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Can Paying Taxes Be a Good Problem?

Posted on July 29th, 2018

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

“I wish I knew where the money went!  I didn’t take any more salary, but I’m paying a lot more in taxes.”

A client of mine recently asked me this very question, which is a question I often hear from small business owners.  In most cases, it’s because they do not understand what “profit” really means since they are not seeing it accumulate in their personal bank account.  And some felt like they were actually losing money, and thought they were fine because that would “save them on taxes.”  So what are we really talking about here, and why is profit so important anyway since you just have to pay taxes on it?

And the answer is, your business cannot survive without profit.  Think of it in terms of your personal financial situation.  If your monthly mortgage payment is more than your monthly income, that shortfall has to come from somewhere.  You either need to increase your income, reduce your expenses, or pay the shortfall out of your savings account – at least until your savings run out.

A business is no different.  If it’s losing money, that shortfall has to come from somewhere, usually the owner, until (again) his or her savings run out, or by delaying payment to suppliers – until they cut you off.  So if you are one of those who thinks losing money to save on taxes is a good thing, be prepared for a nasty surprise not too far down the road.

Understand, we’re not talking about foregoing legitimate tax deductions and paying more taxes than you should.  Who wants to pay taxes, right?  So how is it that your business can be profitable, but yet you’re not feeling the joy in the form of a growing cash balance?  The short answer is that there is a huge difference between “profit” and “cash flow,” and between financial reporting for managing your business, and for tax purposes.

On the tax side, since most small businesses report taxes as an S-Corporation, let’s use that as an example.  In an S-Corporation, the profit is not taxed directly on the company’s  tax return, but rather, it is reported on the K-1 in the owner(s)’ personal tax return.  The profit itself may not have actually been distributed to the owner, but nevertheless, it is still taxed there. And this is the first thing you must keep in mind.

So then you ask yourself the question, “Where’s the cash?”  And the answer is, look on your company’s balance sheet.  If it’s not in your operating account, then on the asset side, it’s in accounts receivable (uncollected sales), or it funded an increase in inventory or purchases of fixed assets, or to fund loans from the company to you, the owner; or, on the liability side, it was used to pay payables, or repay debt (including loans from you, the owner), or to fund shareholder distributions (again, you).

Next, look at your cash flow statement.  At the very top is your profit (money flowing into the business) or loss (money flowing out of the business),  followed by all of the changes in your balance sheet items, together which reflect all “sources and uses” of funds.  And at the very end, is your ending cash balance shown on your balance sheet.

The bottom line is, if your business is truly profitable, somewhere along the line you benefited from it, because if you had NOT made a profit, you would never have been able to fund any of these business expenditures, and then it’s game over, you’re out of business.

So taxes are like any other business expense, a necessary evil. As your business grows and your profits increase, you have to pay more taxes as a percentage of your increased profit.  It just has to be planned and reserved for, and where possible, minimized with legitimate tax reporting methods, but on your CPA’s tax return, NOT your books.

Related Articles

Profit vs. Taxable Income

Profit vs. Cash Flow Made Easy 

Analyzing the Components of Cash Flow

Whose Income is K-1 Income Anyway, Mine or My Business’?

 

 


The Difference Your Method of Accounting Can Make #2

Posted on July 22nd, 2018

Jack Kern
Owner /President
Outsourced Accounting Department, Inc.

In my first article on this topic (“The Difference Your Method of Accounting Can Make), I talked about a private ambulance company that was able to obtain significant bank financing, improve receivable collections and cash flow, and solve an employee turnover problem while simultaneously reducing labor costs, all by simply using the proper accounting method to evaluate their true financial situation. In this article I will talk about what can happen when the wrong accounting method is used.

To provide a little background, over the past fifteen to twenty years, as banks have gotten bigger and bigger, the banking industry has gotten away from requiring financial statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”), the underlying premise of which is to “match” revenues with their related costs (Accrual Accounting).  Instead, for its own convenience, the banking industry has gone to using tax returns, credit scoring, and what’s called a “global, debt service coverage ratio” to measure a small business’ ability to repay a loan. Basically, this means that if the company’s and its owner’s combined tax returns show a lot of income, and the owner has a high credit score, you’re in! If not, you’re out!

The problem with this loan underwriting approach is that while a business owner can utilize legitimate tax methods to reduce his or her business income for tax purposes, using this same information may very well work against them when applying for a business loan.  And since banks no longer require GAAP financial statements for “small” businesses, owners don’t request them from their CPA firm because they don’t understand why they need them, and they don’t want to pay for them.

