Dashboard: Where’s the Money?

[Music] welcome to another 21 hats dashboard brought to you by our sponsor the great game of business I'm Lauren Feldman and I'm here with Gan marks to talk about the things we think business owners should be following this week welcome Jean hey Lauren I'm not even going to mention the great game of business you did a good job bringing them up this time so you just did Jean oh yeah okay I guess you're right all right well anyway I maybe we'll mention at the end as well great great company great organization well we're both big fans that's the only thing we need to say Jean is usually you've been writing about stuff that matters to business owners this week I'd like to focus on just one story that you wrote your Washington Times piece about how business owners pay taxes as as you suggest there there's a lot of nuance to the taxing of businesses it's complicated a lot of it's not well understood sometimes I suspect even by business owners themselves um to me the most important well see what you think but to me the most important part of your story is understanding that owners can wind up having to pay taxes on money that they aren't actually taking home uh you gave us an example of this through a client of yours with two owners and a million dollars in net profit can you walk us through that example yeah I'd be happy to do that um so okay so I do this is an actual client of mine um I used round numbers obviously didn't disclose who they are because it's you know they're private information right 2022 was you know it was a good year for them like it was for many business is and um their company which they're they're a small manufacturer um they they made a million dollars I mean their their net profits were a million dollars now they you know there are two partners it's a partnership so they each have to share in those profits which basically means that $500,000 is going to flow through down to their tax returns and so they're going to be showing income of $500,000 a piece you know because they're splitting that million dollar in profit now you know if if President Biden and again this is not I don't want to make this like a political thing I just the the whole good right the whole goal here is to is to just make sure that we all know you know the facts here you know so um the President's trying to do a lot of good things he is trying to raise some money and his his big thing him and his party has been sort of going after the quote unquote wealthy told off on that for a minute just explain to us first how it works tell us what happens to the $500,000 that in net profit that each of these owners co-owners get so the $500,000 gets so it's a million dollars in profits for the business and the business again is a partnership so you know the business doesn't pay taxes on this the individuals pay taxes on them it's a pass through structure there a pass through it's exactly right so and because they each own 50% of the business um they each share 50% of the profits so they each show on their tax returns $500,000 in profits income comes down on their tax return um and assuming no other things going on they they might have income from other places interest income or whatever uh they can certainly take their standard deduction against that you know there might have other things going on in their personal lives but just to keep things like just really super simple they're each reporting $500,000 on you know of taxable income which is subject to uh income tax now um the president wants to raise the upper limit of income taxit let's just talk about the way it is before we talk about what might happen Okay because you described them having getting caught kind of in a cash crunch where they're paying money I mean this is the way it is right now regardless of whether tax rates go up or or what this is a cash crunch they're facing or faced in the past year correct yeah so okay so um fair enough so if there each they're each earning the government is going to tax them based on that $500,000 okay however however and the example that I use in the com that I wrote is um these two people my two clients they didn't take home $500,000 a piece they took home a lot less um and let me explain why of that million dollars that the company earned um they that million dollars only generated $400,000 in cash during 2022 why because of that million dollars in profits about $150,000 is caught up in inventory which basically means that these guys um you know they they were not able to take a deduction for this inventory because it hadn't been sold yet but they bought it so the inventory is sitting on their balance sheet and they paid for it but it's still just sitting there so even though you know you've got this profit you've spent $150,000 extra in cash for your inventory that hasn't been sold yet does that make sense Lauren yeah just to be clear um make sure I understand our listeners understand when you calculate profit something like inventory um is deductible I mean you you you don't when you sell it when but when you sell it that's the key so at at the end of the year this is inventory that's just sitting there so they are in that's the cash crunch part of this the cash is in the inventory but they're paying taxes as if they had that money in their pocket that is correct so they've been selling their inventory during the year but they've also been buying more inventory to replenish their stock of course and at the end of the year they they've got $150,000 more in inventory sitting there they had at the end of last year which they spent money on and it's just sitting it hasn't been sold yet now you know it'll be sold in 2023 but the cash has already been spent it's just sitting there they've invested in that inventory and there it is for the future fair enough yes okay they've also made other Investments as well they purchased Capital Equipment during the year uh two machines that they bought um that does like slitting and another one that does welding um and they spent about $200,000 in cash for those equipment purchases because interest rates are up now they didn't want to finance it so they bought this Capital Equipment so that's they don't get a you know you know that Capital Equipment itself it's cash that went out the door but the equipment again is still sitting on their you know on their balance sheet well explain the accounting on that too is that like the inventory don't they get to take it to deduct it in the year they spend it so there are tax Provisions that allow you to deduct your Capital Equipment um up to