From time to time, one of our Profit First or other clients asks about running up their expenses in order to reduce taxes. This is a really bad idea. Here is why running up expenses to pay less in taxes doesn’t work.
Money Management and a Healthy Business
Profit First is all about keeping track of your finances in order to optimize profits. Along the way a business owner improves the budgeting process and gets a better handle on cash flow. One of the items that becomes more obvious is just how much money is going to pay taxes. And, like any serious business owner, you would like to reduce that expense. You know that business expenses are deductible from your income. So, aren’t they a good way to reduce how much you pay in Federal, State, and Local taxes?
Be careful here. Intentionally running up expenses can cause both immediate and long-term damage to your business by raising havoc with your money management process.
Every tenth and twenty-fifth in Profit First, money is allocated to various accounts, including the operating account. The first effect of spending more than you have is that you are robbing one or more of your accounts and will not be able to correctly follow the Profit First method.Profit First is a very disciplined approach to running a business and one in which your multiple bank balances give you an immediate picture of your financial health. When you mess with the system you will mess with the results.The fact of the matter is that if you intentionally run up expenses you will immediately reduce your taxes but at the immediate expense of your business.And, over the long run, this is a sure-fire recipe for business failure! Let’s look at an example.
It’s All about the Arithmetic
Your taxable income after deducting for legitimate expenses is $100,000. Your business is in the Kansas City, Missouri area. Missouri state tax is 6% on all taxable income in excess of $9,000 and with taxable income of$100,000 you are in the 22% Federal tax bracket. Thus, the last $1,000 you made was taxed at 6% + 22% = 26%.
So, let’s say that you would like to reduce your taxes by $5,000. How much more in expenses do you need to incur and how much income do you need to lose to make this happen?
A is the amount of money you need to lose!
$5,000 = A x 0.26
Which is the same as
A = $5,000/0.26So:
A = $19,230.77
In other words, you need to come up with expenses of$19,230.77 in order to reduce your taxes by $5,000
So, why did you want to reduce your taxes? You wanted to pay less in taxes so that you would have more money! But, in order to pay $5,000 less in taxes, you need to reduce your taxable income by $19,230.77.
In other words, to save $5,000 you needed to spend $19,230.77. You did not come out ahead. You ended up losing $19,230.77 minus $5,000 = $14,230.77!
NOTE: This is a simple example and the numbers are made up, although the tax rates are current for 2018. The point is not the exact figure but the fact that you end up losing in trying to reduce taxes by adding expenses to your business!
If you need a more detailed explanation based on your own financial situation, contact us at Exigo Business Solutions.
Doing Your Taxes
There are all sorts of legitimate deductions that businesses can take in order to reduce their taxes. And, when you work with professional accountants like the folks at Exigo Business Solutions,you can devise business strategies in advance that will improve your tax picture year after year.
With the Profit First method, you will create bank accounts for taxes and allocate money to these accounts on the tenth and twenty-fifth of every month. So, you will find tax time relatively painless.
A Note of Caution
It not unheard of for a small business owner to go back into the office in the evening or on weekends to create false records of fake expenses. This will indeed reduce your taxes, providing that the IRS does not catch on. If they do, you will become intimately familiar with the process by which the IRS collects what you owe them!
But, let’s assume that you get by with this trick. As a small business owner, you are responsible for your own FICA contributions. The end result of not paying the taxes you owe is that you will also not be paying the portion that goes to fund your social security. Think long and hard before you go this route. Not only is it illegal but you had better not need your social security when you get old because you get paid based on what you paid in. And, when you don’t pay in over your working years, the direct deposit to your bank account may be very skimpy in your later years!
If you still have questions or are interested in implementing Profit First in your business schedule a meeting with a Certified Profit First Professional today!