There are three questions we routinely hear from our small business clients:
How much money did I make?
Where did it go?
How much do I owe in taxes?
Real frustration sets in when questions 2 and 3 come together and there are taxes owed, but no cash to pay them. Some of the most common reasons a business owes taxes when the corresponding cash is not available:
Depending on the accounting methods used, it is not uncommon for cash receipts to not match the tax year. Many small businesses are on a cash basis for tax purposes, which means they only count revenue when they actually receive it, and only deduct expenses when they actually write the check. If your company had a large December but didn’t receive the cash until January, by the time the tax year rolls around, you’ve forgotten the cash collected last Winter that was on your books two years ago! The same goes for the timing of expenses. Items at the end of the year often straddle tax years.
Capital assets pose a separate problem. When you buy a piece of equipment for the business, there are usually different tax treatments to choose how you will expense for taxes. One popular option has been the Section 179 election. This allows you to write off for taxes most, if not all, of the purchase price of the equipment in the year it was placed in service, regardless of whether it was paid for in cash or financed. That’s great the first year, but in subsequent years, there are no more tax breaks, even if you’re still making payments to the bank.
Some things are never deductible for tax purposes. An example would be the 50% limitation on meals and entertainment. That limited amount actually went out the door, but you are essentially paying taxes on it. Depending on your tax rate, that could be something around 150% of the actual cash amount. That means for you to spend $100 on a non-deductible item, you need $150, first to pay the tax, then pay the expense. Other common non-deductible expenses are country club dues, officer’s life insurance premiums and anything else the IRS does not deem reasonable and necessary.
Most people understand that distributions from the business to the owner are not deductible. Owners often forget how much they have taken out of the business, or they spend it personally, without setting aside for the taxes due.
Less obvious are loan payments. Many business owners don’t account for debt payments in their tax planning. When the loan is received, there is no tax due on the money received. Consequently, when the loan is repaid, there is no tax deduction. The interest is deductible. Using the example of non-deductible expenses from above, it could take as much as 150% of the debt payment to cover the tax first, followed by the loan payment. For leveraged businesses, this is not an insignificant amount!
There are many other possibilities to consider from tax credits to accrued and prepaid expenses. The short answer is, plan with your accountant. Do it early and do it often. In today’s environment, not only do business situations change rapidly, so does that tax law. Better to take a few minutes to confirm what you think you already know.