a certain amount during you know during the year um so particularly for small businesses can take an immediate deduction when they when they buy Capital Equipment however that deduction has now decreased it used to be you could you could deduct 100% of the cost of that equipment if you bought it and put it into service during the year now you can only deduct 80% of that so the Capital Equipment that they bought during the year still a pretty good deal it's a good deal it's going to go down to 60% next year and 40% the year after that so that's depreciation deduction that that deduction for Capital Equipment purchases is going down each year that was part of the tax form act 2017 but for this purposes they purchased $200,000 worth of Capital Equipment which they can't deduct not all of it they can deduct some of it correct right but they could not deduct all of it so they've got this $200,000 in cash that they' paid for the equipment it's sitting there on their balance sheet they were not able to take a deduction for it and again they're investing in the future but they'll only be able to deduct it over the the lifespan of the equipment which in this case is about 7 to 10 years so it'll be equal over that period of time they can take that deduction okay so the $200,000 just to be clear here yep it sounds like they spent a million dollars then y on equipment and the $200,000 is the 20% that they weren't able to deduct first year okay that is exactly right that is exactly right so it's non-deductible cash you couldn't you couldn't take a deduction for it on this year's tax returns but you still spent the money just like getting back to the inventory we weren't able to deduct the cost of the inventory because we haven't sold it yet but we still spent the money on it and between inventory and the equipment both of those are investments in the future because this is an ongoing business right they need to buy products and sell it and they also trying to invest in equipment to make themselves efficient and make more products going forward but between the two it's $350,000 in cash that they paid that they have not able to take a deduction for in 2022 does that make sense yep okay next they paid during the year about $200,000 in estimated tax payments now these were estimated tax payments for the year so you know they it's it's not a deduction it's taxes so it's $200,000 in cash that went out the door that has no impact on their you know on their profits and the way that they paid those taxes because they pay them individually is that they had to take a distribution from their business the business had to give them the money so that they could pay their individual taxes because the profits flow through to their individual returns so the business paid out $200,000 to them 100,000 you know a piece that they use to pay their their individual taxes but the business can't take a deduction for it it's just distribution in cash to pay those taxes does that make sense I think so finally their accounts receivable went up between the beginning of last year and the end of this year uh sorry the beginning of this year and the end of uh the end of this year by about $50,000 what that means is they sold stuff they recorded the profit but they haven't been paid for it yet so it's non-cash in other words they're being taxed on it because they recorded that profit but they don't have the cash in their bank yet uh they know hopefully they'll collect it you know within the first month or two after the end of the year but as of the end of 2022 they're paying taxes on those profits but they don't have the cash to really pay those taxes because they haven't been paid for the sale does that make sense it does it's kind of the reverse of the inventory thing where they've invest the inventory they've invested the money but it's just sitting there uh in this case they've they've made the sale they've recorded the sale but they don't actually have the money correct so they paid money for inventory went out the door but they haven't sold it yet so there's cash that went out but they haven't recognized any income uh they paid money for this Capital Equipment that they couldn't deduct $200,000 so cash went out the door but they can't even they can't even deduct that against their income they paid money for their estimated taxes that was just a distribution to them to stay current on those and they're still waiting on more money from their customers for sales that went out the door that they were taxed on but they haven't gotten paid for yet right those are all the those are the the the the four big items that that I use that I qu there's other items as well but they they all net out pretty much to the same thing so if you take the million dollars in profits you have to deduct from that $150,000 which was cash that went out that they haven't recognized any they aren't able to sell yet they take out another $200,000 in cash that went out for Capital Equipment another $200,000 in taxes that they can't deduct and another $50,000 in cash they haven't received yet which is why even though they made a million dollars their cash only went up $400,000 and I get that question a lot from clients saying you're showing all this money that I made here but I don't have to cash in my bank account to pay for this stuff you know like to pay for the taxes on this where's the money where's the money show me the money and the answer is well you you you haven't you haven't frittered the money away hopefully um taken it and you've you've reinvested it in your business and of course you're also still waiting on payments from your customers you know so that's the difference between the million and profits and the actual cash that's left over and the problem is is that these business owners are going to be taxed at a million dollar not the $400,000 increase in cash and you know a lot of them are you know so instead of uh you know saying well these two owners increase cash by 400,000 so really they put in their pocket an extra they put in 200,000 a year they earned each right which by the way is pretty middle class when you take the deductions out and you know you're paying a mortgage and food and all of that I mean it's upad w wait they're each taking home $200,000 in cash they're each taking home $200,000 in cash that's cor so so if this were if they were employees they their salary would have to be well over $200,000 for them to end up with that correct yeah that's correct because they paid they paid the taxes on that 200,000 already which would put them in a pretty high percentile in