“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 legitimatetax reporting methods, but on your CPA’s tax return, NOT your books.