Business owners who feel tight on cash are usually surprised when their income statements show substantial profit. If the business is profitable, where is the cash? The short answer is that the cash is somewhere in the business such as in inventories, in accounts receivable or in fixed assets; or it was distributed to the owners.
The longer answer is that the income statement follows tax or accounting rules and profit/loss usually does not reflect the cash flows of the business. Unfortunately, business owners are taxed on the profit in their business, and not on the true cash flows.
This post will explain three very common scenarios where business owners have profit but a low cash balance.
In the following examples, assume the business owner has $0 cash at the beginning of each example and that the business is not a C corporation.
Example: John is a builder. He sells a house at a $20,000 profit and uses the $20,000 to buy more land. John again has no cash. He has $20,000 in a land asset. John doesn’t think he has profit because he has no cash. Unfortunately, the $20,000 invested in land is not deductible until the land is sold and John must pay tax on the $20,000 profit from the sale of the house. John is in a bad position because he now has no cash to pay taxes. Business owners who have profit have to make sure they set aside funds to pay taxes before using the profit to purchase more inventory or fixed assets such as equipment.
Example 2: Joan is a successful architect. She has $150,000 profit in her architectural firm. She has $150,000 in the bank account. She then takes a distribution of $80,000 from the business. Joan is surprised that she has $150,000 in profit when she only has $70,000 in the bank. The reason is that the distribution is not a tax deduction to the company. Joan will have to pay tax on the $150,000 profit. The money for the distribution either came from current or prior years’ profit (that was taxed in the current or prior year), a tax-free return of amounts invested in the company, a capital gain to the extent the distribution exceeds accumulated profit and amounts invested.
Example 3: Tim has a small manufacturing business. He has profit of $80,000 and uses all of the profit to pay down debt. While Tim has no cash at the end of the year, he will have to pay tax on his $80,000 profit even though he has no cash because debt paydowns are not deductible. Business owners are surprised that paying down debt is not deductible because it is a cash outflow. When a loan is taken out, the loan proceeds are not taxable to the borrower because they have to be paid back. When the business owners uses the loan proceeds for business expenses, the business expenses paid with borrowed funds will be deductible. Later, when the debt is paid down, the business owner does not get a second deduction.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.