A case in point: A while back, a client of ours found out what happens when your bank relies on your tax return to support your line of credit.  As a matter of practice, our firm always prepares the company’s internal financial statements based on GAAP, and then at year-end, if our affiliated CPA firm also prepares their tax return, they also prepare GAAP financial statements to accompany them.  However, in this case, the client used another CPA firm who simply took our financials and converted them to cash basis for tax purposes, and a tax return was all the bank required to support the company’s $500,000 line of credit.

For the record, we did strongly recommend to their CPA that he also prepare compiled financial statements in accordance with GAAP using our internal numbers.  However, as his firm was strictly focused on tax preparation services, he told our mutual client that he knew the bank’s management, and that he didn’t need GAAP statements.  Then the CPA made some major accounting adjustments for tax purposes that made it appear that the company had distributed a large amount of money to the owner all in one year, and paid off a stockholder loan that was subordinated to the bank’s loan.  In fact neither of these were true, and compounding the problem, this was at a time when the company’s “taxable income” (cash basis) was already way down.  The outcome?  The bank panicked and terminated the company’s half million dollar line.

Sadly, the owner had already taken corrective action based on the internal numbers we provided to him, which painted a true picture of what was going on in his business and reflected the measures he had taken.  Had the proper financial information also been provided by their CPA on an accrual basis, it might have instilled more confidence on the part of the bank’s management in the business owner, and perhaps the outcome would not have been quite so drastic.  But instead, the bank had no idea what was really going on in the business, and this is what banks do when they don’t know what’s going on.  Lesson learned – the hard way!

Related Articles:

Profit vs. Taxable Income

Profit vs. Cash Flow Made Easy

Securing a Small Business Loan – Part II: Positioning

 

 

 


The Difference Your Method of Accounting Can Make

Posted on July 16th, 2018

Jack Kern
Owner /President
Outsourced Accounting Department, Inc.

A while back I was doing some consulting for a well established private ambulance business that was having trouble getting approval for a $30,000 bank loan to buy two wheelchair transport vehicles. When I met with the owner, I asked to see the information that she gave to the bank. It was a classic situation I see with many small businesses – using cash-basis tax returns to provide to the bank, and in this case, with multiple entities and extensive intercompany transactions – such that no one could tell how the business was really doing by looking at the financials. At the same time, another business adviser was using this same information and advising her that she needed to let go of several paramedics — the life blood of her company, because her direct labor costs were “too high.” And ironically, management had been complaining about not being able to attract and retain quality employees from the local labor market.

The first thing we did was go back two fiscal years and recast the accounting on an accrual basis as I discussed in my recent article, “‘Profit’ vs. ‘Taxable Income‘,” and then combined the businesses for financial reporting purposes and eliminated the intercompany transactions. The end result revealed a company that exhibited strong earnings, but slowly turning accounts receivable creating a severe strain on cash flow. Moreover, when we compared our numbers to an industry study we obtained from the ambulance association, we discovered that as a percentage of revenues, our direct labor costs were actually lower, not higher than the industry average. At this point, we slammed on the brakes to review exactly what was going on.

Next, and perhaps most amazingly, we did a survey of the labor market and discovered that the company’s wage rates were far below the competition, which explained why the company was having a difficult time attracting and retaining quality employees. And the employees that were left had found ways to get around this by helping each other to abuse the company’s overtime policy. The remedy? We gave the employees an across-the-board pay raise and simultaneously cracked down on overtime abuses, and in the end, everyone came out ahead.

The final outcome of all of this was almost as unbelievable. First we wrote a business plan based on the revised numbers and obtained approval in only two weeks for bank financing totaling $650,000 (after previously having been declined for only $30,000 as stated above). This included a working capital line of credit, and a revolving line of credit to enable the company to purchase vehicles with just a phone call to the bank. We then looked into the accounts receivable turnover issue and discovered a production bottleneck in the billing department, which was quickly addressed and eliminated by bringing in temps to catch up our billing, and then addressing some personnel issues in the billing department.

None of this would have been possible without first correcting the company’s method of accounting and financial reporting. And by the way, the company’s method of reporting for tax purposes was left unchanged.

Related Articles

Profit vs. Taxable Income

The Role of Cost Accounting in Planning Your Business’ Success

What is the Basis of Accrual Accounting

Profit vs. Cash Flow Revisited: The Matching Principle