Tax Accounts for Your Business

folder

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.


Continues Below




It took us a while to get a system that worked, but we finally got there, and now, when filing season comes, we’re not left gasping for air at the bill, because we already have the money set aside to pay for it.

Here’s what I do.

First, at the end of each month, I set aside a percentage of profits equal to my effective total tax rate (federal + state + local where applicable). That money gets distributed and put into a separate tax payment checking account. If there’s no profit that month, then I start a running tally until there’s a cumulative net profit. Once there’s a positive number, tax payment money gets distributed. Every three months, I make my estimated tax payment to Uncle Sam and to other tax authorities as necessary.

Yes, paying taxes is a pain. It’s a necessary pain. It’s a lot better than having to explain to your wife that you need to raid (or raze) the emergency fund because you need to pay taxes and that the company “owes” you. We were very fortunate that our company was a viable and going concern and was profitable enough to pay us back. I suspect a lot of small business owners are not that fortunate and wind up with a double whammy – losing the money they invested and the money that they owed in taxes.

Save yourself the hassle. Set aside the money every month so it’s there when you need to pay taxes. Being in the hole because of that tax bill was one of the biggest thorns in my side for a couple of years. Avoid that pain, because it festers in the back of your mind like a sunburn in the middle of your back – irritating and unreachable.

About Jason Hull, CFP®

Jason Hull, CFP®, is the Chief Technology officer of myFinancialAnswers, an online comprehensive financial planning service.

Close