Here's how those who own their own business draw rents from that business without incurring the tax penalties that apply to dividend payments. The strategy works for businesses of all sizes.

by Mark E. Battersby
[December 28, 2000]

Are you concerned about getting the profits out of your ISP business without paying the double-taxation that dividends are subjected to, once at the corporate level and again when they are included on your personal tax return? Afraid of incurring the penalty tax that underpaid Internal Revenue Service auditors often impose on the "excessive compensation" of many ISP business owners?

Or perhaps your ISP business could profit from an infusion of badly-needed cash? Are you reluctant to invest additional money in your business? Are the tax benefits from the business wasted because of the operation's low or nonexistent profits—and its low tax bracket?

One transaction cures many problems and may be the solution for you. That transaction is the often neglected and little understood, sale-leaseback.

At its most basic, your ISP business sells its assets, the building that houses the operation, the equipment used in that operation or even the computers, servers and routers, that are the business. In return, the business receives an infusion of working capital. The buyer of those assets (who usually uses borrowed funds) could be the operation's owner or principal shareholder—you.

The basic share-leaseback
When the owner or principal shareholders of an ISP business also own the assets of the operation, the business pays fully tax-deductible lease payments for the right to use those assets. An unprofitable ISP business is exchanging depreciable equipment or property for badly needed capital and immediate tax deductions for the lease payments.

The new owner of that equipment, whether the business's owner, chief shareholder or, perhaps, a trust established for the benefit of the owner's children, will receive periodic lease payments. Thus, with one transaction, the owner has found a way to get money from the business without the double-tax bite imposed on dividends or fear of the excessive compensation penalties the IRS levies where they feel the operation's profits may be paid out as compensation.

Those lease payments are, of course, taxable income to the recipient. Fortunately, tax deductions offset much of that income before it reaches the recipient's bottom-line taxable income.

Depreciation write-offs or deductions cost the owner of those assets nothing out-of-pocket. Somewhere down the road, those depreciation deductions will have to be paid back or recovered, usually as ordinary income, but that is at some distant date.

The owner or owners of the ISP business's equipment and assets are also entitled to deductions for the expense of borrowing the money used to purchase them. Additional tax deductions such as management fees, maintenance, insurance and the like, further reduce the tax bill on lease payment received from the ISP operation.

As a result of a sale-leaseback you, the owner, are receiving a steady-stream of lease payments that, unlike dividends, are tax deductible by the business. Plus, as the owner of those assets or equipment, you are entitled to take advantage of all of the tax deductions associated with it.

Except where the assets of the ISP business are already subject to restrictions imposed by lenders or other investors, you, the owner of those assets are enjoying tax write-offs that might not fully benefit the ISP business entity with its small or nonexistent profits and correspondingly lower tax bracket.

The mechanics of a sale-leaseback
You'll probably want to be able to treat the sale as a capital gain instead of income. Capital gains are taxed at a fixed rate, while income is taxed at a "progressive" rate that takes a larger percentage from rich people than poor people. However, you'll probably have to treat the sale as income rather than capital gains.

The tax rules of the United States are quite clear when it comes to the sale of any depreciable asset between so-called "related" taxpayers. Capital gains treatment is denied when depreciable property is sold or exchanged between related taxpayers. This rule covers sales or exchanges between a person and all entities that are controlled by that person and between a taxpayer and any trust in which that taxpayer or spouse is a beneficiary unless that beneficiary interest is a remote contingent interest.

Any business selling it assets to its owner or principal shareholder may run afoul of the restrictions preventing capital gain treatment for the proceeds from those sales. However, only your accountant or banker can advise you whether that restriction applies and, if so, its impact on the transaction.

Benefiting from a sale-leaseback
It should be obvious that the sale-leaseback of your ISP business's assets, equipment or building can be the cure for any number of problems facing you and the business. However, the complexity of the rules, the requirement that the transaction be conducted at "arm's length," have a bona fide economic purpose rather than mere tax avoidance, and be properly structured as both a "sale" and subsequent "lease," all require professional assistance.

Be sure to consult the appropriate financial and legal advisors.

—End