WHERE’S THE MONEY?
Mountains of money, canyons of cash. But where’s yours?
GEORGE WILSON ADAMS CPA MBA
December 17, 2021
Too Broke To Owe the IRS?
Your business checking account is overdrawn. Payroll is due tomorrow. You feel flat, busted broke. But your accountant tells you that your business made a profit of $50,000 and you are going to owe thousands of dollars in taxes to the IRS.
How is this possible? Is your accountant crazy? Where’s the money your accountant says you made?
This is one of the most frequently asked questions I receive as an accountant. Some people are shocked into disbelief that they owe taxes to the IRS when there is no money in their bank account. Many people simplistically believe that the balance in the bank determines the amount of taxes they owe. This is completely false, and in this article I intend to answer this question for once and for all time. Read and learn so you can plan and act appropriately.
The Balance in Your Bank Account Has Little to Do With Taxes
The amount of money you have in your business bank account is NOT directly related to taxable income. You bank account reflects money in (deposits) and money out (payments and other withdrawals). Not all deposits are taxable income. Not all payments or withdrawals are tax-deductible expenses.
Taxable income is measured annually and is not directly effected by what happened in prior years; your bank account, on the other hand, reflects the cumulative effect of all deposits and withdrawals going all the way back to when you first opened it. These are the fundamental reasons why your bank account doesn’t directly determine your taxable income and the taxes you will owe for the year.
A Simplified Illustration: The Story of One Year in the Life of a Small Business
Perhaps the best way to show why cash flows and taxable income are separate and different is to tell the story of one year of bank account activity for a small business. This story must be told with numbers as well as words.
Shown below is a short list of illustrative transactions for a typical small family business. The effects of each transaction on the bank account and taxable income of the business are clearly revealed. Every difference between how a transaction affects the bank account and taxable income is explained in simple, clear terms.
For simplicity assume this business uses the cash method of accounting to calculate taxable income.
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Money |
Effect On |
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In the |
Taxable |
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Transaction |
Bank |
Income |
Explanation of Difference |
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Jan. 1st Starting Point |
$0 |
$0 |
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Owner opens new business account with his own money |
$1,000 |
$0 |
Cash contributed to a business by the owner is not taxable |
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Proceeds from a new bank loan |
$20,000 |
$0 |
Loan proceeds are not taxable |
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Sales revenue from customers |
$10,550 |
$10,000 |
Sales tax collected from customers is not |
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taxable revenue |
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Sales tax payment |
($550) |
$0 |
Payments of tax escrow funds are not a |
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deductible expense |
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The business makes leasehold improvements and upgrades |
($20,000) |
($513) |
The IRS says that most commercial leasehold improvements must be depreciated over 39 years |
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The business makes a loan payment |
($499) |
($300) |
Only interest expense may be deducted; repayments of loan principal are not deductible |
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Payroll |
($1,000) |
($1,000) |
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Owner draw |
($2,000) |
$0 |
Owner draws or distributions are not a deductible expense |
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regardless of what type of entity the business uses |
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The business defaults on its bank loan and the bank issues IRS Form 1099-C |
$0 |
$19,801 |
Cancellation of debt income is generally taxable unless the business is bankrupt or insolvent |
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The business loans money to the brother of the owner |
($7,500) |
$0 |
Loan disbursements are not a deductible expense |
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The business owner spends the last dollar on a losing lottery ticket |
($1) |
$0 |
Net gambling losses are not tax-deductible |
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Ending Balance |
$0 |
$27,988 |
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Conclusion: There is nothing at all in the bank account and this business has $27,988 of taxable income and may owe thousands of dollars of taxes to the IRS and Maine. |
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This example clearly shows why the balance in your business checking account has little to do with taxable income and the taxes you owe the IRS. Note that this is true even though the cash method of accounting was used here for income tax purposes.
While I’m on the subject of money, here are seven more key points:
The Most Expensive Money: Early Withdrawals From Retirement Plans
One of the most expensive ways of obtaining money is to take early withdrawals of retirement funds from IRA’s and similar plans (Roth IRA’s have different rules). If you withdraw money from your IRA or 401(k) plan before reaching age 59 1/2 the withdrawal will be subject to federal and Maine income taxes PLUS a 10% federal penalty. (Exceptions apply to this rule.)
In addition to these direct costs you will also face the indirect cost of having all your other income taxed at a higher rate because the early withdrawal of retirement funds will inflate your taxable income.
