A question about income tax

[AnthemLights]

SO, I am feeling very confused and a bit dumb.  I thought I knew my way around a tax return and now I am finding myself stumped.

 

(Kind of) a hypothetical situation:

 

Say someone borrows  40K to start a business.  They invest the 40K in inventory which they sell off throughout the year.  To make things simple lets say that at the end of the year, they have made enough money after expenses to pay back the 40K.  Let's further say that they have no inventory left and that they made no additional money....living mostly off of savings from previous years.  (All this is kind of half way true)

 

At the end of the year aren't they worse off than when they started?  Because, even though they were able to pay the 40 back, they would still have to pay taxes, right?

 

I am aware that there are 2 sides to a company....the profit and loss and balance sheet and that the business is worth more at the end of the year than at the beginning.  (At the beginning it would have been worth -$40K and at the end of the year it would be worth -0-.)  Real life though, it doesn't seem right.  

 

So, what was the point??  I don't know what taxes would be on a profit of $40K, but for a single guy, I am sure it would be substantial.  What am I missing?

 

 

 

[maize]

I don't think the scenario you present represents a profit of $40,000. 

 

The initial purchase of inventory is an expense, so -$40,000;

if other expenses (storage, advertising, rental space, etc.) equal $-20,000, and the total income is $60,000 so you just break even, wouldn't profit be $0?

 

(I am not an accountant)

[AnthemLights]

Maize, that's exactly how I would have understood it as well.

 

I asked our accountant.....he said profit of 40k....maybe he misunderstood? or maybe I said it wrong?

 

ETA - He's the one that brought up the balance sheet and talked about the worth of the company which kind of made sense when I was talking with him, but as soon as I hung up, I couldn't make it make sense anymore.

 

 

Edited August 21, 2016 by AnthemLights

[Shred Betty]

I don't think the scenario you present represents a profit of $40,000.

 

The initial purchase of inventory is an expense, so -$40,000;

if other expenses (storage, advertising, rental space, etc.) equal $-20,000, and the total income is $60,000 so you just break even, wouldn't profit be $0?

 

(I am not an accountant)

Exactly my thought, your first paragraph describes breaking even, that's 0 profit not 40k profit. though maybe it doesn't matter, because tax is figured on income of 40k earned, not profit of 0 after expenses? hmm, I always go straight to the publications on irs.gov, click publications, that's where they explain the tax code.

 

Not an expert, not an accountant, but ba in business and I know my way around irs.gov publication search engine and application to complex personal not business returns.

[maize]

This may help?

 

https://www.boundless.com/accounting/textbooks/boundless-accounting-textbook/detailed-review-of-the-income-statement-13/understanding-the-income-statement-84/cost-of-goods-sold-and-gross-profit-382-3576/

 

The amount spent on inventory is part of your cost of goods sold, which is deducted from sales revenues.

 

I think you may need a new accountant.

[Arcadia]

Beginning

Loan (liability) is -$40k

Inventory (assets) is +$40k

 

End

Profits is $40k

Loan is $40k assuming interest free

 

If he/she counts paying off the loan as an expense, then profit drop to $0

 

I though business tax are on a quarterly system? I am not a tax accountant though. Just used to preparing quarterly financial reports when I was working.

 

ETA:

I'm assuming you are asking business income tax. Hubby was self employed so he filed business tax forms and personal tax forms. Since he didn't pay himself so he basically had no income.

Edited August 21, 2016 by Arcadia

[Shred Betty]

Yes you MUST make tax payments as income is earned throughout the year not pay it all at end of year, or else pay steep penalties on top of tax,,, I hear this surprises some new business owners.

Maybe they meant income of 40k and not profit of 40k, and maybe tax is figured on income, not profit? I'd look at the pub database for a sec if I knew what type of business it was. That determines their tax code I'd imagine.

Edited August 21, 2016 by Shred Betty

[IfIOnly]

Business should also have other expenses and writeoffs to bring income down, right?

Edited August 21, 2016 by ifIonlyhadabrain

[The Governess]

SO, I am feeling very confused and a bit dumb. I thought I knew my way around a tax return and now I am finding myself stumped.

 

(Kind of) a hypothetical situation:

 

Say someone borrows 40K to start a business. They invest the 40K in inventory which they sell off throughout the year. To make things simple lets say that at the end of the year, they have made enough money after expenses to pay back the 40K. Let's further say that they have no inventory left and that they made no additional money....living mostly off of savings from previous years. (All this is kind of half way true)

 

At the end of the year aren't they worse off than when they started? Because, even though they were able to pay the 40 back, they would still have to pay taxes, right?

 

I am aware that there are 2 sides to a company....the profit and loss and balance sheet and that the business is worth more at the end of the year than at the beginning. (At the beginning it would have been worth -$40K and at the end of the year it would be worth -0-.) Real life though, it doesn't seem right.

 

So, what was the point?? I don't know what taxes would be on a profit of $40K, but for a single guy, I am sure it would be substantial. What am I missing?

So, you borrow $40k. That will show on the balance sheet as a $40k liability balanced out by $40k in cash.

 

You buy $40k in inventory. Now you have a balance sheet with $40k in inventory and $40k in loans, and no cash.

 

Now, let's say you sell your inventory for $80k over the course of a year. At the end of the year, you will have $80k in cash, and no remaining inventory.

 

The $80k you made is your revenue. Deduct the cost of goods sold from your revenue, which is the $40k you paid for your inventory. You now have $40k gross profit on your income statement.

 

From this number, subtract your business expenses: rent, payroll, etc. You can also deduct the interest you paid on the loan. Let's say all of the expenses were $20k. Subtract them from your gross profit to get your net profit, which is $20k.

 

Your cash balance was $80k, and after the $20k in expenses were paid it was $60k.

