Tax Tips for When You’re Ready to Branch Out

By Mark E. Battersby

Maybe you operate a speed shop and are considering manufacturing a few custom components. Maybe you own an off-road business and are thinking about starting a guided trail ride service. Or, possibly, you’d simply like to expand your current services into another town or state.

Branching out or diversifying means expanding a performance, racing, restyling or vehicle customizing business’s operations, products, services or geographical reach to encompass new areas or markets. In other words, branching out is about diversifying and growing beyond the initial scope of the business.

In today’s sluggish economy, it is not unusual for an existing business to branch out—or for the shop owner or self-employed performance, restyling or customization professional to start another business in the same or a different field.

Few realize, however, that Uncle Sam, in the form of our tax laws, stands ready to become a welcomed partner.

The federal government 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 a primary business.

The Right Path

There are various strategies for, and reasons why, a performance, racing, restyling or vehicle customizing business should branch out or expand. However, with most businesses having limited resources and capabilities, it is important to select a suitable means of expansion that can improve recognition, reach and profits.

Among the methods, strategies and options for branching out are acquisitions, mergers, collaborations, joint ventures, partnerships and more.

It is increasingly common for aftermarket professionals to have multiple businesses. In fact, in today’s tough economy, more and more people are using—or forced to use—their hobbies, sports or secondary interests to generate additional income.

While many professionals routinely use losses from their secondary activities to offset income from their primary businesses, few professionals realize that with or without the extra income, Uncle Sam stands ready to pick up part of the expenses of many of those extracurricular activities.

If an activity is operated as a business, tax laws permit expense deductions to the point where they may offset wages, savings and investment income—and the tax bill on that income from other sources.

Start-Up Costs

In most cases, the ordinary and necessary expenses of carrying on a trade or business are tax-deductible. Of course, if there is no business, there can be no tax deductions for business expenses.

Don’t despair, however, because special rules exist for the expenses incurred when starting a new business.

Anyone who pays or incurs business startup 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 deductible amount is reduced, dollar-for-dollar, when the startup expenses exceed $50,000.

The so-called “organizational” costs of business entities are a separate class of expense from startup expenses, although subject to similar rules. An incorporated performance, restyling or customization shop or business can, for instance, choose to deduct up to $5,000 of any organizational expenses incurred in the tax year business begins.

The balance of startup 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.

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 LLC, incorporated startup or branching out enterprise won’t escape IRS scrutiny under the hobby rules.

Corporations (both S and C), LLCs and limited partnerships offer protection to owners for the debts of the operation. But this protective 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.

A Business or Just a Hobby?

While it is increasingly common for business owners or self-employed professionals to have multiple business activities, in almost every situation comes the question of whether the new activity is merely a branch or subsidiary of the existing business, or will the IRS view it as a separate activity?

In order to be treated as a business for tax purposes, a profit motive must be present, and some type of economic activity must be conducted. According to lawmakers, among the factors that would ordinarily be taken into account include:

• The manner in which the activity is conducted
• The expertise of the taxpayer, or his or her advisers
• The time and effort expended by the taxpayer in carrying on the activity
• The expectation that assets used in the activity may appreciate in value
• The success of the taxpayer in carrying on other similar or dissimilar activities
• The taxpayer’s history of income or losses with respect to the activity
• The amount of occasional profits, if any, that are earned
• The financial state of the taxpayer
• Elements of personal pleasure or recreation

Remember that when it comes to determining whether an activity is engaged in for profit, all the facts and circumstances are to be taken into account.

Intangible Still Deductible

Often overlooked by many are tax deductions for the secondary operation’s “intangible” assets. The purchase of a going business usually includes “goodwill,” an intangible asset that, because it was purchased, can be amortized over a 15-year period.

An intangible business asset that does not qualify as purchased or acquired may be amortized only if it has an ascertainable value and a measurable, useful life.

Other, often deductible, expenses are the costs for developing the all-important website. Generally, the cost of website development must be capitalized and deducted over many years. The expenses of operating and maintaining the site are deducted in the year incurred.

Despite the IRS’s reluctance to provide definitive guidance, it is clear that many businesses that pay large amounts to develop sophisticated sites have been allocating their costs to items such as software development (currently deductible like research and development costs) and currently deductible advertising expenses.

Yet Another Trap for the Unwary

Our voluminous tax rules limit the deduction for losses from so-called “passive activities.” Generally, losses from passive activities may not be deducted from non-passive income (for example, wages, interest, dividends or profits from the business).

A passive activity is one that involves the conduct of any trade or business in which the taxpayer does not materially participate. Materially participating can be measured in a number of ways, including putting in more than 500 hours each year. Materially participating also occurs when the individual’s participation constitutes substantially all of the participation in the activity.

The IRS can both tax and help underwrite a secondary, part- or spare-time activity. On the one hand, it stands ready to tax all of the activity’s income. On the other hand, many of the activity’s expenses may be used to offset “hobby” income.

Operate the activity as a “business” and the amount by which the activity’s expenses exceed its income—the “losses”—can be used to offset income from other sources, such as a business. So, is your secondary activity a tax business?

Joining Forces

Joint ventures, partnerships and collaborations involve working with others on a new project rather than having your business go solo. Two similar or complementary shops or companies can decide to share resources and reduce costs by creating a branch in a new location or to undertake a specific project.

Collaborations and joint ventures can also be very useful where expenses in a location might be high. And, of course, collaborations and joint ventures are excellent ways for smaller businesses to compete with much larger and better-equipped competitors.

On the Downside

Expanding your business into a similar or altogether different field may upset your operation’s current customers. Some could view it as abandoning them or selling out. Good communication and transparency can help.

Aftermarket professionals should be flexible, ready to make a quick recovery and prepared to cut back quickly if demand drops. The future may see a change in customer preferences, price changes from suppliers or a whole new way of doing business.

Thus, the first step is to ensure that the shop can survive under the new conditions. Once that’s achieved, look to growth strategies.

Having access to legal, accounting and other expertise is extremely important when expanding or creating a new business, as well as helping your current business survive and to grow as rapidly or efficiently as possible.

Mark E. Battersby writes on financial and tax-related topics. Learn more at thetaxscribe.com.