By Jason Watson, CPA

Posted Saturday, September 16, 2023

Yeah, you’re reading that right. Our website and various articles express ways to save on taxes, but they also had an undertone of building wealth. Building wealth is your primary and perhaps only mission; not saving taxes. If we can do both, Yay! This article will take building wealth one step further and broach a topic not often discussed- paying more in taxes. Wait! What? That sounds crazy, especially from a tax accountant.

Stay with me for a bit. Why would you want to pay more in taxes?

There are a small handful of reasons to pay more in taxes, but let’s start with borrowing. When a lender looks to give you a pile of money based on your good looks and charm, in the back office they are doing two things. First, they are ensuring you can service the debt. Do you have enough cash flow to make the payments? Second, they are looking for collateral to secure the debt in case your good looks weather away, and you can no longer service the debt. Charm only takes you so far, just ask Tina.

As a side bar, lenders are in a continuous conundrum. They need to pay their investors and pay their bills, and on top of that they need to add a risk-adjusted premium to the interest rate. This can be a self-fulfilling prophecy since if the risk-adjusted premium is too high (ie, risky borrower), the lender might be putting too much debt service pressure on the loan and unintentionally push it into default. A bank that does not have any defaults will eventually fail for being too conservative.

Ok, back to the two-pronged approach- cash flow and collateral. This might come as a surprise, but most people want to pay the least amount of taxes, and to that end most people want to maximize their tax deductions. Crazy! Say it isn’t so! However, when a lender looks at your tax return, they might envision the guy from Monopoly with the empty pockets.

There is a balance here, right? On one end, you want to pay the least amount of taxes and on the other end you want that big fat loan (and one at a respectable interest rate). It might seem counterintuitive in taxes, but you’ve heard the saying- you have to spend money to make money. Taxes might be one of those “spends” to make money.

How?!

Many tax court cases remind taxpayers that “deductions are a matter of legislative grace and a taxpayer must satisfy the specific statutory requirements of the deductions he claims.” These are literally the words woven into many tax court rulings. As such, tax deductions are not a requirement… they are an allowance.

Here we go-

Limit Your 401k Deduction
There are certain tax deductions that you can elect to not do, and therefore not list on your tax returns. A great example is your company’s discretionary 401k contribution. In a solo 401k situation, a business owner might want to have their company put 25% of their officer compensation into the 401k plan. Perhaps hold off a year or two during “borrowing times.”

Eliminate That Home Office
Another good example is reimbursements from your company for home office, cell phone, internet and mileage. You are not required to reimburse yourself for the business use of your personal assets (home, phone, car, etc.).

Skip Business Meals
Business meals are purely discretionary and skipping business meals does not mean literally skipping them, unless you are on a diet. As a good steward of your business, you should continue to collaborate with colleagues and recruit new customers, and all the things in between. However, you are not required to use business funds and report the expenses as tax deductions.

Spending Diet
You can also do a little dieting with your spending. While this is a short-term change in habits that might not have a lot of punch on a tax return or set of financial statements, it is a good consideration. Do opt for that used van or truck that the business requires? Do you take it a step down or two when purchasing the next round of laptops? A lot of personal vanity worms into company expenditures and bifurcating your tastes and spending habits between you and your business is tough. If you have nice things at home, you likely have nice things at the office, and nice things cost money, and this ends up on tax returns.

As a lender reviews your company’s financials, they are determining discretionary cash flow. How much cash does this company throw off after paying its operational expenses and other commitments? For lack of better information, any expense and eventual tax deduction listed on a tax return must be ordinary and necessary for the company to operate.

So, as you attempt to stuff a bunch of expenses into your company to lower your tax bill (yes, that happens from time to time), please understand the downstream effects on your borrowing capacity. Want some math? Of course!

Lenders bounce around 40% to 45% debt to income ratio (DTI) for debt servicing limits. They total all your income streams and multiply by 40%, and compare this to your pooled obligations plus whatever you are considering purchasing. If you increase your “tax reported” cash flow by $20,000 annually, a DTI of 40% suggests that you can afford an additional $8,000 in debt servicing. At 7% interest rate, this equates to an additional $100,000 in borrowing capacity.

Is this overly simple? Yes, but it still illustrates a good point.

Let’s talk about that big fancy truck that you want your company to buy and therefore depreciate.

Depreciation is a funny thing. Depreciation is built to offer you some tax relief for mortgaged purchases of real estate, machinery, equipment, etc. For example, you spend $100,000 on some equipment that lasts 7 years. The bank gives you a loan for 7 years. Match made in heaven. However, those loan payments are not tax deductible, so to help with the “expense of purchase,” depreciation comes in with a tax deduction.

This makes sense too since most machinery and equipment goes down in value. But what about rental residential real estate? Typically, these purchases increase in value, yet you are allowed to depreciate the building over 27.5 years which is similar to most loan terms of 30 years. Even if you pay cash for real estate or equipment, there is still a cost of your equity that you are wanting to recoup. Ergo depreciation.

Another side bar- Canada tax law allows you to opt out of depreciation on real estate. In the United States, however, allowed depreciation is assumed depreciation. If you don’t depreciate your rental, the IRS will assume you had when you go to sell which can be very bad (but there are depreciation catch-up solutions if you need it).

Back to depreciation and cash flow. A lender is going to typically add depreciation expense back to your tax return, plus other little odds and ends to arrive at your global cash flow since depreciation expense is not a cash expense. However, if your depreciation is associated with a purchase made with borrowed funds, those loan payments of course count against your cash flow.

One of the other good reasons to perhaps pay more in taxes is selling your company. We have seen a lot of small business sales lately; some good, some bad. Similar to a lender, a buyer wants to know how much cash flow your company produces since most small businesses are selling their future cash flow (and perhaps some assets here and there). But here’s the rub; if you want to sell your company today, you better had started thinking about it 5 years ago as you tighten up your decisions and financial documents.

A lot of things can be explained away to a prospective buyer when they review your tax returns and financial statements. However, the more you explain and the more things you have to explain, the more doubt you cast on the veracity of that future cash flow.

Additionally, a buyer might not be as concerned about your cost structure since they are more focused on your revenue and how it will apply to their cost structure (think merger versus acquisition). However, to beat a dead horse, a lot of business mergers and acquisitions rely on financing, and we circle back to lenders. Said differently, if you want to sell your business, you need to make it attractive from a cash flow perspective in order for your buyer to obtain financing.

As mentioned, paying more in taxes might yield more wealth and that is truly what you are after in this world. By paying more in taxes, with careful consideration and calculation, you might actually put yourself into a better wealth building position over time.

Please don’t confuse what we are saying here. Making certain choices about 401k contributions, or reimbursements, or deferring certain expenditures into the future, etc. are not the same as manipulating your financial documents to not show actual expenses. If your business needs to survive by spending money on certain things, those expenses / tax deductions must be expressed on your tax return. While orange might look good from time to time, it is not a good look on a daily basis.

As such, there is a balance between accurate financial reporting and representing the health of your business accurately, and wanting to increasing your company’s “good looks and charm.”

Having said all this, if you want to review some tax reduction strategies or consider tax planning, here are some helpful resources-

Jason Watson, CPA is a Senior Partner of WCG Inc., a business consultation and tax preparation CPA firm located in Colorado Springs, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online and from mostly average retailers.