Why Your Business Owes Taxes When It Didn’t Generate Cash Profits

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Your business has several silent partners: Uncle Sam and his state and local cousins. Many of the decisions you make on a daily basis will impact their take, so it’s wise to be at least somewhat familiar with the tax laws when you run your own business.

One of the most important financial metrics for most businesses is “How much cash did we generate?” However, business owners sometimes do not realize how much taxable income (not cash income) their business generated during the year. Then, at the end of the year, they get a tax bill that they do not expect. This can wreak havoc with cash flow and business growth plans.

Here are a few of the situations that can cause this, and some ideas for how to deal with them.

Your business is required to pay taxes based on the accrual method of accounting, but you’re keeping your books on the cash method.

Under the accrual basis of accounting, you must record income when you make a sale, not when you get paid. In general, this applies to any business that sells goods from its own inventory such as retailers, wholesalers, distributors, and manufacturers. However, the amounts you pay out for inventory are not deducted from your net income until the inventory is sold. For many businesses, a lot of cash is tied up in inventory, so it’s not hard to see how you could have taxable profits but no cash!

It’s extremely important to handle your inventory and sales accounting correctly. Be sure to have your bookkeeper or accountant prepare your monthly financial reports using the accrual basis. It’s worth spending a little more money here on good financial reporting. 

From a business planning and management standpoint, this is where good inventory and credit management techniques come in. Learning how to manage your inventory levels so that you don’t have any more goods on hand than you need to run your business profitably and managing your receivables so that there isn’t a long lag between the time you make a sale and the time you get paid for it both make a significant difference in your cash flow and your profitability.

You paid off debt or bills from last year, during the year.

Debt repayments are not tax deductions! If you’re finally becoming profitable and paying off the loans and credit cards that helped you start your business, remember that you already deducted the expenses that those loans and credit cards paid for in a previous year. This means that your taxable income may be more than the net funds generated from the business during the year. From a business management perspective, ask your accountant to prepare a Statement of Cash Flows along with your monthly Balance Sheet and Income Statement. This will help you really understand what’s going on in your business because it reconciles your net income with your cash flow.

You’ve invested in equipment, vehicles, or other assets that are needed to run your business.

The Federal tax law allows for many of these purchases to be deducted immediately from your taxable income instead of being depreciated over time. This is often referred to as the “Section 179 deduction.” This is a great deal, but there’s a trap here. Many people do not realize that this is a tax deferral, not a tax savings. The tax savings reverses in future years because you won’t have the depreciation deduction in those years — you used it up when you bought the asset.

If you think your tax rate will be going up, you may be better off taking the depreciation deduction in future years, when it will save you more money. If you finance the purchase with debt, you need to be very careful. A typical scenario is that a business owner buys an asset, finances it, and then takes the Section 179 deduction, saving taxes in year one. However, in future years, they have debt repayments, which are non-deductible, and no depreciation expense to report. The result? Taxable income is higher than the cash generated from the business. This can result in cash flow problems if you haven’t planned for it. From a business planning and management standpoint, think of the tax savings from the Section 179 deduction as a loan from the government that you will have to pay back.

These are just a few examples of what can happen. Taxes can become complex very quickly when you have a growing business with multiple types of transactions. To avoid surprises, always have your tax professional do a tax projection for you well before it’s time to pay your taxes, so that you can make informed decisions when you’re running your business — you’ll be glad you did!