Cash flow versus net income that is taxed is an important concept for business owners to understand. All too often clients, especially in the first years of business, say “I do not feel like I made any money”. So how do they have taxable income reported on their tax returns? There are a lot of differences between cash flow and taxable income and we will highlight three of the major ones:
If a client is a business that holds inventory this can cause significant differences between cash flow and net income. Inventory costs can only be deducted in the year that the item is sold. For businesses that are accumulating and holding a large amount of inventory this can result in issues come tax time. For example, if a business owner starts a business in 2014, spends $50,000 on inventory, and has $30,000 worth of inventory still on hand at the end of the year then their deduction for 2014 would only be $20,000. While these inventory deductions are not lost forever, it is a timing difference between when cash is actually paid and when they get to take the deduction on their tax return. Now In 2015 if they sell the rest of the $30,000 worth of inventory and does not buy anymore they get the tax benefit of $30,000 without having to pay any cash out of pocket. This is why we emphasize the importance of accurate inventory counts, especially at year end, for tax purposes.
Fixed assets are equipment, furniture, improvements, etc that the business plans to hold and use for longer than a year. These are not inventory for sale, but assets that they plan to use in the operation of the business Fixed assets are capitalized and deducted through depreciation expense on the tax return. Depending on the type of asset this can be over 3, 5, 7, 15, or even 39 years. So the business owner pays for the asset upfront, but has to take the deduction for it over its useful life. However, this is not always a detriment to business. Section 179 allows a full deduction of certain fixed assets in the year put in service up to the limit threshold which for 2014 is $25,000. This can be useful if you finance a piece of equipment you may be able to take Section 179 expense and deduct the costs in the first year while you are paying it off for a longer period of time.
Loans and Other Financing
Loans and other financing can also cause a discrepancy between cash flow and net income. For example, a business owner borrows money to get the business started. When the business becomes profitable they have to use the majority of that positive cash flow to repay the debt used to finance the business operations. For tax purposes they have net income and are earning money so are subject to tax. For cash flow purposes they are putting the majority of those earnings towards repaying the debt.
It is important to understand the differences between cash flow versus net income. Assuming you will not have taxable income only because cash flow is negative can cause some unwanted surprises at tax time. It is important to talk to your tax professional about these issues to understand where your business stands from both a cash flow and taxable net income perspective.