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I have the opportunity to buy a 24% of a start-up S Corp. I will not work for it or be related in any other way. It did not make money last year but it is on pace to make a profit this year. My question is this: I understand that I could claim 24% of any losses but what happens if the business makes a profit and reinvests all of that back into itself? I won't see a dime but will have to pay 24% of the taxes on any gains?
Am I missing something? If that's the case how would I ever make money from it?
You are correct. If the business is profitable and reinvests in itself, then the value of your shares should increase. So you would recognize a gain upon sale of the interest in the company. You pay tax on the distributive share but also get an increase in your tax basis in the shares.
I have the opportunity to buy a 24% of a start-up S Corp. I will not work for it or be related in any other way. It did not make money last year but it is on pace to make a profit this year. My question is this: I understand that I could claim 24% of any losses but what happens if the business makes a profit and reinvests all of that back into itself? I won't see a dime but will have to pay 24% of the taxes on any gains?
Am I missing something? If that's the case how would I ever make money from it?
Yep. Gotta take the long view.
That being said, you should at least discuss with the other shareholders if the company will dividend out enough money to cover the taxes. I typically did that.
There are limits to claiming losses from stock in a s-corp.
S corporation losses are passive losses that can be only used to offset passive income (rental income or income from an activity where you do no materially participate). This does not include capital gains and interest income. Unused passive losses, however, can be used the next tax year to offset passive income. Passive Activity Loss ATG - Chapter 3, Passive Income
Also, S-corporation losses cannot exceed your adjusted basis in the stock and losses will reduce your basis in the stock (but not below zero).
The money that an S Corp pays to its shareholders is generally called a distribution, not a dividend. As such, the distribution is not taxed at all.
If the S Corp made a profit, that profit is taxable to each shareholder. Each shareholder generally gets a K1 from the S Corp indicating the shareholders share of the profit (or loss). This number can be different from what was distributed. The S Corp decides how much of the profit to distribute vs how much they will retain for the S Corp's usage (improvements, maintenance, finance growth, etc)
The point is, you pay tax on your share of the entire profit not what they decide to distribute.
It is more complicated than this, as an example, if the distribution is more than your basis, tax may be due. If the S Corp declares a loss, you may be able to deduct some or all of it, based on various limits, etc.
Your situation sounds like you could pay tax on profits without any distributions from them to cover the taxes. That is not necessarily a bad thing but something you should evaluate. I have had this situation before, it is not all that uncommon.
Location: Prescott Valley,az summer/east valley Az winter
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jw has it about right~ make money and you pay the taxes on it in whatever tax bracket you are in. After 50 years of taking home very little and paying a lot of taxes on no income I am now in a position of selling the business and the first $350,000. of the proceeds have already had the taxes paid on it during the last 50 years. It was hard for years but now will be a huge help in my retirement.
The shareholder of an s corporation will receive a Schedule K-1 (Form 1120S). http://www.irs.gov/pub/irs-pdf/f1120ssk.pdf The K-1 informs the shareholder of the various losses and types of income. For someone unfamiliar with tax law, it can be somewhat complex to figure out how to treat the various items on the Schedule K-1 and so you may need a professional to file your tax return.
An advantage of S-corporations is that you do not have to pay social security and Medicare taxes on the flow through income, which is different from partnerships.
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