Most entrepreneurs go into business expecting (or at least hoping) to turn a profit. But some businesses are formed with the expectation that they will sustain losses at least for a period of time before profits are realized. Fortunately, with some strategic planning, these losses can be put to good use.
Entrepreneurs may be able to use business losses to offset other income, provided the business is structured properly from a tax perspective. The structures most likely to enable this are LLCs taxed as partnerships (which is the default tax status for multi-member LLCs) and LLCs or corporations that elect to be taxed as S corporations. For ease of discussion, I’ll simply refer to these as LLCs and S corporations, respectively, in this post.
LLCs and S corporations are “pass through” entities meaning that the profits and losses from the business are passed through the entity to the owners, rather than being subject to tax at the entity level. This is in contrast to C corporations, which are subject to double taxation, first at the entity level and again at the owner level.
Since profits and losses of LLCs and S corporations are passed through to the owners, the owners are generally able to deduct their share of the company’s losses, which may allow them to offset income from other sources, thus reducing their overall taxable income.
Tip: Owners can generally deduct losses but only up to their “basis” (i.e., the amount of their investment in the company) in their LLC interest or S corporation stock.
Losses for a C corporation, on the other hand, are not passed through to the shareholders, meaning that the shareholders cannot use business losses to offset their own taxable income. To be clear, losses for a C corporation can be put to good use by offsetting income of the corporation from other years, but the shareholders themselves cannot directly make use of corporate losses.
As a result, many businesses that wish to use early losses to reduce the taxable income of the owners elect to form LLCs or S corporations. And if the company will rely on large amounts of borrowed money, the business will almost surely be an LLC rather than an S corporation. The reason for this is that, because of the different tax rules for LLCs and S corporation, LLC members are typically able to deduct greater losses than S corporation shareholders when it comes to borrowed funds.
Related: LLC Allocations v. Distributions: What’s The Difference?
Keep in mind that while the prospect of early business losses could lead you toward forming an LLC, there could be other factors (whether tax-related or otherwise) that instead weigh in favor of forming a C corporation. So before you settle on an entity, make sure you (with the help of your business attorney and accountant) have considered all potentially relevant factors.