We are smack dab in the middle of tax season with only a couple of weeks left before the individual filing deadline. That means S corporation business owners all over the country are wringing their hands, hoping for a great March and April to pay their tax bill. This annual ritual of scrounging for cash to pay last year’s taxes is a huge distraction for businesses. And it leads to all kinds of shenanigans.
Most tax planning advice given to small business owners is based on spending money.
“Buy new equipment before year-end.”
“Prepay next year’s insurance policy.”
“Buy the heavy duty truck for your new ‘business vehicle’ so we can write it all off in year one.”
I’ve heard (and at times have said) it all. Don’t get me wrong, if you are going to spend money, do it tax efficiently. But why spend money in the first place to lower your taxes? Let’s look at the numbers and see how absurd the spending strategy really is.
If you decide to spend an extra $10,000 at year end to ramp up your deductions it might save you $2,500 in taxes. So net-net you are $7,500 OUT of pocket. Decide is the operative word. I am describing a situation where you can spend the money and use the purchase in your business OR you can choose not to spend the money and it won't kill you or have a negative impact on the business.
If you decided NOT to spend that money, your profits would be $10,000 higher and your tax bill would be $2,500 higher. So after paying your taxes you would be left with $7,500 IN your pocket.
You see how that works right? When you're 'smart' and employ the spending ’strategy’ you give up $7,500, but when you act like a fool and pay more taxes you KEEP $7,500.
Why is it that we lose our minds when it comes to taxes? Are small business owners so loath to render unto Caesar that they’d rather spend 100% than keep 75%? I don’t think so. I think first, they are getting bad advice. And I think second, they are reacting emotionally to the very frustrating experience of having to come up with cash to pay a tax bill. So when someone says “Do this and your taxes will be lower” they just do it without thinking about the bigger picture.
Here’s the truth. Most of the truly strategic tax saving strategies require CASH. And the best way to accumulate cash is to not spend it. So we need a better strategy, one that provides the cash to pay taxes, avoids spending, and allows us to stockpile cash for use in future tax saving strategies. It might sound sexy, but it is dead simple. And those who follow it enjoy...
Enough money on hand to result in stress free cash flow management
The opportunity to self fund everything from life insurance to asset purchases
The resources to take advantage of long term strategies down the road
Let's break this strategy down to four simple steps.
Step 1
Setup a separate savings account to hold nothing but money you will use to pay taxes.
Step 2
Every month close your financial statements (quickly) and multiply your YEAR-TO-DATE net income before taxes by an approximate tax rate based on your tax bracket. Your CPA can help you come up with this. A good place to start is 25%-30%.
Step 3
Compare the result of step 2 to your tax savings account balance. If step 2 is more than your balance put that much money INTO your tax savings account. If it’s less pull money OUT OF your tax savings account and redeposit it into your operating account.
If you make estimated quarterly payments just subtract the payments already made from the result in step 2 before you compare it to your tax savings account balance.
(NI) x (25%) - (E) - (B) = transfer amount
Where...
NI = Net income
25% is your estimated tax rate. This may be higher or lower based on your situation
E = estimated payments already made
B = balance in tax savings account
Transfer amount = amount to move into (out of) tax savings account
Step 4
When tax time comes around your final tax bill can be paid out of your savings account. If you use a conservative percentage (usually somewhere between 25%-30%) you will almost always have extra left in your account after you pay the tax bill. This can be distributed as an extra dividend for you to spend as you like or you can roll it back into the business. If the balance in your tax savings account is not enough to cover the tax bill the remainder is usually not very large and paying it causes none of the disruption to your business or hand wringing that you experienced with your previous tax bills.
If you want to see a simple example of this strategy take a look at the following spreadsheet.
If your business is larger or smaller just add or subtract zeros as appropriate. You should get the picture.
At the end of the year there is $10,750 available to pay the final tax bill. If the final return winds up being less whatever is left over can go to the owner. Also notice that in the two worst months when the business was losing money the owner was able to take money out of the tax savings account and deposit it back into the operating business where it could do some good.
Without this plan the business owner would need almost $11,000 on top of the quarterly payments at tax time. And that’s IF the quarterlies were being made. If he followed the norm and just took the 4% underpayment penalty “loan” from IRS by not making any estimated payments he would be stuck with a $40,000 tax bill. But most likely he would have spent that $40,000 back in December on a new truck to “save taxes”. And, YES, it would have lowered his tax bill down to about $30,000. But where is THAT money going to come from?
I’ll tell you where it’s going to come from. Next year’s profits. But to pay that $30,000 to IRS the business has to make $40,000 in profits ($40,000 less 25% tax leaves $30,000). In a growing business this snowball continues to get larger year after year. There were a lot of businesses that let that snowball grow unchecked between 2000 and 2009. It never caused a problem because their January, February and March numbers were always solid and higher than last year’s. They cannibalized current year profits to pay last year’s taxes after spending down their tax bill the previous December. And then what happened?
Whether it’s a recession, a competitor who opens up across the street or just grandma’s common sense voice ringing in your head, eventually that unpaid tax bill is going to create some serious headaches. Not only are you running on borrowed time you are just spending more than you should. Remember our example earlier. If you make $10,000 of profit in a month and spend all of it on a blockbuster family vacation not only are you failing to put away the $2500 you will eventually owe Uncle Sam, you are blowing $7500 that you could use down the road to help fund one of those fancy long term tax saving strategies you can never afford because your CPA tells you “I’m sorry, you don’t have enough cash to do that.”
Pay this year’s taxes out of this year’s profits and you will never again dread that terrible, horrible, no good, very bad day called April 15th.
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