Don’t Have Enough Money to Pay Your Taxes? Blame These Two Words
(This post originally appeared on Inc.)
You’re a smart person. You run a profitable business. You know how to make deals. You’ve navigated your company through good times and bad. You’ve been doing this for a while. But there’s something that still perplexes you. A basic accounting concept that you’re still trying to understand. It has to do with two words. And every year around this time, when you owe taxes, those two words come back to haunt you.
Your business has an accountant. He may file a C-Corporation return. Or a partnership return. Or an S-Corporation return which is the most common tax return filed for small companies. On a partnership or S-Corporation return the income from your business flows through to your personal returns. You might have filed this return already or maybe it was extended. But no matter. Tomorrow is April 15th which means your personal income tax returns are due, along with any payments for 2014. So you’ll have to pay that. And I’m betting you’ll have an estimated payment due for 2015 too. Which means that, if you haven’t already, you’ve got to scrape up some cash. You go through this exercise every year. Every year, without fail, you’ve got the same question.
And it goes something like this: “How is it that my tax return shows I made all this money (and owe taxes) and yet I still don’t have any cash?”
I’ve been a CPA for 25 years and I’m used to this question. I get it a lot. From smart business people. And yet as smart as they are they’re a little confused. Their tax returns show profits. The IRS is owed money. But the money isn’t just sitting there. There’s yelling and juggling and a lot of carrying on. Usually you come up with the money. Some of my clients don’t (and that’s a problem because you always, always pay in what’s due when it’s due, even if you extend your returns).
So where’s the money? The answer lies in two words: accrual accounting.
Every day you deal with complex problems. You handle arguments between employees. You negotiate supply arrangements. You work out contracts with customers and partners. All of this is second nature to you. But this accrual accounting thing? It doesn’t make sense to you. I get it.
Business owners deal in the black and white. Dollars and cents. Profits and losses. You buy low and you sell high. You mark up an item to cover your overhead. You make sure everyone’s billable. To you, it’s all about cash. A sale isn’t a sale until the cash is in the bank. Your satisfaction is not completely earned until you’ve made your payment. That makes sense to you. But unfortunately, not to the IRS. You don’t like paying taxes, but you accept it. You expect to pay taxes on the cash you’ve earned. But, like many companies, you’re not on the cash basis of accounting. You’re on the accrual basis.
According to the Journal of Accountancy “companies selling merchandise generally must use the accrual method to account for purchases and sales. C corporations (other than farms) must use the accrual method if their average annual gross receipts for the previous three years were more than $5 million. Tax shelters and general partnerships that have c corporations as partners and fail the $5 million test also must use the accrual method.” For the most part, particularly if you’re a growing company selling products, you’ll find yourselves on the accrual basis of accounting. Most accountants prefer it. For financial reporting purposes it’s the generally accepted way of accounting.
Accrual means this: you recognize both revenues and expenses when the transaction occurs, NOT when the cash is received. So when you ship your products the profit is recognized and your taxes are due, even if you’re not getting paid until 90 days later. Even if that receivable has been on your books for six months…unless you actually write it off (and we hate writing off bad debts). Take a look at your balance sheet. Have a lot of receivables at the end of the year? Are they growing even now? Assuming your payables are not growing as much then that’s a good thing because it shows that you’ve been shipping product and making money. But that’s not a good thing because, under the accrual method, you owe the IRS. I know it’s still a receivable. But you still owe the IRS. Whether the money is there or not.
And the money isn’t there. You’ve been buying more materials to satisfy the orders that are coming in. You’ve been reinvesting in your business. You bought some equipment. You hired a few more people. You purchased more inventory to accommodate your growing sales. So even though you didn’t put any more money in your own pocket you still spent it to fund your growth. All of this means that your cash has been spent. But the IRS doesn’t care about your cash. They only care about two words: accrual accounting. Under accrual accounting, you made money last year. So pay up. Now.