We all know that paying tax on your company’s income is one of the unavoidable requirements of running any business. If you’re earning money from your trade, then you must pay your fair share to the IRS each year.
But what’s less well known is the negative impact that tax can have on your business’s cash flow, and how the somewhat confusing nature of the US tax system can lull you into a false security when it comes to the size of the tax bill you can expect to pay.
Your estimated tax payment – and why it’s misleading
For most US businesses, you’ll pay your tax bill annually based on an ‘estimated tax payment’ figure provided to you by your CPA.
So, for 2016, your business’s estimated tax payment will be a function of your prior-year income.
The tax you’re required to pay is based on the income you brought in last year – but there’s a BIG problem with this approach.
The estimated tax payment approach doesn’t take into account that your business may grow and increase its income – it’s not truly an estimate of your current year’s tax. And that can cause some big problems when it comes to paying your bill.
What you’re paying is a ‘safe harbor’ amount to protect you from having to pay any penalties with the IRS. It’s not a true estimate of what your tax bill will be.
That’s a big, big misunderstanding that can exist between you and your accountant – and I can’t tell you how many times I’ve had conversations with our clients about this particular misconception.
The impact on your cash flow
So, now you know that there’s a problem surrounding your estimated tax payment figure (that isn’t really an estimate). But what impact can an inaccurate tax estimate have on your business’s finances?
The answer is a short one: not accounting for the full tax amount can have a serious effect on your cash flow. And there are two parts to taxes that you need to watch for, from this cash-flow standpoint.
- Putting aside cash for your tax bill
Any sensible business will put aside cash in a separate deposit account to cover the cost of its projected tax bill.
And when you know the size of your tax bill, that has a number of benefits:
- You can plan your tax strategy more effectively when you know the size of your tax liabilities before they’re due.
- You can set aside the right percentage of your income each month and gradually build up the full amount you’ll have to pay to the IRS.
- Because you spread these payments into your tax account across the year, there’s not one giant hit on your cash flow at year-end.
- Calculating a more accurate tax figure
Putting aside a percentage of your income is an extremely sensible strategy when it comes to tax. But it only works effectively if your tax numbers are accurate and true. And, as we’ve already seen, your estimated tax payment figure isn’t a true estimate of the tax you are likely to pay on your growing income.
So, how do you overcome this obstacle?
The answer is to calculate the correct tax you should be paying as a growing business. And that means accounting for the growth in your business that’s not included in the calculation based on your prior year’s income.
In short, it means calculating a more realistic tax number, based on where you believe the business will be in the future, not in the past.
So if your income last year was $100,000, and this year you’re on track to make $150,000, under the usual approach you won’t pay any tax on that additional $50,000 of income.
That sounds like a positive at first (less tax = more profit, after all). But what it actually means is that you won’t have set aside enough cash to cover the tax on that additional 50k.
So when the bill does finally arrive, there’s a big ol’ hole in your cash flow!
We’ll help you remove those nasty tax surprises
What, then, can you do to fill the hole in your cash flow and get your tax planning up to date and running efficiently?
To prevent any nasty shocks once your current year tax bill arrives, we can work with you to calculate a realistic tax figure, based on your estimated growth in income. And when we have this amended tax figure, we can let you know the right amount of your income to put aside each month to ensure you cover this larger tax cost.
That way, there are no surprises, you have the right amount of cash allocated and set aside and your cash flow doesn’t suddenly plummet into a negative situation when you settle your tax bill.
You can find out more about our tax efficiency services here and the ways in which our Awesome 8 approach to business advice will minimize your tax bill and maximize your profits.