terms of payment I mean more than middle class I think yeah it wouldn't be bad it wouldn't be bad but I don't think anybody would really call them wealthy okay I mean I think they're doing good and let's not forget you know Lauren these are people that took risks you know they're running their they're not employees so to even compare them to employees is like apples and oranges because employees can always leave a job and go to another job um they don't have to worry about being sued they don't have to worry about collecting money they don't have to worry about overhead um people that run a business assume all those risks which is why their business owners and not employees you know so their return is $200,000 a piece for you know for the year fair enough okay however however uh they're being taxed as if they're earning $500,000 a piece that's the million dollars in profits and that puts them in a whole different definition according to um what again the president would like to tax because there's this definition of the wealthy and the wealthy um by his definition is people earning more than $400,000 a year individually and if you earn that amount if some of his legislative proposals had gone through which they haven't but if they might if he gets reelected and has a democratic Congress then those people would be taxed at a higher even a higher tax rate plus they would have other dedu CS limited that they could take for example the qualified business you know income deduction in other words a deduction for uh pass through businesses um so they're being you and and plus they're also being called wealthy and my case is in in this piece is that these people are not wealthy I mean they're doing good although they're taking risks but you know what the president defines as wealthy somebody making over $400,000 a year is it really you know Apples to Apples with what a business owner is really making because though they might be showing preer profits of a certain amount the cash they're taking home is a lot less than that and that's the point of the that's the point of the column well I I would say this there there are very few people out there I don't know of any uh writing about small business who understand this stuff the way you do as a business owner yourself as an accountant yourself uh um and and I think it's a a really important story to understand the way this really works and I as I said before tell me if I'm wrong about this I I think a lot of business owners themselves get tripped up on this and well you you were saying it before they're they're asking where's the money uh they don't understand uh necessarily how this happens without it being explained to them by a professional uh like you my clients get I mean I get these questions all the time like like I said like I you know I don't get this G you're showing me my tax I made a million dollar show me the million dollars I don't have a million dollars you know what I mean so y I get that um I get that a lot having to explain that the other thing that a lot of business owners don't understand because most of them run these pass through companies es Corps and Partnerships so they might distribute themselves like these guys distributed to themselves a couple hundred thousand doll a year um you know they're like well that's all that we made because that's all I took out of the business and you're like no no no that's what you took out of the business but that's not how the government is calculating your profits you know and there's a big difference and by the way there's we're just talking about federal taxes man I mean you know cities have their own net profits taxes and states have their income taxes as well most States but I I think In fairness we should acknowledge that I mean most of this is going to work out okay in the long run I mean the inventory will probably get sold one hopes right and um you know you most of this stuff you you get caught up on and and the fact is that you you know you're right business owners certainly do take risks that employees don't take but they also get equity and the the clients you're describing here own a business that has probably significant value correct yeah they do um and that is really where the profits are all tied up is in the value of their business so it is you know they are they're buying inventory they're selling inventory they're investing in that Capital Equipment for example that's adding to their balance sheet that that increases the Goodwill and fair market value of the business and you're right at some point if an owner cashes it out say they sell all their assets pay off their liabilities whatever's left over is their Equity you know and hopefully that's that's their payoff man that's their retirement that they can go off to in the future you know but that's that's not like reality for most business owners I mean unless they're much older well it's a different it's a reality I mean it is there it does exist but it it it's on paper until you make the sale or borrow against it yeah it's it's on paper I mean it it only becomes reality if you decide to sell your business and cash out and that's you know businesses are a livelihood for people so they're not going to people don't they're whenever I say like oh well if you want to just pay off all everything and walk away you can just sell all your assets and pay off your liabilities and they're like well I'm only 45 years old I'm not doing that you know I'm doing this for another 20 years you know what I mean so um so that's not reality either it's also true that business owners do get other tax breaks right I mean there are things that a business owner can can deduct as part of the business that you know an employee uh wouldn't be able to um so it's it's not all I you know that's funny that you that you say that as well AR because I I love when companies come to me saying like you know oh it's a you know it's fine for me to spend the money because you know it's a tax deduction but you're still spending the money you know so you know businesses at least legitimate business business get tax deductions for business related expenses so they wouldn't necessarily be expenses they would be spending on themselves you know so like yeah they get a deduction uh for the business use of their automobile because they're using it for their business but not for their entire use of their automobile you know they don't get deductions for their house they don't get deductions for their food they don't get deductions you know for their vacations got it um some owners like to bend the