7 Ways Tax Laws Hurt Your Business + 3 Solutions

Operating a business has its perks including the ability to claim tax deductions. The problem is some of the tax laws actually hurt your business if you do not consider how the law affects every aspect of your business.

 1. Tax law - Owner’s salary is not tax deductible. Owners are not paid through the payroll process.

The tax law applies to sole proprietors, partnerships and LLCs.

 Why this tax law hurts your business

• When financial reports are prepared on the tax basis, owner’s salary is not listed as an expense.
• When you do not see owner’s salary on your profit and loss statement, it’s often excluded when calculating your prices.
• When your prices do not include owner’s salary, you’ll always wonder ‘where did the money go’? The money was never in the business because you did not include the cost in your prices.
  • 3 ways businesses generate money
  • Cash flow starts with prices
  • Don’t generate the cash to pay yourself – waiting for leftovers
• Limits your ability to grow because your prices are not high enough to generate the cash to hire someone.
• This laws contributes to feeling like you are stuck on the hamster wheel.

2. Tax law - Income taxes are not tax deductible

 The tax law applies to sole proprietors, partnerships, LLCs, and S-corporations.

 Why this tax law hurts your business

• Similar to the owner’s salary
• Feels like a penalty for being successful, when it is a cost of doing business

3.  Tax law – Accelerated depreciation expense aka Section 179

The tax law allows businesses to buy an asset and claim up to 100% as a tax deduction in the first year.

Why this tax law hurts your business

• Claiming the Section 179 tax deduction is great in the first year, but it creates the feeling of riding a cashflow rollercoaster. Here’s an example:

With section 179 (year 1)

Taxable income $200,000

Section 179                $50,000

Net taxable income $150,000

Income tax  30%       $45,000

Year 2 through 5 without section 179

Taxable income $200,000

Section 179                0

Net taxable income  $200,000

Income tax  30%       $60,000

How can everything stay the same, but I owe $15,000 more in taxes? Here’s one of the ways…It’s common to assume the increase in income taxes is due to an error by the tax accountant.

The tax bomb was ticking since you claimed the section 179 deduction. 

When you claim 100% of a tax deduction in year 1, that leaves 0 tax deduction for years 2 through 5. Your taxes will naturally increase.

4.  Tax law – Income taxes are not paid by the business.

The tax law applies to sole proprietors, LLCs, partnerships and S-corporations. The business passes the taxable income through to the owner’s personal tax return. The business does not pay income taxes directly to the IRS or the state.

Why this tax law hurts your business

• It is hard to see how much income tax is related to the business vs your personal
  • The business’s taxable income is reported on the personal tax return along with all of the other tax information – spouse’s W-2 from their job, rental property, interest income, tax deduction for children, etc.
    • The business must distribute money to the owner so the owner can pay the income taxes from personal checking account to the IRS and state.
    • Paying income taxes from your personal checking account feels extra painful, so it’s tempting to get creative and look for ways to reduce the tax bill.
    • When you get creative with tax deductions, you end up draining the cash you could have invested in growing your business.

5.  Tax law – Sell now and pay income taxes later.

Why this tax law hurts your business

• The law is very different from when you were an employee. As an employee, income taxes are done for you. You know exactly how much you can spend when you see the amount deposited into your personal checking account. It’s likely that the amount withheld from every paycheck will cover the tax bill when you file your taxes. Employees are less likely to have surprises at tax time.
• Managing cashflow for tax purposes is a lot different for business owners. When you receive $1,000 from a customer, you are responsible for knowing know how much belongs to the tax authorities, vendors, suppliers, employees, insurance company, landlord, etc.
• As the business earns money, it’s owner’s responsibility to estimate and save enough money to pay income taxes on time. Not saving enough throughout the year often leads to surprises at tax time.

6.  Tax law – IRS requires every business to use a consistent accounting method.

The two most common accounting methods are

        Cash – when cash changes hands, you report the transaction.

        Accrual – when the financial commitment is made, you report the transaction. With the accrual method, you’ll see the amount of money your customers owe you by looking at the Accounts Receivable report. You’ll see how much money the company owes vendors by looking at the Accounts Payable report.

Why this tax law hurts your business

This law is good for tax purposes

It’s good that businesses get to choose between the cash or accrual method when filing their tax return. Usually, the cash method is best for tax purposes.

The problem is when you use the cash method for operating your business.

It’s best to use the accrual accounting method for your internal financial reports. The accrual method provides a more complete picture of true profitability and your financial commitments.

7.  Tax law – IRS requires you to choose any recordkeeping system that clearly shows your income and expenses.

Why this tax law hurts your business

• It’s great to have flexibility, but the guidance is vague.
• This leads to financial reports that only meet your tax reporting needs.
  • Once a year, your bookkeeper extracts enough information to summarize the transactions so the totals for each category can be reported on the tax return.
  • The information is only useful for tax purposes. Your accounting system does not include the details of each transaction. This makes it difficult to review profitability by department, service and customer.
  • When you question a number on a report, there’s not much information in the accounting software to help you identify a problem. The financial reports are useless when making decisions in your business
• When you select a recordkeeping system that supports your business
  • Your bookkeeper will update the system more frequently – at least weekly
  • So the details are entered in the system.
  • You’ll end up with useful financial reports

Solution

1. Owner’s salary, income taxes and assets are a cost of doing business. Include them on your financial reports and when you set your prices.
2. Plan to pay income taxes by saving a % of sales every month.
   • Divide your total income taxes by your total sales to determine the amount you need to save each month.
   • This is a simple way to create a system you can automate to reduce surprises at tax time.
3. Switch to operational financial reports that are useful to you.
   • Use the accrual method. It’s easy for your tax accountant to make a tax adjustment when they prepare the tax return.
   • Review Monthly financial reports instead of waiting until the end of the year
   • Invest in financial systems that track profitability by department, service, and customer

Bottom line

No wonder it feels like you’re riding a financial rollercoaster.

When you run your business based on tax laws, it’s easy to overlook key aspects of operating a truly profitable business.

Don’t let these tax laws hurt your ability to grow your business…make the switch to operational financial reports.