One thing I learned starting a business is the government games all the numbers to make a business look like it’s making as much money as possible. That way the government can collect taxes at the highest rate as soon as possilbe. While I have no experience with large corporations that can lobby the government for tax breaks — and there’s a lot to solve in the tax break area — I do understand the smaller business model that makes up the majority of America’s job creation. What if I were to tell you a first year company that made a million dollars could go broke? It’s very true. Let me show you some numbers.
Assume we’re looking at an S-Corp. These are corporations, whose income flows to the individual shareholders to pay taxes at their personal rates. So, let’s say 35% federal and 5% state for a 40% tax rate. Say the company has revenue of $10 million and makes one million. A 10% profit margin sounds great right? Here’s the issue. The taxes will almost put them out of business (you can check-out the conceptual math at the bottom of this blog).The tax bill due April 1 on that million is $400,000 at 40%. Also due on that date is an estimated tax bill for Q1 of the next year equal to 110% of the previous year’s taxes equaling $110,000 ($400,000 x 1.1 =$440,000/4 (quarterly.) So a total of $510,000 will go out in taxes.
Let’s also assume that, like most businesses, a lot of cash has gone out the door that can’t be expensed right away, if at all. There are a lot of examples: entertaining clients and meals are only 50% deductible. That means if you spend $100 on a client dinner, only $50 of it can be taken off taxes, so you pay another $20 in taxes over and above the $100. You have to entertain those prospects or clients if competitors do, so there’s no choice. I saw Obama and Boehner had their golf summit on the taxpayers’ dime. They understand the value of networking too. Also, some normal expenses for the owners are not deductible, like health insurance for employees. Say that these non-deductible expenses amount to 1% of costs — very conservative.
Assets purchased are not viewed as expenses right away. They get “depreciated” as an expense over time. So, as the company buys computers, servers, machines, furniture, vehicles, inventory, etc., cash goes out the door, but deductions like depreciation must be taken over many years time. Say that’s 5% of the total revenue out the door in cash, but not counted as costs on taxes.
Revenue billed does not always match cash in the door. Customers don’t always pay, or pay on time. This applies to most business to business (B2B) companies, and non-cash businesses. Even timely payments can be 30 days after a bill is sent. Say with past dues, it averages 45 days. That is a lot of cash a company is “loaning” their clients.
As we stated, the S-Corp income shows on the shareholders taxes; if there are four equal owners, they each show $250k in income. Even though the income is declared by the owner on their taxes, businesses need to leave cash in the business to pay bills, make payroll, look safe to the bank and clients, etc. – so let’s say four weeks of cash needed to run the business must be left in the bank for the company to operate safely.
In this situation, in year one, the cash out the door for the company would be more than $1.5 million above the cash in the door. The “rich” owners have burned their safety net of cash, they’re scrambling for a line of credit to defer accounts payable, not pay other businesses on-time. This is not an unusual situation for a business in its first few years.
I was shocked how bad it was in the first few years when we started the business. We were struggling to survive cash flow wise, we were not taking salaries, and when we did, they were small ones, and supposedly, according to my taxes, we were making good money. During the first seven years in business, we paid out more than four times in taxes than the founders actually got to keep. I stopped looking after seven years – it was too depressing.
Look at an entrepreneur who is paying herself a $50,000 a year salary (it was a lot less for me the first few years). Say the company makes $300,000 in taxable profit. The entrepreneur needs to leave all the profit in the busiess due to cash needs described above. She now has a taxable income of $350,000. She is a part of the “rich”, not paying their “fair share” we hear about. Her tax bill is $140,000 for the year. The entreprenuer gets to keep the non-tax portion of her salary, or $30,000. So the government receives $4.67 for ever $1.00 she get to keep for starting the business, risking her career and capital, and working full time.
Especially for a growing company, it takes a long time for accounts receivable payments, depreciation discounts off of taxes, cash reserves for the business, etc. to build-up to a sustainable level. All I know is that we may not have made it in those first few years had there been even a slight tax increase.
Warren Buffett, an Obama supporter, recently said the tax rate was not high enough on the super rich. That is the basis for the “Buffett Rule” tax increases being proposed today. Buffett was brilliant at minimizing his taxes by taking almost 100% of his take home pay as capital gains (the 15% capital gains tax rate is much lower than the income tax rate). Three major issues stand-out to me.
1. Basing a tax system on a once in a lifetime business person’s success might not represent the norm for other people. He has achieved the richest man in the world status on a few occasions, and is currently the third most affluent. Not many people, even successful ones, can compete with his results, even at tax avoidance.
2. Buffett offers this after his wealth has been made beyond what is possible to be spent in his remaining years. The US tax system taxes earnings, not wealth. It taxes those trying to become the next Buffett, not Buffett himself. He can donate or pay whatever he would like in taxes. He has that right, so he could solve the “inequity” at any time.
3. The reason capital gains tax is lower than income tax is that the earnings were already taxed at the corporate level (it is a double tax). In effect, the income is taxed at a higher rate overall, but not as shown on his personal taxes. In addition, Buffett’s company, Berkshire Hathaway (where most of the taxes are actually paid) admittedly knows that they owe taxes back to 2002. Instead of paying up (an estimated 1 billion dollars), Berkshire Hathaway is threatening the IRS with protracted litigation and is in the process of cutting a deal with the IRS Appeals office. It’s kind of hard to take him seriously on this subject given the disconnect between his actions vs. his words.
So, keep this in mind when you hear about increased taxes, even on the rich. S-Corp small businesses are the majority of the “rich.” They do not actually have that cash … it’s all sitting as assets in the business, trying to grow and survive. I’m sure there are some people making a fortune who do not struggle or some of us feel may not feel earned it. So what? Basing fiscal policy on anecdotal stories of people, who we feel are fiscally luckier than us, is a formula for failure. We need to encourage our economic engine to bolster the small businesses that create jobs. Remember, this is America – the Land of Opportunity, not the Land of Entitlement.
Company X’s Tax Burden to Nowhere
Revenue: $ 10,000,000
Cost of Goods Sold: $ 5,000,000
Salaries: $ 2,500,000
Other Expenses: $ 1,500,000
Profit: $ 1,000,000
Taxes: $ 400,000
Assumed Cashflow: $ 600,000
Assets Purchased (un-depreciated): $ 500,000
Non-Deductible Expenses (meals/ent/etc.): $ 100,000
Cash Left in Business: $ 692,308
Accounts Receivable: $ 1,250,000
Accounts Payable: $ (500,000)
Net Cashflow: $ (1,442,308)
Q1 Estimated (110% of prior year): $ 110,000
Total Net Cashflow: $ (1,552,308)