rules and be like hey well we're going a conference so we'll call this a vacation okay certain expenses related to the conference you might deduct but the rest of it you know what I'm saying you got to spend the money I hear you let let me ask you this yeah I I view this as a a misunderstood kind of cash crunch it's I I think the business owners you describe are going to be okay but the it's more complicated than the average person would realize and that many business owners would realize what what would solve this problem I guess I ask this in two ways one what can a business owner do right now to try to uh prepare for this and make sure that they don't get caught and are there policy changes that would make sense that would make this um you know easier and you know more fair for business owners well let me let me answer the policy changes later um because that's it's like more political than anything else I mean I I could tell you one thing um if you're running a business whether you're a democrat or a republican um you've got to deal with taxes legislation and regulations you know and you always have to be thinking ahead about what's going to be impacting your business always thinking ahead so if you read my article one of the line items in this profit to cash reconciliation is 2022 estimated taxes paid so these guys paid their taxes you know during the year they're they're good about doing that they hate it but they do it and that you know because of that and then not only that but we're constantly looking at the year to make sure that we're on track sometimes people pay in too much taxes because the year isn't as good as they thought sometimes they pay in a little too they pay in less than they should because they're doing better so it's really important to pay in those estimated taxes and then to work with your account or financial person to make sure that those estimates are on track with what reality is going to be and if you do that then you don't get you don't get caught short the people that really get screwed are the ones that like they don't they ignore these estimated taxes throughout the year because they're just estimates and it's not like anybody's like you know the government's not breathing down their neck for it so they don't pay it and then at the end of the year they don't have the cash to pay their taxes you know let alone potentially being exposed to fines and penalties so the key to you know managing your way through this regardless of regulatory legislative who sits in the white house or in Congress is to PL always be planning ahead with your financial people and always be putting in your estimated taxes so that you know you're not taken by surprise because my best clients minimize their surprises you know that's that's my my best advice to any you know to any business and by the way this is not me this is just I've learned this from my smartest clients you know that's they're always just planning ahead so they don't get caught with their pants down you know um as far as legislative and Regulatory stuff you know you ask what what kind of policies could help you just want lower taxes yeah you got it and that's like a whole other obviously a whole other debate I I will say you you say in the piece that you're terrified uh that the Biden Administration wants to tax them even more than they're being taxed now there there's not a lot of likelihood that's going to happen anytime soon is there well he's I mean he's campaigned on more taxes for the wealthy um and by the way that's not are those proposals going through Congress Jean no they're they're not hitting it right now but but come on Lauren I mean we're like what 18 months away from another general election I mean you know well there'll be a lot that happens before then yeah but I mean again like I just said my best clients are always looking ahead it's just it's not it's not an imminent concern no I mean it but it I mean I don't know I mean two years is kind of imminent to me I mean it could happen you know and and you have to prepare for it and you know and I think it's important that that business owners know and by the way I I also want to also be clear the president wants to increase these taxes tax the wealthy quote unquote all that kind of stuff because he's got spending programs that he you know very much believes in you know climate change and infrastructure and all sorts of things um you know dependent care if you if you are also a supporter of that and you you know you know and and the president's programs then fair enough if he's going to increase your taxes to do that it's completely fine um but you should just know this these are your options that you have as we get into 2024's election year and I know you and I are going to be you know talking about the elections a lot over the next year um but these are things you have to make choices with you know fair enough well as I said I think you do a real service there aren't enough people who write about business who really understand the way it works hopefully this shines a light for for both business owners and non-b business owners uh so thank you for writing this piece and for taking the time today thank you for talking about it right I mean it's it's it could be pretty dry and boring and yet it is I don't know I where is the money is not dry and boring to anybody who's looking for the money yeah it's exactly right and I think just I it is and again it's your right you would think by now people would get it but um they don't and and the reason why is because a lot of business people you know their their minds are occupied with other things you know creative and Innovative and and also it's complicated I mean someday we'll talk about how pass through structures actually work and uh and explain that maybe yeah we can dig into that that sounds fine but yeah it is it is complicated but it's huge it's very important so takeaway is plan ahead and pay in your estimated taxes thank you Jean Marks is a CPA who writes weekly on small business for the guardian the hill the Philadelphia inquire the Washington Times the Chicago Daily Herald Forbes and entrepreneur you can also hear him on ABC radio's eye on the world with John Bachelor Jean hosts two small business podcasts with paychecks Corporation and the Hartford this episode was brought to you by the great game of business which helps businesses use an open book management system to help build healthier companies you can learn more at Great game.com thank you Jean thank you Lauren we will see you again next week have a great week everyone [Music]