Taxes · Accounting

How are amortized startup costs treated when a business is closed?

Chris Carruth VP/Director. Strategy | Business Development | Operations | Product | Solutions

July 10th, 2015

Given most startups do not work, sure someone can answer this. Question is if all costs have been amortized, i.e., not treated as cash expenses during the pre-revenue period, and the business closes, what happens to the loss? For example say a company had 2 investors, each put in $25k, startup costs were incurred that used up the $50k and there is no revenue to date. Now the business is being wound down. Is the $50k treated as a loss on the personal return of the investors according to their equity? 
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Peter Weiss President at American Outlook, Inc.

July 10th, 2015

The first question is was the business organized as a tax pass-through (LLC, partnership, S Corp) or a C corp.  

If it's a C corp the default position is capital losses, short or long-term depending on the calendar.  If they've been in less than a year and you can document the closedown or write-off they get short-term losses which are more valuable.

If the company has taken the steps to get Section 1244 treatment for small business losses, the capital loss may be treated as an ordinary loss which is more useful and potentially more valuable than even a short-term capital loss.  Here is a link to a summary:  https://www.law.cornell.edu/uscode/text/26/1244.

If it's a tax pass-through the answer is more complicated.  Assuming you've been through at least one year-end tax return with them, they have been allocated losses or profits.  You wind-down the company, sell or write-off the assets, settle the debts and reflect these activities on the next tax return and their K-1s.  To the extent something inside the partnership does not tie out exactly with the their basis in the investment, they will make an adjustment on their tax return to zero things out.

I had a client organized as an LLC which went into shut-down.  By the time we were done the investors got ordinary losses nearly equal to their original investments.  Depending on their marginal tax rates and state of residence that result could be worth more than $0.40 in tax savings on their invested dollar.  Not a happy result but one of the best outcomes you'll see in a company which did not succeed.

Benjamin Olding Co-founder, Board Member at Jana

July 10th, 2015

I'm not quite sure I understand the amorization detail you are pointing out, but I'll try to answer anyway.

I believe this is a personal income tax question, not a business tax question.  Let's call the business Startup X.  There are two possible scenarios I know of:

1) Startup X is organized as an S-Corp.  The owners will each receive a K-1.  the total profit (or loss) for the year is split as a percentage of ownership (not a percentage of raw dollars invested, unless of course - coincidentally - all investment occurred with the same valuation).  

On the K-1 will be the losses for that year.  If there were assets that were being depreciated over a series of years, the disposal of the assets will cause the rest of the depreciation to occur in this year.  Example: you bought a $12k machine and depreciated it over 3 years.  The business fails in year 2.  The first $4k already showed up on the K-1 of the owners from the first year.  The machine is sold for $2k.  Net, there is $6k worth of loss that shows up on the K-1 from this machine.

Each individual owner will place the K-1 loss on their Schedule E of their income return.  The total loss they are allowed to take against their regular income in the same year will be determined by other factors (mostly how much income they had), but you can roll over the difference to the next year.

All K-1s (from the current year and past years) will have an adjustment to the investment basis.  In addition to reporting the business income loss from shutting the company down on your Schedule E, you also get to report the investment loss, but minus any basis adjustments.

2) The second scenario is that Startup X was not organized as a S-corp (S corp is a Federal designation - but corporations are organized at the state level; a little confusing, but if you're not an S, then for Federal purposes, you're this type).  

This scenario is much simpler for the owners: the business losses are irrelevant to the owners income tax filing, since it's not a pass-through entity.  You just take the entire investment you made (amount of equity that resulted in is irrelevant) and write it off as an investment loss.  Imagine buying IBM shares and then disposing of them for $0 - it's basically that scenario on your taxes.

