Cash…Is Not Always King!
In our General Business article this month, we talked about what accounting basis business owners should use to account for their operations. Most small business owners will choose either the Cash, Accrual or Income Tax Basis to record their transactions and we discussed the definitions of these three accounting bases in our General Business Article, but we didn’t necessarily tell you everything when it comes to taxes and sometimes what you don’t know really can hurt you.
Most small businesses will, when they can, report income to the Internal Revenue Service (“IRS”) on the cash basis. In many ways, it is the most flexible method since you can, to an extent, control how cash flows into and out of your business and that’s one of the main areas we focus on when it comes to year-end tax planning. Unfortunately, even if you are a cash basis taxpayer, sometimes you don’t need to have cash in hand before being required to report taxable income. That’s what we want to talk to you about this month.
For the U.S. Congress, cash isn’t king, revenue needs are king and sometimes that makes for some really strange income items. Let’s take a look at some of the more common “non-cash” income items.
One common “non-cash” income item arises from what we call flow-through entities in which you may have an interest. Flow-through entities like S Corporations, Trusts, Partnerships and Limited Liability Companies may show on paper that you have taxable income, but not distribute any cash to help you pay taxes. This can happen for a number of reasons including the business’ working capital and debt payment needs. For example, you may be in a partnership that made $100,000 in taxable income from real estate operations, but all of that money went to reduce the debt issued to acquire the real estate.
Another common item of “non-cash” income can hit you whether it comes from a flow-through entity or from your own personal operations. Installment sales of depreciable assets can be tricky. Say you have a business that you sell for $1 million made up of equipment worth $250,000 and goodwill worth $750,000. The equipment originally cost you $250,000, but your tax basis is zero because of depreciation. You take $100,000 down and a note for $100,000 per year over the next nine years and you are tickled pink that you’ll make the IRS wait for a substantial part of the tax you’ll eventually pay.
Don’t look now, but when you bring your information to us to prepare your taxes, you will soon be seeing red. While it is generally true that an installment sale is a good thing, Congress decided that you would have to pay tax immediately on any tangible personal property (equipment, etc.) you sell to the extent of depreciation you took. In our example, you will have to recognize $250,000 of income in the year of sale at the higher ordinary income rates. That’s a pretty tough pill to swallow when all you got was $100,000 and the next $100,000 won’t come until a year from the sale date.
Remember all those times we told you to put off receipt of income? Well, be careful how you go about doing that. We generally suggest delaying billing so your customers don’t have a chance to get the check to you before year-end, but sometimes clients just tell their customers to hold a check until the following year. That’s a really big “no-no.” You see the IRS has this handy little tool called “constructive receipt.” What that means is if you had the right to receive income and could have received the income except you refused to take the cash or check, you will pay tax in the year you could have gotten the money.
For example, suppose you rent a building to XYZ Company for $10,000 per month. In September, you look at your estimated taxes and figure out the $30,000 you’ll receive in October, November and December for rent will cost you a bundle in taxes that you don’t want to pay. If you tell XYZ Company to just hold the checks, then you have constructive receipt of that rent income and you owe the taxes in the current year rather than when you receive the cash.
Does any of this seem a little crazy to you? Try the next one on for size. Remember when you loaned your son that $250,000 to buy a new house? Ok, so you didn’t, but let’s imagine you did. He was supposed to pay you back at some point interest free. Don’t expect an IRS agent to view those two words “interest free” the same way you do. Another revenue tool the IRS has is the prohibition against making below market rate loans, especially to your kid. If you don’t charge interest and receive the cash, the IRS will use the “Applicable Federal Rate” it publishes to “impute” interest income to you. What’s really bad is you pick up the income, but your son doesn’t get the mortgage interest deduction.
These are but a few of the “Gotchas” in the Internal Revenue Code that can absolutely blow all of your fine tax and financial planning, and contrary to popular opinion, the number of these Gotchas is not decreasing with “tax simplification.” That’s why we’re here. You are where you are because you work hard and know your business or profession. We know ours. Before making any “big” financial decisions, it helps to have a professional look at all the options and their implications for your financial health. Give us a call and let us help you on the front-end so you can avoid any unnecessary surprises on the back-end.
Have a great September and please remember to keep our troops throughout the world in your hearts and prayers!