704 to force recapture of historical losses if the shelter fails to comply with the restrictions in place associated with the respective investment. But for the small business operation, it is a different story. 

For the small business owner, any negative basis is DISALLOWED for tax purposes. Basically the negative position carries forward until the business earns enough money to cover the negative basis and the basis goes positive. With S-Corporations and Limited Liability Companies, loans to the business are separated to account for basis in the business. Essentially you have loan accounts and stock/capital accounts. 

In general, loans are adjusted first before the stock or capital accounts are adjusted related to earnings. This can create some financial hardships for some business owners as in some situations actual cash has to be transferred to cover the loan situation. This is due to the structure or wording of the respective note instruments. I advise you to discuss this matter with your CPA. 

In general, loaning your business money without having adequate basis in excess of the loan is NOT a good idea. From an outsider’s perspective you increase the risk to any other party lending money whether as a vendor or even a financial institution. You may be even liable for income tax in some situations in regards to the IRS Code. 

Everybody’s case is different and the rules are extensive, this article would go on for days in order to cover all the variables. Please consult with your accountant. For the reader, when you hear the term ‘Negative Basis’ you should immediately think ‘Tax Shelter’ or if in small business, disallowed deduction for tax purposes. Knowledge is Power. 

© 2015 – 2022, David J Hoare MSA. All rights reserved.

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