When you add up all these costs they tend to range from 30% to 60% of the amount you withdraw from your retirement! Beware of this and search for other financing sources before you touch retirement money. Retirement money is the very last resort. Never touch it unless you truly have no choice.
Monetize Tax Savings
Seeing is believing. I’ve been frustrated by the task of trying to convince some clients that a sophisticated tax strategy has saved them thousands of dollars. I’ve proven the savings to them in black and white, with charts and graphs, equations, references to tax law, etc. But one of the most common questions I am asked in this context is very simple: “Where’s the money you claim to have saved us? We don’t feel it.”
Some people need to have tax savings monetized and rendered into a physical form they can touch and see. This is possible. Through proper cash flow management the taxes you save by using any given strategy can indeed take a physical form.
For example, one of the most common strategies I recommend as a CPA in order to achieve tax savings is to incorporate and make a business an S corporation. This is likely to produce significant savings from reduced social security taxes. But if these tax savings are spread throughout the year and manifest themselves as a small monthly reduction in tax payments to the IRS they will be abstract. Many people won’t see or feel the savings.
The answer for such individuals is to monetize tax savings by specifically funding a savings account with dollars that otherwise would have gone to the IRS. Any bank can help you set up automatic withdrawals from your business checking account. During the year you can pretend that these automatic withdrawals of funds are payments to the IRS. The reality is that they are payments to you because they are true tax savings. You could even give this account a subtitle right below your name: “Money Saved By Strategy X That Would Otherwise Have Gone to the IRS.”
These savings can be made to accumulate in your own account. Anytime you want you can visit your bank and ask to “see” the money. You could even withdraw the funds from the account and enjoy the psychological thrill of staring at a pile of cash. Afterwards, you could re-deposit the funds back into the account, and have these savings continue to earn interest or dividends.
Sometimes belief needs a crutch. Don’t be afraid of this. If you need to physically see the money your accountant claims to have saved you, so be it. Arrange your finances to make this happen.
After a few years of repeatedly staring at piles of cash accumulated through smart tax strategies you will begin to believe. You may no longer need to visit your bank to touch and feel the money you have saved by arranging your taxes adroitly.
If you believe you can count on your accountant you will no longer need to physically count the money he or she claims to have saved you. This is an act of reason and memory, NOT an act of faith.
The Power of Compound Interest
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
Albert Einstein
Compounded interest is one of the most powerful forces in the entire universe, because it is based on exponential growth. Invest $1,000 at an 8% annual rate of return and your investment will more than double after ten years, and more than quadruple after twenty years. The graph above shows the incredible power of compounding and what it can achieve.
The lesson here is very clear: Invest when you are young. Leverage dollars using longevity. Shift dollars away from consumption (having fun) and towards investment (having a future.) You will have more fun in the long-run if you have a future.
The Rule of 70 will give an approximate answer to how long it takes to double your money. Divide 70 by the annual effective rate of return on any investment and you can calculate how long it takes to double your money. If the annual rate of return on an investment is 3.5% it will take approximately twenty years to double your money (70 / 3.5 = 20). If the annual rate if return is 7% then your money will double in about ten years (70 / 7 = 10).
Start saving when you’re young. The past will finance a better future.
Gift, Thrift or Theft?
Once upon a time I had a client who owned a service business. The business was failing and my client was completely broke. He meant to do well, but he was both immature and an amateur. The business was organized as a general partnership despite my advice to use an S corporation.
One Valentine’s Day my client offered to give his girlfriend a 33% interest in the business. She was impressed by his seeming generosity, but didn’t understand the consequences of owning a general partnership interest in a failing business.
The truth is that 33% of zero is still zero. The business was insolvent and had no economic value. It was actually worth less than zero. It’s possible my client’s motivation was pure thrift: he wanted to save the cost of giving his girlfriend expensive jewelry on Valentine’s Day and to win her respect and admiration with a completely worthless piece of paper which said she was a 33% owner of a company.
Even worse (for the girlfriend), there are potentially adverse tax and economic consequences to owning a general partnership interest. General partners are completely liable for all the debts of the partnership. Each general partner in a partnership is 100% liable for ALL the debts of the business, regardless of what their actual ownership percentage interest is. (A general partner may sue another general partner to recover any costs paid in excess of their prorated share. Good luck with this.) Thus, it doesn’t matter that someone is a 33% general partner because of the commercial law doctrine of “joint and several liability.”
