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Growing Business, Debt Service
By Jason Watson, CPA
Posted Sunday, October 29, 2023
Another problem a business entity might face, regardless of S Corp status, is debt service.
In a perfect world, if you had a $10,000 K-1, hopefully you received close to $10,000 in cash. But growing businesses might be re-investing all their cash back into the business and if a business has high debt service, taxable income might be present without cash. For example, your business made a $65,000 loan payment. Perhaps $60,000 of this was principal payment since the loan is near the end of its term, and the remainder was interest.
If the business has $100,000 in net ordinary business income after expenses and deductions but before accounting for debt service, it will only have $35,000 in cash but have $95,000 in taxable income. This in itself is not bad, but the business might not be throwing off enough discretionary cash flow for the owners. Huh? Example time.
|Net Business Income||100,000|
|Taxable Business Income||95,000|
|Effective Tax Rate||30%|
|Cash Surplus / Deficit||6,500|
The tax rate above of 30% is high and is artificially inflated to illustrate the point. In this example you have $35,000 in cash available for a shareholder distribution, and $28,500 will be eaten up on your individual tax return for taxes leaving $6,500 for happy meals and taco Tuesdays.
Loans are one thing. Buying a bunch of inventory can also cash-strap your business. Remember inventory is not deducted until it is sold or depleted, or deemed shrunk or obsolete. There are some newer accounting methods thanks to recent tax code changes to might allow for inventory purchases to be treated as cost of goods sold immediately.
Another concept to point out is that depreciation of an asset is supposed to alleviate some of this problem. Let’s say you purchased some equipment for $100,000. Similar to the example above, you had a high portion of your debt payment being applied to the principal amount of the loan. This reduces your cash yet taxable income is left unchanged.
However, depreciation steps in and saves the day by being a non-cash reduction in taxable income, and helps alleviate the principal loan payment problem. Here is an example using the same table above.
|Without Depreciation||With Depreciation|
|Net Business Income||100,000||100,000|
|Taxable Business Income||95,000||70,000|
|Effective Tax Rate||30%||28%|
|Cash Surplus / Deficit||6,500||15,400|
The depreciation amounts and effective tax rates were made up numbers to illustrate this point. As you can see, depreciation can alleviate some of the cash crunch. Then again, if you elected to depreciate it instantly with a Section 179 deduction, then you are back to square one. This is one of the examples where the bird in the hand is not worth two in the bush- the pleasure of an instant tax deduction via Section 179 which lacks the stamina to help you in future years (which presumably are at a higher income).
Note: This really isn’t a reason not to elect S corporation status- it is a problem for any business entity.
Cash is king. Plan ahead before paring down debt.
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