Why do I have to pay tax when I made a cash loss?
How can there be a profit if the year’s ended with no cash? It’s quite common for businesses to end the year with little or no cash, only to be told by their accountant that they made a profit and must now pay tax. The reason for this is that tax is decided on the net profit the business has made, not what it has left over.
When cash doesn’t equal profit
If your balance sheet is showing a cash loss, but you’re required to pay tax because you’re technically showing a profit, it’s time to review that balance sheet. What you’re looking for are areas where assets and stock and drawings get added in.
For example, if you have a net profit of $100,000 but no cash, see if you can find $100,000 worth of extra stock, equipment or drawings. The chances are pretty good you’ll find most of it in there.
It’s also a good idea to review the assets you’ve purchased over the year. The catch here, of course, is that you can’t deduct the whole amount of the asset, only the depreciated amount.
For example, if you had $100,000 on the last day of the financial year, and you spent it all on new equipment, then you have no cash. But if the depreciation rate was 10%, then only $10,000 of the $100,000 goes as an expense. So your net profit is $90,000, but you’ve got $0 in the bank. And what the Inland Revenue Service (IRS) is looking to tax you on is your net profit.
When you’re reviewing your business to find out where cash doesn’t equal profit, there are a couple of other important factors to keep in mind:
- Stock you’ve bought during the year – the same rule applies as above, if you were to buy $100,000 at the end of the year. The next day you’d still have it, which means your stock level has gone up, but you can’t claim any of it as any expense.
- You’ve spent too much – this is the one that many business owners stick their head in the sand about. If your business is showing a cash loss, stop playing ostrich and take a long hard look at what you’ve spent yourself – money that’s not recorded as wages or salary.
What you can do about it
It’s not uncommon for businesses to show a cash loss, especially those that are still finding their feet. But when it comes to the tax you have to pay, consider how you’re spending your business’s cash before you actually fork it out.
For example, instead of spending that $100,000 on new equipment on the last day of the financial year, consider an alternative time to buy, so that your cash balance has time to catch up with what your profit statement is reading.
If you’re spending too much, look at ways you can rectify this, by reducing expenses and increasing your sales.
It’s also important to get advice. Speak to your accountant or engage a tax agent who can suggest ways of restructuring your spending.
What it all boils down to is the profit you’ve made in your business doesn’t equal how much cash you have. Unfortunately, that’s not what interests the IRS or your accountant. So it’s important to review your business finances and look for ways to restructure your spending so you’re the cash you have on hand in more in line with your profits.