I OWE taxes?!?! How can that be when I had a loss?
It is the midst of THE season. What season might that be? The dreaded tax season…
For those of you who have already optimized your finances, you can stop reading, as you will likely have minimal surprises when your tax return is complete. But those of you who haven’t should read on to figure out what might be causing you to owe money to the government, when you thought you had a LOSS for the year.
Cash vs. Accrual Basis
First, it’s important to know what your basis of accounting is. For a more detailed discussion on the basis of accounting, see the prior post “A Tale of Two Methods.” To briefly simplify, under the cash basis of accounting, you pay tax on income when you receive the money and you deduct the expense when it is paid or charged on a credit card. Under the accrual basis of accounting, you pay tax on income when you perform the service or complete the sale, and you deduct the expense when it’s incurred.
Many small businesses will be able to file under the cash basis of accounting, which is simpler. However, there may be impactful differences among the two methods. It is my experience that not understanding the methods or knowing what method you follow for tax purposes can create a major problem at tax time.
Without getting into too much accounting detail, the timing of when income and expenses are recognized can cause major differences between what is filed on a tax return, and what is kept in your internal accounting system. And, not only does this cause a difference in one year, but the opposite impact may occur the following year.
Small business scenario
The best way to understand this is to look at a simple example: John’s Janitorial Service performed a job for Rebecca on December 30. John booked the Accounts Receivable invoice on 12/30, as he needed to send the invoice to Rebecca so he could get paid. But Rebecca didn’t pay John until January 4.
On the accrual basis of accounting, John would pick that income up (and be taxed) on the current year tax return. However, if he is following the cash basis of accounting, he wouldn’t pick that income up (and be taxed) until the following year.
As you can see, the cash basis could cause a difference in the income shown on his books when compared to what is reported on his tax return for BOTH years. Depending on the change in Accounts Receivable and Accounts Payable, the fluctuations could be extreme and have a large impact.
Many times, businesses are looking at their accrual basis financial statements (which is how they run their business), without factoring in the cash basis financial statements (which is how they pay their taxes). This is the first issue that many have when getting hit with an unexpected tax bill.
Deduction limitations & other issues
The second issue is that there may be limitations on what can be deducted. For example, meals are only deductible at 50% for tax purposes. This means that half of the meal cost doesn’t provide a tax benefit. Starting in 2018, entertainment expenses are not deductible at all for tax purposes -- so no tax benefit for that golf membership or tickets to the Mizzou game. Political donations and some portions of dues also are not deductible at all. These expenses are examples of what accountants refer to as “book-tax differences,” meaning that there is a different treatment on the books (100% deductible) as opposed to on the tax return. There are numerous other items that may cause book-tax differences; these are just some of the more common ones.
Finally, errors in coding may also cause issues. Many times, financial statements have “adjustments” done due to incorrect entries that were made. A common example is coding the entire amount of the loan payment to interest expense. In reality, the principal repayment portion is not an expense, only the interest is. There may be other mistakes that are made that could cause major changes to the book financial statements.
One of the goals of Optimized CFO + Controller Services is to help business owners avoid surprises at tax time. By regularly looking at the financials, we can minimize any errors in coding. We can also project out estimated taxable income, factoring in some of these book-tax differences, and differences with the basis of accounting. If you’ve recently been shocked by an unexpected tax due, or unhappy with the amount of adjustments that are made each year on your tax return, I would love to talk.