Every business owner wants to know HOW to make the most money while paying the least amount of income tax. After all, if you pay too much income tax you might be considered by some to be un-American! But not knowing how to follow up after taking advantage of huge tax breaks can be fatal for some businesses.
Recent changes in the U.S. Tax Code have made it much easier for business owners to save significant income tax dollars (without having to cheat the government). Take for example, the recent legislation passed by Congress and signed by President Bush. The legislation extends the rules that allow the business owner to "write off" up to $100,000 of qualified equipment purchases in any given tax year. This increased write off (also known as a section 179 deduction) allows the business owner to save significant amounts of income tax. Sole proprietors and partners in partnerships and LLCs can save federal income tax, self employment tax, and in some cases state and local taxes as well. Pretty sweet, right?
There is absolutely nothing wrong with taking advantage of favorable tax law such as the section 179 deduction. However, business owners should know HOW to FOLLOW-UP on the tax deduction to avoid the appearance of operating a very low-profit business. Unfortunately, many business owners rely on "tax-basis" financial statements to record their historical business operations. That means that the business financial statements reflect income tax profit--rather than the higher economic profit generated by the business. How can this cause problems?
Have you ever heard the old expression, "First impressions are lasting impressions?" Business owners using the "income-tax" basis financial statements often have to overcome the skepticism of lenders and potential investors who are concerned about "low profits" generated by the business. When a lender or purchaser sees a financial statement showing lower profits, a "first impression" is imbedded in their minds. Sure, the lower profit can be explained by pointing out that "tax depreciation" (higher depreciation) was used for preparing the financial statements. But it is too late to leave a better "first impression." Subconsciously, the lender or purchaser usually has a hard time shaking that first impression.
In an effort to save money on accounting fees, many business owners are satisfied with the "tax basis" financial statements. However, many of those business owners are really "shooting themselves in the foot." It is possible to enjoy tax benefits and still leave a good impression with lenders and potential buyers.
Smart business owners should ask their CPAs to prepare financial statements on an economic "book income" basis rather than an "income-tax" basis of accounting. The "book income" basis will not reflect the higher tax depreciation, but rather, the book depreciation, which might be calculated on a straight line method. There may also be other accounting differences between the "book" and "income tax" methods of accounting. However, the book income method is meant to show an "economic reality" rather than the taxable income.
If the business owner insists on using the income tax basis of accounting, then the business owner should ask the CPA to prepare supplemental "EBITDA" reports on an annual basis. EBITDA is short for Earnings before Interest, Taxes, Depreciation and Amortization. Look at the following example:
|Income Tax Basis Profit -||$48,000|
|Add: Interest Expense to finance the business -||$4,500|
|Add: Income Taxes (Assuming non incorporated)||$0|
|Add: Depreciation Expense (Includes section 179) -||$110,000|
|Add: Amortization Expense -||$5,000|
|Earnings before interest, taxes, depreciation, amortization||$167,500|
Compare the Income Tax Basis Profit of $48,000 to the EBITDA profit of $167,500. Which number is more impressive? Which number would you want your banker or potential buyer to see first? Remember, you only have one chance to give a good first impression.
Whether it is the physical appearance of your business--or the financial appearance of your business, good first impressions are extremely important. A bad first impression for a business can be the equivalent of financial suicide when it comes to courting lenders and potential buyers.
In the upcoming Part II of this series, I will discuss the tremendous cost to business owners who underreport business income. It will be a real eye-opener!
Grover Rutter is a CPA and Business Broker who has been dealing with closely held businesses for over 30 years. "Now that the baby boom generation is maturing, the business advice they receive has to be much different from 10 to 20 years ago," Rutter explains.
For this reason, Grover has written a newly released book that provides "straight talk" to business owners so they can learn very quickly HOW to increase and maintain their business values. This book provides an excellent "self examination" for business owners to apply to their own business situations. Your Business IS Your Goldmine! (Learn How to Get the MOST Out of Your Business) delivers an important message that most business owners NEVER hear! HOW TO GET THE MOST FROM YOUR BUSINESS! This powerful (and easy to use) message will help business owners put their business financial well-being into perspective. The tax deductible Guide is less than $20, and should be read by every business owner. Interested readers may find the guide atwww.Lulu.com/businessadvisor