By acquiring a 33% general partnership interest my client’s girlfriend was now on the hook for all business debts and could be held legally responsible for them. My client, in effect, shifted the burden of some business debts to his unwitting girlfriend, exposing her assets and income to the claims of creditors. Economically, he won while she lost. This scenario illustrates the perils of action without thought.
Beware of Paupers Bearing Gifts.
Trojan Horse at the Gates of Troy
A seemingly unintended gift to the City of Troy crafted by the cunning of Greek General Odysseus, who hid inside with many of his fellow soldiers. Truly it may be said of the Trojans that they brought disaster upon themselves.
Money Versus Capital: What’s the Difference?
Many people think money and capital mean the same thing, or almost the same thing. This is wrong. These two concepts are completely different and it is dangerous to confuse them.
Imagine you have a profitable apple orchard. Each fall you harvest the apples and sell them. You also make cider and apple pies and sell them too. These quality products attract customers to your orchard and make it not only a place to buy apples but also a destination in itself for families and children. Your beautiful orchard can be a place of music, fun, festivity, and enjoyment.
The trees of your orchard are capital. The apples produced by the trees are money. (Yes, sometimes money does indeed grow on trees.) The trees endure and produce money year after year. The apples are rendered into a form of instantaneous and highly liquid wealth called money.
Capital can produce money if it is invested wisely and effectively. Money can be invested and turned into productive capital if the investment is sound and makes sense. Money can be spent; capital can be lost. Money is the power to spend; capital is the power to earn. Money has no country and may freely orbit the world; capital is always local and tied to a particular factory, farm, business or physical investment.
Capital can be destroyed as easily as money can be spent or lost. For example, if you cut down all the trees of your apple orchard and sell them for firewood you will have converted productive capital into non-productive money, at a vast loss.
The need for liquidity, for quick cash, is something the world will take advantage of. Beware and prepare. The lesson is clear: Don’t cut down your orchard and sell the trees for firewood just because you need quick cash. Pawnshops are just as destructive when it comes to turning capital into money.
The rate of return on capital depends on what it is invested in, whether it is an orchard, a factory, a farm, or a lobstering business. Sometimes investments lose money producing a negative rate of return. Sometimes, as in the notorious Dutch Tulip Craze of 1637, enormous rates of return can be earned – for a while, until reason returns.
Market bubbles (such as the housing boom in the U.S. that lasted into 2007) can artificially and temporarily inflate rates of return. A very high rate of return on an investment is frequently (but not always) a sign that something is wrong.
The rate of return on physical cash is less than zero because of inflation. Cash will lose value over time. While it is wise to always have a reserve of liquidity in case of emergency you will pay a significant price for investing in cash, which loses value year after year.
Here is an historical summary of the annual U.S. inflation rate. Note that the inflation rate for any given year also represents the negative rate of return for cash that is not invested in an income-producing asset:
The only time it makes economic sense to hold significant amounts of cash is during periods of deflation (falling prices.) As the above historical graph shows, inflation dominates the economy over the long run. Deflation occurs only during relatively short periods. Since the Great Depression of the 1930’s the Federal Reserve has done a better job protecting us from the highly destructive force of deflation.
If you want your money to grow in the long run plant seeds now and nourish them. Stay away from pawnshops and their equivalent. Don’t cut down your apple orchard and sell the trees for firewood.
Thinking About Money Makes People Miserable
Scientific studies have proven that thinking about money makes people feel miserable. See:
http://www.scientificamerican.com/article/money-buys-unhappiness/
Thinking about money causes people to compare themselves to both peer groups and those who seem to be better off. While it is tempting to believe that the grass is greener on the other side of the fence, it is an empirical fact that the actual knowledge and insight you truly have about other people’s lives is likely to be quite limited. You could seek out more knowledge about other people’s lives. Should you? Remember the old adage: “Don’t listen at keyholes lest you be vexed.”
The information you gather from looking at the success and happiness of others on FaceBook, for example, is like looking at the world through a pinhole. You don’t know what you don’t know and so accurate comparisons are impossible. Don’t deceive yourself and don’t hurt yourself with self-deception.
Studies have shown that people who spend significant time on FaceBook and similar sites are exposing themselves to dissatisfaction because they compare their own lives to what they see. Just remember that what you see is seldom the true reality. People show their best faces on FaceBook.
