Every business owner knows the drill; we made a profit this year so we need to spend our cash to save on taxes. I want to challenge you to think differently this year to “save cash” not “save taxes.”
The inherent flaw in spending your cash is that you have to spend a dollar to save 40 cents in tax. Last time I checked, that just seems like a bad idea. Every year, you come up with every excuse to go ahead and spend money that you think you would have spent anyway. You buy new computers, you buy some extra supplies that you always use, buy a new vehicle because you heard you can “write off.”
My argument is that if you did without all of those costs up to December, maybe you did not need to spend it after all! My most successful entrepreneurs spend a dollar at the last possible moment it is needed.
Build Wealth or Save Taxes?
You can only build wealth from “after-tax” income, so every attempt to lower your taxes lowers your ability to create wealth. The number one key performance indicator of wealth creation is “how big of a check did your write to the IRS.” If you did not write a big check, you either cheated or you did not make any money, both are bad. Do not pay more taxes than you should, but you should be focused on building wealth above savings taxes.
What if I am Cash Basis?
For those of you who are cash basis businesses, you can easily fall into the trap of draining your cash paying off vendors at year end. While this seems enticing, you eventually take it to the illogical extreme and have such a huge amount pushed forward it causes you to make sloppy decisions at year end. Here are just a few of the issues that you could encounter:
- Bank financing – Your year-end financials are more important than ever these days. By focusing on taxes instead of good business fundamentals, you distort your balance sheet at year end and spend the next year explaining why your balance sheet looks bad at December so you can get your line of credit or bonding renewed.
- Missed Opportunities – Because you dumped all of your cash in December, it takes longer than you think to build it back in January and February. By not having cash available to start new projects, you delay or miss out on new opportunities. To delay acting on an opportunity wastes a day of potential productivity that can never be recovered.
- “Deferring Taxes” versus “Saving Taxes” – Did you really save taxes or did you just defer them? Be honest with your language when you spend your year-end cash. It is not saving taxes unless you are saving at a high rate this year and you pay a lower rate in the future. Not likely to happen. Most entrepreneurs defer taxes at year end and push their rates down into the lower brackets to end up paying at a much higher rate in the future when they have kicked the can as far down the road as they can.
- Borrowing money to finance that year end equipment purchase – This is the ultimate tax trap. You borrow $100,000 to buy that new piece of equipment (that could have been delayed) and you end up taking the expensing election on the equipment. Inevitably, this purchase pushes you down into the 20% or lower bracket. The only way to repay debt is to make after-tax profit. To make enough profit to repay the loan, it pushes you into the higher brackets and you end up paying close to 40% tax to generate enough cash flow to get out of debt (if you are lucky). The politicians (and most tax advisors) are not doing you a favor to trap you into this bad decision by calling this a tax break.
A Better Way to Think
You need to approach taxes as the logical outcome of a profitable business that is your primary wealth-building engine. These are the keys to make this happen:
- Owner’s Wages – Set your wages out of the business at a market rate for the job your have in the business. Then live off of that wage. Do not fall into the trap of consuming the profits of the business.
- Get Profitable with the Business You Have – Once you properly set your wage as an owner, your net income gives you a true picture of the profitability of your business. If you are not profitable, the key is to make all labor productive and eliminate any labor that does not add value. You have to get your current business model profitable before you grow.
- Grow Your Own Capital – Once you are profitable, retain after tax business profits until the business is fully capitalized. My definition of being fully capitalized is having 2 months of operating expenses in cash with nothing drawn on a Line of Credit. A business that has 2 months of cash can act on opportunities as they come up and you do not need to “get permission” from your banker. Cash is the greatest “opportunity magnet” I know of.
- Get Shareholders Healthy – Once the business is fully capitalized, you can then take distributions to get your personal finances healthy. Get out of debt first (yes, that means all debt… including your home!). Then build up your emergency fund.
- Strategically Redeploy Profits – Once your business and personal finances are stable, then you can make strategic decisions about the after tax profits of the business and decide if you want to grow the business larger or just continue to harvest the profitability of the business.
- Beware of “Consumption Cancer” – Everything you buy owns a piece of you and creates a financial drag. If you learn to live off your wages and leave the profits of the business for wealth creation, you have mental clarity of what produces wealth, what is investing and what is consumption. If you set a lifestyle target before you have the income to act on it, you will stand a better chance to control consumption.
The dot com bubble taught us that you cannot have a business that does not eventually make a profit (unless you sell it to a fool first to get it off your hands). The real estate bubble allowed banks to get sloppy with lending because they thought your property (either your home or business property could be sold for at least loan value). It is time for entrepreneurs to get back to fundamentals and build profitable businesses that do useful things and grow your own capital. Stable businesses are the ones that create jobs that last and build a strong economy that can weather the storms of the market.
Greg Crabtree has worked in the financial industry for more than 30 years and founded Crabtree, Rowe & Berger, PC, a CPA firm dedicated to helping entrepreneurs build the economic engine of their business. In addition to serving as the firm’s CEO, Crabtree leads the business consulting team—helping clients align their financial goals with their profit model and their core business values. He is the author of Simple Numbers, Straight Talk, Big Profits! For more information, please visit: http://www.seeingbeyondnumbers.com/.