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Profit vs. Taxes

Sep 16, 2011

As we head into the last quarter of the year, many small business owners are looking to minimize their tax liability.  That's a good thing, right?

 

First of all, I (along with the good accountants that I know) recommend that you make decisions for sound business reasons, not just for tax reasons.  If it covers both bases, then great.  Buying something you really don’t need simply to show more expense and reduce taxable income is usually not a great idea.  By doing so, you typically reduce your cash reserves, and in today’s economy having some extra cash is a good thing since being able to borrow it in a pinch might be questionable.

 

Think about what we need profit for in the first place.  It’s used to do essentially three things – reinvest in the business, pay debt, or pay out to the owners, or some combination of the three.  Having no profit does mean you will pay no taxes, but it also means you have nothing to reinvest (purchase inventory, equipment, take advantage of discounts), repay debt (the bank wants their money regardless), or pay yourself or other investors.  So bottom line, profit is really a good thing to have.

 

Let’s think about it another way, using a simple math example.  If you have no taxable profit, you pay no tax but you also have zero dollars in your pocket.  If you make one dollar, you will pay tax on that at a rate of let’s say 35% (just an example), or $.35.  But, you still have $.65 left to put in your pocket.  Therefore, even if you pay taxes on that incremental dollar, you are still financially better off.  Of course this is an overly simplified example and the real world of tax regulation is always changing, but the principal still holds true.

 

I have known many businesses who believed in managing to reduce their tax liability which worked fine until they either wanted to borrow money or sell the business.  Then this practice comes back to bite them since they can’t demonstrate to a lender or potential buyer that the business can make enough money to repay the debt, or return a profit to the new owners.



Tags:
Category: Taxes

Bruce Morse


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