The best way to manage your money is to treat it like a job you perform periodically. Effective financial management probably requires at least quarterly and perhaps monthly review. And so at regularly scheduled times report for work and analyze your finances systematically, including spending, saving and where your money is going.
Make corrective adjustments based on the very best available information, knowledge and insight. Where do you want to be financially in five years? What is your plan for retirement? What are you doing about managing debt and your income taxes? Think carefully about these crucial issues and choose wisely. People preparing for retirement must have at least a 20 year comprehensive financial plan.
After you have performed this important financial planning work walk away. Shut down all discussion of money, spending, and savings. Do what you have decided to do. Set aside money and financial issues so you can obtain psychological peace and order in your own mind. If you don't control money, money will control you.
Implement your financial and budgetary decisions and follow them consistently until your next scheduled financial review. When the time comes again to review money issues, report for work on time and treat the work and thinking seriously. Few issues are more important in this world than money.
Never ‘ambush’ yourself or others in your family with financial and economic issues, which merely cause pain and distress. And never allow others to ambush you with these contentious issues. You must be strong enough to say “shut up” to both yourself and others when this is necessary. Silence is golden. Inner peace most of the time is essential to a quality life.
Idle talk and impulsive chatter about spending and money is inherently harmful. Impose a taboo on talking about money. When new money issues come up write them down and accumulate them in a file for your next scheduled financial review. Treat the issue of money comprehensively. It is the most important homework you will ever do as an adult.
Money issues hurt. Money issues should be discussed only at regularly appointed times, and at no other time. Your periodic financial meetings mean you buy silence and inner peace and order the rest of the time.
It is indeed the case that money doesn’t buy happiness; thinking and talking about it brings harm and misery. There are more than a few miserable millionaires out there who are deeply unhappy about their financial position because all they ever do is worry about losing their money.
Another source of financial harm is the enormous temptation to spend. We are constantly bombarded with advertising and slick and appealing images of products and services. Resist the impulse to buy. Control your spending, spend wisely when you must, follow your own financial plan, and ignore the billionaires and spendthrifts of the world who are of no help to you at all.
One of the worst catastrophes that can befall an individual is to be plunged into sudden, unexpected wealth. Studies of lottery winners reveal how an abundance of wealth can create deep misery, unhappiness, strife, and conflict. While this is counter-intuitive and surprising, it is an empirical fact.
Beware not only of poverty but also of great wealth. Each can injure and cause harm if not managed effectively. Poverty requires hope and courage; wealth requires wisdom and discretion. A super-abundance of resources will test your character and intellect just as an extreme lack of resources will. See:
http://www.usatoday.com/story/news/nation/2012/11/28/winner-lottery- bankrupt/1731367/
Be quiet about money and don’t become a slave to it. Don’t talk or think about it constantly and silently follow your own best financial plan. This is an effective way to both accumulate and enjoy wealth. In this sense we can truly say ‘silence is golden.’
The Enemies of the Present and the Future
A miser is an enemy of the present because he never enjoys his wealth, and forever defers spending. Misers fear spending because they fear the future and always worry if they have saved enough money to safeguard themselves from the misfortunes of life. The truth is that no amount of money will guarantee absolute safety.
A spendthrift is an enemy of the future because he never prepares for it financially, and forever defers saving. Spendthrifts fear saving because they fear to miss out on enjoying the present and always worry they are deprived of the pleasures of life. The truth is that those who don’t save for the future won’t like the future they will eventually live in.
Misers and spendthrifts illustrate two extreme and opposite points on a spectrum. The philosopher Aristotle, in his Nicomachean Ethics, famously said the best answer for most choices is the golden mean between two extremes. Courage, for example, is the mid-point between the extremes of recklessness and cowardice. Financial prudence is the golden mean between the extremes of parsimony and profligacy.
The wisest choice for money management is to be a friend of both your present and your future. Allocate resources responsibly. Spend AND save carefully in a way that reflects your own values and plans. The first step to achieving this is to create a financial plan.
Conclusion
In wise hands money is only a tool, not an end in itself. The true and ultimate source of real value in this world is the person you see in the mirror every day. Can you count on yourself? Money is created by, used, misused and abused by people in countless ways. In order to understand this insight you must be able to count what is truly important.
People who can’t count don’t count.
He that wants money, means, and content is without three good friends.
William Shakespeare
As You Like It, Act III, Scene II
The Worship of Mammon
Evelyn de Morgan (1909)
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
450 South Main Street: The HQ of IQ
Brewer, Maine 04412-2339
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