Hope this helps more than it confuses.  Startup X itself will not own any income taxes, but that does not mean it will not owe any taxes unfortunately.  Many states have filing fees at a minimum.  Make sure you file all taxes/fees in your state correctly.  It once took me 3 years to shut down a subsidiary.  By the time the state got back to me explaining how I was not 100% done, I had to keep filing the next year's tax filings.  Until the company is shut down, it exists - and you are responsible for all filing requirements for every year it exists (regardless of whether the bank account is $0).  It's July, so you should have enough time - but be diligent.

Notice that in the second scenario (which I'm guessing you are in), all the business losses you've been accumulating get basically wiped out when you shut it down.  In some cases, these accumulated losses are an asset of sorts - a profitable company could use these losses to offset their income and save on their business income taxes.  This is not as simple as it sounds - there are a lot of restrictions on being able to do this.  Accountants will delight in charging you to calculate a "test" to see if this is possible.  If the investment was $100k and no one has suggested this to you before now, I don't know if I'd suggest looking into it - you definitely need the acquiring company to pay for all the accounting fees.  Just be willing to be tax inefficient and walk away.

However, I will say that it's sometimes easier to sell a company for $1 than deal with shutting it down.  It clears you of all subsequent tax liability (the new owners get that) with one piece of paper.  So if there's any value to what you have on paper that someone else can use, it's potentially worth basically giving it away, if for no other reason than to avoid the headaches of an improper shutdown.

Muhammad Gadit E-commerce & Business Management Professional

July 10th, 2015

Can u share more details, as in what that $50k were invested in?
Additionally based on current info, your balance sheet would be showing zero balance. Therefore yes.

Muhammad Gadit E-commerce & Business Management Professional

July 10th, 2015

Can u share more details, as in what that $50k were invested in?
Additionally based on current info, your balance sheet would be showing zero balance. Therefore yes.

Bill Wittmeyer CEO Electronic Sensor Technology INC

July 10th, 2015

The proper treatment will depend upon each investor's tax situation and they should consult their tax accountant or attorney.   

Benjamin Olding Co-founder, Board Member at Jana

July 10th, 2015

@Peter Weiss - it looks like we posted at the same time.  I did not know about the 1244 treatment; very cool.  It appears to be a federal designation.  

I saw no reference in the link to the corporation's pass-through status.  What would the business have to file for an individual to claim this?

Peter Weiss President at American Outlook, Inc.

July 10th, 2015

Ben, 1244 applies only to "C" corps.  In effect 1244 creates an approximation of partnership tax characteristics to investors in qualified small corporations that fail.  

It's sort of the flipside of Section 1202 (currently not in effect) which has the potential to give huge cap gain tax advantages for successful investment in qualified small business under certain circumstances.

Benjamin Olding Co-founder, Board Member at Jana

July 10th, 2015

Interesting - never been in that situation; thanks for sharing.  This seems like an underappreciated advantage to investing in small businesses.

Is the test for "small business" applied at the time of stock purchase or the time of stock sale/disposal?

Bhakti Soneji Principal at Bhakti Soneji Tax Services

July 10th, 2015

Agree with Peter and Benjamin. 
Chris - by amortization do you mean you have amortized the start-up costs over the years? That means business losses reflected each year include those partial start-up costs as well. In my mind, it is unusual for start-ups to amortize start-up costs. 

Peter Weiss President at American Outlook, Inc.

July 10th, 2015

Ben, the initial tests for both 1202 and 1244 are at the time of investment.  There are a number of rules including age of company, total assets, amount raised, etc.  

1202 was in effect for new investments in equity from (I think) 2005 or so until the end of 2014.  My friends in the Angel Capital Association believe it will be retroactively extended from January 1, 2015 but last year it adopted for 2014 near the end of the year - you can't bet on it but it is worth making sure an offering falls within 1202's last rules in case it is extended - all upside and no downside.

1244 remains in effect and I don't know if it sunsets at some point.  Interestingly I'm suddenly seeing it appear as a term in angel focused term sheets.  Until maybe the last twelve or eighteen months I'm not sure I've ever seen it; now it shows up moderately frequently.  I find that virtually no angels understand it's import and very few of the CEOs raising capital understand it or even know why it's there.