Becoming a profitable business is an objective that most companies seek, both as a stated goal and as a day-to-day objective. Businesses of all sizes and types, industries, and stages all look forward to profitability. However, as the old saying goes, the two inevitable things in life are death and taxes. For businesses striving toward profitability, one often overlooked aspect of profitability is taxes. When profitability comes, the tax man won’t be far behind.
Profitability doesn’t necessarily mean that everything about the business is where it could be. Many businesses achieve profitability and still lack the cash to pay the bills—including ones sent by the tax man. Why? How? Because profits and cash flow are very different creatures.
No one looks forward to the tax bill. It looms even larger when cash hasn’t come along with profitability. A tax bill is a sure sign that the business has hit a major milestone; hopefully it isn’t a roadblock.
Accounting Profits, Cash Flow Realities
Profits are calculated based upon the rules of accounting for the business. Tax rules frequently differ from how the financial and managerial accounting reports look. Differences arise from timing differences and the methods used for depreciation and amortization of assets. The differences between cash-based or accrual-based accounting can also create timing differences between revenue recorded and the matching expenses, especially in businesses that:
- are heavily service-oriented;
- use deposits and pre-payments; or
- have revenues delayed until the end of projects.
Another chapter of the profit story is the “opportunity cost” of investment of time and dollars (put into the company or forgone because of cash flow and building the business). The ability to recover the capital appreciation is dependent upon a sale, merger, or other ownership transfer that allows the recapture of the investment.
Timing of Revenues and Tax Implications
The ability to match the recognition of revenues with the expenses associated with them and the ability to reduce the time between revenue recognition and receipt of cash payment significantly impacts whether or not the business has the resources to pay the tax man. Managing growth, cash, and tax implications is important to the ability of the business to do business AND its ability to stay in business. Many a profitable business has fallen into the trap of failing to pay its taxes—and failing to be in business as a result.
Understanding the Factors that Impact Your Taxes
No one can afford not to understand how expenditures made by the business on equipment, inventories, and operating expenses impact tax liability. The following factors have substantial influence and impact on the tax situation of the business owners and the business:
- Legal entity type
- Sole proprietor
- Partnership
- LLC
- Single person
- Multiple person
- Corporate tax election
- Corporation
- C
- Subchapter S
- Loans from shareholders
- Repayment of loans from shareholders
- Deferred compensation of owners
- Capital contributions
- Investment in capital assets
- Expenditures on:
- Meals
- Entertainment
- “Personal” expenses
- Proportion of draws/distributions versus salaries and benefits
- Previous year(s) losses: ability to carry forward
- Accounting method: cash or accrual
- Uncollectible accounts/bad debts
- Industry accounting principles
What’s a Business to Do?
Understanding the profitability and cash flow position of your business is essential to managing tax liability and timing of revenues, expenses, and cash flows. Know your business and know the implications of the factors listed above on your business. Have an experienced, knowledgeable accountant and other legal and tax advisors involved in your business. From day one, your choices in how you do business impact when (and how) the tax man cometh. With proper planning and a sound tax strategy, when the shadow of the tax man reaches your business, it can be a major milestone and not a major pain in your … bottom line.
Copyright © 2007 Lea A. Strickland and F.O.C.U.S. Resource, Inc.
