6 minute read
PAYING MORE IN TAXES
By Jason Watson, CPA - WCG, Inc.
Yeah, you’re reading that right.
Previous articles here expressed ways to save on taxes, but they also had an undertone of building wealth. Building wealth is your mission – not saving taxes. If we can do both, wonderful! This article will take building wealth one step further and broach a topic not often discussed – paying more in taxes. Why?
There are a small handful of reasons, but let’s start with borrowing. When a lender looks to give you a pile of money based on your good looks and charm, in the back office they are actually doing two things: they are ensuring you can service the debt. (Do you have enough cash flow to make the payments?) And they are looking for collateral to secure the debt in case your good looks weather away. Charm only takes you so far – you need collateral.
As an aside, understand that lenders are in a continuous conundrum. They need to pay their investors and pay their bills, and on top of that they need to add a riskadjusted premium to the interest rate. This can be a self-fulfilling prophecy since if the risk-adjusted premium is too high (ie, risky borrower), the lender might put too much debt service pressure on the loan and unintentionally push it into default.
Ok, back to the two-pronged approach – cash flow and collateral.
This might come as a surprise, but most people want to pay the least amount of taxes; to that end most people want to maximize their tax deductions. However, when a lender looks at your tax return, they might envision the guy from Monopoly with the empty pockets.
There can be a balance here, right? On one hand, you want to pay the least amount of taxes and, on the other hand, you want that big fat loan (and at a respectable rate). It might seem counterintuitive in taxes, but you’ve heard the saying, “you have to spend money to make money.” Taxes might be one of those money expenses. How?
There are certain tax deductions that you can elect to avoid, and therefore not list on your tax returns. A great example is your company’s discretionary 401k contribution. In a solo 401k situation, a business owner might want to have their company put 25% of their officer compensation into the 401k plan. Perhaps hold off a year or two during “borrowing times.”
Another good example is reimbursements from your company for home office, cell phone, internet, and mileage. You are not required to reimburse yourself for the business use of your personal assets (home, phone, car, etc.).
As a lender reviews your company’s financials, they are determining discretionary cash flow. How much cash does this company throw off after paying its operational expenses and other commitments? For lack of better information, any expense that becomes a deduction listed on a tax return must be ordinary and necessary for the company to operate.
So, as you attempt to stuff a bunch of expenses into your company to lower your tax bill (yes, that happens from time to time), please understand the downstream effects on your borrowing capacity.
Let’s talk about that big fancy truck that you want your company to buy and then depreciate.
Depreciation is a funny thing. Depreciation is built to offer you some tax relief for mortgaged purchases of real estate, machinery, equipment, etc. For example, you spend $100,000 on equipment that lasts seven years and the bank gives you a loan for seven years – match made in heaven. However, those loan payments are not tax deductible, so to help with the “expense of purchase,” depreciation comes in with a tax deduction. This makes sense, since most machinery and equipment goes down in value. But what about rental residential real estate? Typically, these purchases increase in value, yet you are allowed to depreciate the building over 27.5 years which is similar to most loan terms of 30 years. Even if you pay cash for real estate or equipment, there is still a cost of your equity that you are wanting to recoup. Ergo depreciation.
Another aside – Canada tax law allows you to opt out of depreciation on real estate. In the U.S., however, allowed depreciation is assumed depreciation. If you don’t depreciate your rental, the IRS will assume you did when you go to sell, which can be very bad (but there are depreciation catch-up solutions).
Back to depreciation and cash flow:
A lender is going to typically add depreciation expense back to your tax return, plus other little odds and ends to arrive at your global cash flow since depreciation expense is not a cash expense. However, if your depreciation is associated with a purchase made with borrowed funds, those loan payments count against your cash flow. Please don’t be confused. Making certain choices – about 401k contributions, or reimbursements, or deferring certain expenditures into the future – is not the same as manipulating your financial documents to not show actual expenses. If the company needs to survive by spending money on certain things, those expenses/tax deductions must be expressed on your tax return. (While orange might look good from time to time, it is not a good look on a daily basis.)
One of the other good reasons to perhaps pay more in taxes is selling your company. We have seen a lot of small business sales lately: some good, some bad. Similar to a lender, a buyer wants to know how much cash flow your company produces since most small businesses are selling their future cash flow (and perhaps some assets here and there). But here’s the rub – if you want to sell your company today, you should have started thinking about it five years ago and tightened up your decisions and financial documents.
There you go. This article was certainly a departure from the norm, but then again it’s mid-March. And the tax man cometh!
Jason Watson, CPA & Senir Partner at WCG, Inc.
Jason Watson, CPA, is a Senior Partner for WCG, Inc. a progressive boutique tax and accounting firm located in northern Colorado Springs. You may contact him at 719-428-3261 or jason@wcginc.com.
