Derive future business success through regular and careful book monitoring
As we all know, was the season for paying Uncle Sam. And for business owners, this month had been an especially delicate time as business owners are juggling with running a business and meeting with their tax professional regularly (sometimes daily) to ensure they do not pay any unnecessary income taxes.
Most business owners who file as an S Corporation have, most likely, filed their tax returns already for the year and consider their “accounting” work done as a result. However, this thinking is both dangerous to the functionality of the business’ operations and detrimental to the business’ future. While tax planning and reducing the payment of unnecessary taxes is important, knowing how the business is doing is equally important, if not more important, and necessary for business to thrive and succeed. As a result, a business should have two sets of records: one for tax and one for the business.
Most business owners, and individuals alike, understand this set of books and why they would primarily exist… to reduce tax liability. However, there is more to it than just reducing tax liability. In some cases, businesses, such as startups may already be functioning at loss. Consequently, reducing tax liability has already been achieved by the mere situation of the business. Under these circumstances, tax records take a new role and that is to possibly take advantage of losses to benefit prior year tax positions or even carry the loss forward to benefit future tax years. Depending on how your business is structured, a business owner incurring a business operating loss has the potential offset tax liability for prior tax years where the business was profitable or even the business owner’s own personal income tax where a tax was due.
Additionally, if carrying back is unavailable, the business owner could elect to carry the loss forward to use as another deduction for tax purposes. However, the rules regarding how this will be applied or function is directly dependent on the structure and tax treatment of the entity.
Another record of vital importance to most business owners is the capital account of the business owners. For owners of companies treated as S Corporations or partnerships for tax purposes, you know, should know, that you must keep records of the amount of a business owner’s investment in the business and any additional increases and decreases on this amount.
The reasoning behind this account for tax purposes is two-fold:
- Know the limit of losses you can deduct
- Determination of profit allocation for tax purposes.
First, your capital account is an account that is increased or decreased depending on a business owner’s actions within the business.
For instance, if a business has a profit, the profit allocable to a business owner will increase the business owner’s account. Conversely, if the business suffers a loss and the business owner elects to report the loss on his/her tax return, it will decrease the capital account of the business owner.
Keep in mind, the amount of loss a business owner may deduct is limited to the amount listed within the owner’s capital account. The amount listed in the capital account must not go below zero (0). Should a business owner take a deduction for a loss that is greater than the amount in the business owner’s capital account, the business owner would be liable for capital gains tax on the negative amount in the capital account as it would be seen as a divestiture of the business by the owner.
This, of course, could create certain legal issues if there are multiple owners and one of the owners is seen to have divested his/her interest in the business.
Would that owner be out of the business? Would that owner automatically lose voting rights? These are important matters one should not take lightly when analyzing their tax positions.
Therefore, keep these factors in mind when considering your tax records. On a side note, remember that while a goal may be to reduce tax liability you may be hurting your business’ future (discussed further below).
Now, as mentioned at the beginning, business accounting records are of essential importance to a business. Unlike tax accounting which is motivated by reducing unnecessary taxes, the goal of business accounting is to determine how a business is doing.
Is the business making a profit on the goods or services sold? If so, is the profit generated sufficient to cover general operating expenses? Also, is the company collecting payments owed by customers? Finally, are bills received and paid in a timely manner? These are just some of the questions business accounting is able to answer. It does so with a focus on a method of accounting called accrual based accounting.
Unlike the cash method (which is used in most tax returns to calculate a business’ profits), under the accrual method of accounting a business sale occurs when a customer is invoiced not when the payment for the goods or services is rendered and expenses are recognized when a bill is received not when the bill is paid.
As a result, the accrual method accurately aligns revenues with the corresponding expenses associated with the particular sale transactions. This alignment allows for businesses to understand when sales were actually made and what costs were associated in producing and working on the sale.
Thus, a business can ascertain if its model is working or discover anomalies within the movement of transactions that have an effect on the operating profit of the business. For instance, if a business discovers in February it incurred an additional expense for electricity than it normally incurs in a February or that it had incurred in January of that same year it can investigate the problem and fix it before it impacts the company further.
Another aspect of business accounting is planning ahead.
When a business owner can see trends in sales, for example higher sales in the fall and slow sales in the summer, he/she can decide to either reduce expenses for the slow summer months or finance the expenses for the slow months knowing they will be paid back through the strong fall sales (presuming the summer expenses are unavoidable. Of course, another concept with regard to planning ahead is expansion and prior financial statements from the business accounting history can show how and when to expand operations.
In many expansion scenarios, financing (i.e., obtaining a loan) is strongly considered is the method of securing funds to expand so, having as much certainty with regard to expansion plans is important. Though, it should be noted most banks want to see profitability on both year-end financial statements AND tax returns. Hence, keep this in mind when preparing your taxes.
There is also another reason for maintaining business accounting records is to be able to compare your business to other businesses in the industry. As mentioned earlier, the best method to use for business accounting is a method called accrual based accounting. Not only is the accrual method the best method to use it is also the standard method used by most, if not all, businesses in some fashion.
As a result, you may be able to “benchmark” your business in comparison with other businesses in your industry. For those wondering, information regarding industry statistics is published and updated annually. For a fee, you can obtain this information from reputable organizations. This is a great tool to see how your business is performing and, most importantly, where you can improve especially if you cannot see where your business needs improvement.
We all understand the importance of getting a business’ books in order for tax time. However, just be sure that as this year’s tax time dust settles you continue to oversee those books for business purposes to ensure the future success of your business.
The intent of this article is to open up conversations on improving your business with your tax/finance professional. Every state has nuances, be sure to speak with a tax professional who is familiar with your state.