It's one of life's certainties, right?
But between death and taxes, there's only one whose pain hits us at regularly scheduled intervals.
So of course, like a teenager skipping class, it hits all the dopamine to feel like we're in control by using a business as a tax shelter.
And your business can (and should) be a tax shelter in many many ways.
Before continuing, the math I'm doing in this article is for illustrative purposes. Always assess your own numbers before making a business decision.
The goal is minimizing taxes, right?
A good CPA will guide you on using your business as a legal tax shelter.
That CPA's job (how they see it and their clients see it... generally) is to save on taxes. So when you talk to them, they are going to give you advice on just that... saving taxes.
And that's a good idea... like when to become an S Corp or forecasting for a major purchase or staying in compliance so you don't get hit with a business-ending tax bill.
But spending money, especially money that you likely wouldn't have spent otherwise, to save on taxes... can hurt not help.
The Downside of tax write-off's
Let's say I tack on, and write off, some extra days of vacation when I go to a conference. Plus some non-work Ubers, my grocery deliveries, and my car payment.
And my CPA is good with this. (Mine isn't but play along!)
Let's also say that my marginal tax rate is 40% which means I'm a top income earner (and also at the most "advantageous" level for this strategy).
Just look at all the tax money saved! I should be happy, right? After all, I stuck it to the IRS and reaped the benefits of business ownership.
Think again.
I might save $40 in taxes for every $100 I can write off.
But here's what gets shoved under the carpet...
I still paid $60 out of my pocket.
And I lost $100 in profit.
Where It starts stacking up
It's highly unlikely that anyone is buying my relationship-driven service business, or yours, as a tax write-off.
(Yes, I know that some businesses are bought for that purpose, but not so the buyer can pass through their personal expenses. They can just set up their own LLC for that.)
If you were to sell your business, you've probably heard talk about multiples being applied on "earnings." Someone gets 1x or 4x or 10x. It's a basic approach to valuing private businesses.
But getting into the weeds a bit, that multiple depends on your industry, supply/demand, your operational model, and more. And "earnings" is actually represented by an accounting calculation called EBITDA.
EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization.
In other words, if my business is deserving of a 3-7x multiple, I just cost myself a potential payout of $300-$700 (the $100 EBITDA x the multiple).
Meaning tax savings only matters to the business owner and their CPA, not to a potential buyer.
So $100 is money I could have shown as profit, earning me that times the multiplier.
And lest you think you can pass this off on someone, there are people who's only job in the M&A process is to determine the Quality of Earnings. Anyone worth their salt (aka with money in their pocket to pay for your business) will employ one of these people.
But that's not all I did to undermine myself with that tax write-off.
It Gets Worse
If my exit isn't an immediate next step, I could have reinvested this money into the business, still getting the tax deduction (yeah!) but pushing future EBITDA, and my multiple, higher (double yeah!).
Meaning the $300 - $700 in lost wealth is just the starting impact of my $40 in "savings".
When I engage with clients as a fractional COO, I'm helping them get smarter making decisions around business strategy and these reinvestment choices.
And, very importantly, executing on those strategies and investment to maximize the ROI.
We tackle such questions as:
"How much do I have or want to invest in business improvements?"
"How do I know amongst all my choices (and there are lots of choices) which one to go with?"
"Once I've made that choice, how do I execute on it in a way that maximizes my chances for success both now and later?"
When done right, the enterprise value (how much your business might sell for) gets higher. You gain more capital to work with. And you've got better choices for investments in future business value.
As I like to say, you get to move on to better, more valuable problems to solve.
Another Use For That $100
There are still other alternatives with the $100 in profit.
I could have also taken that money and reinvested it outside of my business.
There are multiple ways to do this that balance a desire for tax efficiency and wealth generation (especially by talking to a good financial advisor).
But even if I took the full 40% marginal tax hit when pulling out my profits, I'd still have $60 to invest outside. Which I could then invest in the stock market. Which then (rule of thumb) typically doubles every 7 years.
