Mental accounting in a picture
“I try not to be surprised. Surprise is the public face of a mind that has been closed.”
–Bernard Beckett
In my previous company, when we started out, we flew by the seats of our pants. Not so much flew as skidded across the runway, trying desperately to reach launch velocity or whatever it is that they call it which allows planes to take off before they crash into the trees or berm at the end of the runway. In the first couple of years, we called ourselves “involuntary non-profits” (not to anyone who might have actually wanted to spend money with us, mind you) because we were trying to be profitable, but we weren’t succeeding.
Then, suddenly, we got a big contract.
If you have read the comic strip Peanuts, you know what I’m talking about when I say that we did the Snoopy dance. We went from 3 guys and 3 computers to 11 people almost overnight. Pretty soon thereafter, we got a check for a sum of money that I couldn’t even fathom. I dutifully cashed it, paid our people, and went about planning.
Things went well for quite a while. We were finally able to pay ourselves a salary, and life was good.
Then, at the end of the year, I went to our accountant to have him prepare our taxes.
Gulp.
We were a limited liability company who chose partnership tax treatment. That meant that all of the profits and losses of the company flowed through to the personal income taxes of the three owners. For the first year, this was great because we had tax losses. Of course, we didn’t make any profits, which was another issue altogether, but from a tax perspective, it was great. In year two, though, we had profits.
This meant that each of us got a big, fat K-1 showing all sorts of income which we hadn’t actually seen go into our pockets.
We weren’t prepared. There wasn’t enough money in the corporate kitty to pay our taxes because we were very aggressive about paying our vendors as soon as we got bills. That was good from the perspective that our vendors loved to work with us, but it was bad from the perspective that our wives were mad about a very significant tax bill that we all had to eat until the company could pay us back.
It took us quite a while to pay ourselves back from that planning fiasco. It wasn’t like we didn’t know that there would be taxes, but we didn’t plan ahead. Monkey Brain was running our corporate books too. It was that same surprise that people feel when Christmas suddenly arrives and they didn’t budget to buy presents.
Yes, you have to budget for taxes when you’re a partnership.
