This weeks tax tip is a continuation from last week.
If you missed it, you can read it here.
So we need a better strategy, one that provides the cash to pay taxes, avoids spending, and allows us to stockpile cash for use in future tax saving strategies.
It’s that simple, and those who follow it enjoy…
- Enough money on hand to result in stress free cash flow management
- The opportunity to self fund everything from life insurance to asset purchases
- The resources to take advantage of long term strategies down the road
Let’s break down my strategy down to four simple steps.
STEP 1
Setup a separate savings account to hold nothing but money you will use to pay taxes.
STEP 2
Every month close your financial statements (quickly) and multiply your YEAR-TO-DATE net income before taxes by an approximate tax rate based on your tax bracket. Your CPA can help you come up with this. A good place to start is 25%-30%.
If you make tax distributions to your partners, as most of you do, I would use a range of 35%-40%.
STEP 3
Compare the result of step 2 to your tax savings account balance. If step 2 is more than your balance put that much money INTO your tax savings account. If it’s less transfer money OUT OF your tax savings account back into your operating account.
If you make quarterly estimated payments just subtract the payments already made from the result in step 2 before you compare it to your tax savings account balance.
Here’s the formula
(NI) X (25%) – (E) – (B) = TRANSFER AMOUNT
Where…
- NI = Net income
- 25% is your estimated tax rate. This may be higher or lower based on your situation
- E = estimated payments already made
- B = balance in tax savings account
- Transfer amount = amount to move into (out of) tax savings account
If we are dealing with partners, do not include the “E” as you won’t know how much each partner’s estimated payments are. And, most tax distributions to partners are made at year end.
STEP 4
When tax time comes around your final tax bill can be paid out of your savings account. If you use a conservative percentage (usually somewhere between 25%-30%) you will almost always have extra left in your account after you pay the tax bill.
If the balance in your tax savings account is not enough to cover the tax bill the remainder is usually not very large and paying it causes little if any disruption to your business.
Softball time!
I built you a super easy to use spreadsheet to calculate all this stuff for you. Tax Spreadsheet
In my example, at the end of the year there is $10,750 available to pay the final tax bill.
Also notice that in the two worst months (August and September) when the business was losing money the owner was able to transfer money out of the tax savings account and back into the operating business where it could do some good.
Now most businesses don’t do this, and worse, their owners don’t make quarterly estimated payments preferring instead to “earn interest on it themselves” (as if interest was still a thing).
In my example the business owner needs $40,000 at tax time. But most likely he would have spent that $40,000 back in December on a new forklift to “save taxes”. And, YES, it would have lowered his tax bill down to about $30,000. But where is THAT money going to come from?
And the plot thickens…..
Stay tuned to next week for the finale of this tax twister where I will explain why buying a forklift at the end of the year may be a stupid idea.
-cf