If I'm currently 50 and I don't touch the money until age 71, $60 might grow to $480 in wealth. (60*2^3)
If I'm currently 36 and I also don't touch the money until age 71, $60 might grow to $1,920 in wealth. (60*2^5)
Still sure you want to "save" that $40 today?
It Even Matters For New Businesses
When I talk to newer businesses, nearly every one tells me they need to figure out "taxes." But dig in and what they really want to know is how much they can avoid paying Uncle Sam and get the tax deductions that weren't available to them before.
Except change the above math we did for a more realistic tax bracket. You aren't a top income earner... yet.
So aside from the immediate shock of paying the self-employment tax (something you should talk to your CPA about), you're likely getting taxed at a much lower marginal rate for that extra you deducted.
So you spent $100, costing you $300 to $2,000+ in wealth depending on your age and business timeline, to save $12 - $20.
No bueno.
Depending on your risk preferences, your goals and your timeline, the trade off where your profit gets reinvested is one of those business decisions you get to make.
How To Think About The Trade-Off
Your outside expectations of wealth expansion (e.g. in the stock market) might not be as much as the business could provide plus you have less control over it.
But the diversification benefit does help hedge (a fancy investment word for protect you) against the risk that your plans to sell won't work out or aren't timed right.
Plus it's passive... The investment does the wealth building for you.
And frankly, I find it nice to have a non-business nest egg because it means I can stomach risk elsewhere knowing that I'm not going to be scraping by in retirement if my business hits a rough patch. That's reflective of my risk tolerance, education, and many other factors. And that nest egg was built, in large part, before I ever opened my business.
You need to decide this trade-off for yourself. And where you allocate your investments will likely adjust depending on your season in life. It certainly has for me.
The Appeal Of The Write-Off
It's okay as well to spend your money. I already play the role of mom elsewhere. I don't need to be yours in business or in financial advice.
Just keep in mind that there is a temptation to add expenses because you can write it off. So it might help to ask yourself whether that's a good enough reason to you. Does that expense help drive you toward your goals?
Still... maybe the math isn't mathing for you.
Maybe your money story is that, to you, "saving" money means getting discounts, not building wealth.
And going on a vacation might feel really good. It might be the perfect thing for you.
(Seriously, take the vacation!)
But it also might not be the best choice to write it off through your business.
As humans, we tend to dismiss the problems of tomorrow.
Everything in our environment, even sometimes including trusted advisors like our CPAs, encourage consumption. And sometimes we so badly want to avoid the pain of our tax bill, we dismiss the pain of poor exit planning and retirement.
(Or just taking the tax hit and planning a real, step away from it all with a vacation paid out of your personal income).
Real Hits To Real Business Owners
Here are some real life examples of what I've had to walk through with business owners, sometimes long before an exit is in view:
- Taxable income is zero/non-existent (because they proudly wrote off a bunch of sh*t) but now they can't qualify for a mortgage or a business line of credit
- Bringing on a partner but then getting off on the wrong foot when the new partner wants to pass through their personal expenses or wants a cut of the real, not understated, profit
- Receiving a lower than expected, pre-exit business valuation then having to choose between paying super high tax rates and/or trade off a nice lifestyle today vs diminishing what they thought could be their retirement standard of living over multiple decades
- Needing to exit ASAP but, having been deeply entrenched in the business, possibly in multiple roles(an operations issue) while underpaying themselves salary (a tax strategy)... the new owner devalues the business because they will have to hire the current owner's role out at the true market rate
There are future financial implications. And there are real life, personally impactful implications that might be affecting you right now.
So define your goals. Make them clear enough that not only will you understand them, that you can also make them clear to your advisors.
And surround yourself with great advisors (not just average ones). That includes CPAs, financial advisors, and consultants who will give you honest feedback on reaching your goals.
If you're making financial decisions for your business without a clear picture of how they affect your enterprise value, that's worth a conversation. Let's talk.
