By: Matthew Andersen, CPA
Welcome to part two of our Tax Strategy series! In our last post we laid out the general framework that we follow to make a significant impact in income tax reduction. This post will explore financial factors that entrepreneurs face when trying to reduce taxes without strategy.
We find that there is a balance entrepreneurs have to strike between paying taxes and showcasing the success of their business. Financial statements and tax returns can be used for anything from lending to business sales. Without strategizing your taxes, you can quickly get stuck in the following situations:
- Trying to get a loan after being aggressive in reducing taxes the year before
- Selling your business based on a multiple of cash flow but according to your books you have no cash flow
- Looking for an investor but your financials don’t look appealing
We have found that with proper planning an equilibrium can be found. This makes your goal to show lenders and investors positive trends while using the tax code to reduce your tax burden.
Here are our top three strategies:
Keep Two Sets of Books
You can legally keep two different sets of books! One set is used by management to run the company and show to lenders and investors. Traditionally, these are accrual basis or GAAP basis financial statements. In this set of books all effort is made to show the truest picture of the success of the company. The second set of books is then used to show the IRS. With these books you should strive to accelerate your expenses, write off everything under the sun, and reduce income. As long as it is permitted, we generally recommend using the cash basis of accounting to report to the IRS. As noted in the first sentence, the only legal way to have two sets of books is to have ones that differ in the accounting methods as stated above. There are guidelines to follow to ensure that you are following generally accepted accounting methods and those methods must be adhered to precisely. We only recommend that you use the rules in your favor, NOT that you fraudulently keep two sets of books.
Only Deduct Business Expenses
We have seen everything imaginable attempted to be justified as a business expense. The tax code is relatively clear on what is deductible vs. what is not. Being overly aggressive and deducting personal expenses is a huge red flag for an IRS audit. Further, it is not explainable and reflects poorly if you are selling your company, looking for investors, or asking a bank to give you financing.
Spend time building a relationship with your banker and CPA. Meet with them regularly, discuss your plans, ask for input, and get ahead of things before they can become a problem. For example, if you are planning a big expansion next year, know you will lose money, and require financing to move forward, the time to have that conversation is today. Do yourself a favor and think ahead by designing a plan, creating your narrative, and getting guidance on the right way to move forward.
Finding a tax strategy that works for you does not have to be difficult, but it requires attention and planning to keep the balance between reducing taxes and drawing an accurate picture of your company’s success. We have one final installment of our series this month in which we will explore how to reduce your tax burden while following the steps and tips we have thus laid out for you. Come back later this month to read part three of our Tax Strategy series!