Preface: If you’ve never respected analytics on tax decision before, you’d be advised to begin today. 2008 is long-forgotten for the majority. Analytical financial management in your tax planning for all entrepreneurs is well-advised for a business, as this blog exemplifies, for successful continuous financial performance.
Tax Planning with Analytics
Credit: Donald J. Sauder, CPA
Tax planning as an ultimate objective should be a balanced approach of analytical and financial management towards tax expense minimization. If you’ve been an entrepreneur for years, or are new to business, you may already have workable ideas to minimize federal and state taxes and keep more for yourself.
In this blog, we’d like to consider a financial management concept that too many entrepreneurs omit, or have never considered when managing their tax planning – debt management. As your business develops this concept is vital. Sole proprietorships are likely not the subject of this blog, but more so businesses with 5 to 35+ employees.
Maybe your advised to borrow on your line of credit, or call your friendly banker for a term loan on that new truck, machine or other high tech equipment to reduce this years taxes. Here’s a conversational excerpt.
“Hey Joe, if I purchase that new gadget for $75,000 what will it save me in taxes” entrepreneur Ulrich inquiries? “Well, you’re in a 30% tax bracket and therefore you will save $22,500 in taxes”, accountant Joe responds. “Given that the business tied up all working capital increases during the year in expansion of employee overhead and a few new vehicles” Joes says, “we’ll need to finance most of the $75,000 to keep our liquidity levels in the green”. “No problem” Ulrich responds, “I’m sure banker Jerry will give us the credit”. “I’ve can put that $22,500 to better use than the IRS”.
What questions arise from the above conversation? First, the question was simply about tax savings. There was a mention of working capital balances, but there was no consideration of analytics, i.e. say debt to equity levels, or cash flow EBIT. This is an important fact. The implementation of the above tax strategy to a highly-leveraged business only increases balance sheet risk, in that the additional equipment requires additional sales, and additional overhead of employee costs, workers comp, etc., for implementation of the new or additional gadget. This increases cash flow leverage to finance the said term loan, typically for five or seven years. A resulting circular equation of debt financed tax planning.
One mistake I’ve seen too often, is that entrepreneurs become very animated about tax costs, and leverage the balance sheet to reduce the tax expenses in the current year or cumulative years, when they should apply logical analytics for successful financial management balanced with tax costs. This myopic approach to tax expense reduction is risk fraught, because it only defers the tax expense. Here’s how the tax deferral works.
How will Ulrich pay the $75,000 loan? He will need to earn $75,000 of net income in future years, at a multiple of 1.3 for the tax effect plus interest expenses. This multiplier is likely 1.4+ depending on financing terms. Plainly said Ulrich will to earn $97,500, before interest expense to pay for the gadget in future years. All principal payments to the bank are likely from future year taxable net income. Therefore, if cash flows tighten, on a leveraged balance sheet, this myopic tax planning approach of prior year cumulative tax deferral could lead to an entrepreneur being overleveraged in the future, i.e. too much debt, on assets, e.g. equipment, that have cash flow production risks. In addition, the planned increased income generated from the gadget will result in increased future years tax expenses too, as stated before.
There is no guarantee of customer purchasing power for your business tomorrow. Three years of marginal debt financed tax planning can lead to an overleverage business, i.e. 25% of equity to assets. If the marketplace turns, the business balance sheet will not sustain operations financing, and very quickly the banker will be calling about the monthly term loan payments, and you will be calling your accountant who hopefully didn’t advise the loan.
Therefore, when tax planning, you’re now advised to look analytically at your balance sheet alongside your tax savings. The balance sheet strength, i.e. equity, can only increase with net tax income or capital contributions. Contributing capital for sustained operations on a continuous basis is not the picture of successful business. Now, debt financed tax planning may sometime be a prudent option for businesses, but advised only after considering the analytical metrics of your business.
If you’ve never respected analytics on tax decision before, you’d be advised to begin today. The 2008 economic malaise is long-forgotten for the majority. Be proactive and manage your business tax planning with a comprehensive analytical approach, and count the cost/benefit of paying taxes to build equity for an optimized business with strong financial pillars. Analytical financial management in your tax planning is well-advised for a successful business and for all entrepreneur’s.