 

Now, during the year, you have also been paying principal payments on the loan. Let's say these totaled $5k. These do not hit the income statement because principal payments on a loan are not considered an expense. But they reduce your cash to $55k.

 

Since you made $5k in principal payments, your loan now has a balance of $35k. Since you have $55k in cash, you decide to pay off the loan. Now you have $20k in cash left.

 

Your net profit is what you are taxed on. So you will owe taxes on $25k. Paying down principal on a loan does not change your net income.

 

Let's say your taxes are $10k. You have $20k in cash, so you can pay your taxes and have $10k leftover.

 

Ultimately, you would want to be able to sell the inventory at a high enough markup so that you could pay yourself a living wage, cover business expenses, pay back the loan, and have enough left to cover taxes at the end of the year and hopefully some cash leftover to put toward next year's inventory. It sounds like, in your example, the selling price of the inventory wasn't high enough for the endeavor to be worth it.

 

ETA: If your revenue was only $60k, that leaves you with just enough money to pay your expenses and pay off the principal on the loan with the $40k in cash that would be remaining. It sounds like this is what happened in the example you gave. But at $60k, your net income is zero and you didn't make a profit. So no income taxes.

Edited August 21, 2016 by lovelearnandlive

[JustEm]

Your accountant is wrong. I'd suggest getting a new one

[maize]

Your accountant is wrong. I'd suggest getting a new one

 

 

It is possible that the accountant is competent when managing written records but is a poor communicator--so they either misunderstood what the OP was telling them about the situation or were unclear in their verbal response.

 

But yeah, I'd be hesitant to hire this person to manage my financial affairs!

[AnthemLights]

It is possible that the accountant is competent when managing written records but is a poor communicator--so they either misunderstood what the OP was telling them about the situation or were unclear in their verbal response.

 

But yeah, I'd be hesitant to hire this person to manage my financial affairs!

 

He is an awesome accountant.  We have used him for years to do our very complicated S corporation and also our Schedule C/Personal Tax Return.

 

I am leaning towards that he misunderstood me or that I misunderstood him.  Hopefully.  Although I clearly remember him saying something to the affect that if a person made $40K, he is going to be taxed on  $40K, even though he has to take that $40K and repay a loan.  Schedule C sole proprietorship so profit just flows onto the personal return as income.  

 

I am leaving for church so don't have the time right now but I want to study the example lovelearnandlive posted with the numbers that fit my scenario.

 

Also, the question was kind of hypothetical.  The numbers aren't quite real....but enough so that by exaggerating them I could get a clearer picture of what exactly is going on.

 

Kid is aware that business taxes are paid quarterly.

 

Thanks everyone.

[The Governess]

I think I see where the disconnect is. To your accountant, "making" $40k means $40k of net income on the income statement. So yes, if you made $40k you will be taxed on it. But in your scenario, because of the loan, it is possible to make $0 and still have a remaining cash balance. Cash remaining and net income are two very different things.

Edited August 21, 2016 by lovelearnandlive

[maize]

He is an awesome accountant.  We have used him for years to do our very complicated S corporation and also our Schedule C/Personal Tax Return.

 

I am leaning towards that he misunderstood me or that I misunderstood him.  Hopefully.  Although I clearly remember him saying something to the affect that if a person made $40K, he is going to be taxed on  $40K, even though he has to take that $40K and repay a loan.  Schedule C sole proprietorship so profit just flows onto the personal return as income.  

 

I am leaving for church so don't have the time right now but I want to study the example lovelearnandlive posted with the numbers that fit my scenario.

 

Also, the question was kind of hypothetical.  The numbers aren't quite real....but enough so that by exaggerating them I could get a clearer picture of what exactly is going on.

 

Kid is aware that business taxes are paid quarterly.

 

Thanks everyone.

 

OK, I am leaning towards miscommunication going on here. 

 

The loan itself doesn't play into your net profit equation at all, except for interest (as a pp noted). The fact that he took out a loan or paid back the loan basically doesn't factor in.

 

What does factor in is the money spent on inventory. If he spent $40,000 on inventory, that $40,000 is an expense (cost of goods sold) that is subtracted from whatever income he took in.

[ktgrok]

He is an awesome accountant.  We have used him for years to do our very complicated S corporation and also our Schedule C/Personal Tax Return.

 

I am leaning towards that he misunderstood me or that I misunderstood him.  Hopefully.  Although I clearly remember him saying something to the affect that if a person made $40K, he is going to be taxed on  $40K, even though he has to take that $40K and repay a loan.  Schedule C sole proprietorship so profit just flows onto the personal return as income.  

 

 

 

I think the confusion is that the kid didn't MAKE 40K, because he also has to account for the inventory he purchased. He made 0 dollars. Your accountant thought you meant 40K net profit, not 40K gross. 

[zoobie]

Do you mean the business made 40K in gross profits and owes $40K in a loan due that fiscal year, resulting in $0 net? Or is the $40K a business profit that the person is using to pay off a personal loan? It's not always a simple subtraction. It depends on the type of business, type of loan and who the actual debtor is, all kinds of things. 

[StephanieZ]

Your accountant probably misunderstood your question.

 

We own a business that carries inventory.

 

Inventory purchase cost is a fully deductible business expense. Sales are income. So, if I spend 10,000 on inventory and sell it for a total of 15,000, then I now have a taxable income of 15k-10k=5k. But, I will get to deduct more expenses (office supplies, utilities, rent, etc) from that remaining 5k of "income" so probably the final taxable income will be close to zero. (Sales tax will be paid all along as sales occur, FWIW.)

 

I think I know what your accountant was getting at . . . The borrowed money that represents the value of the business itself (excluding inventory value) is sort of a "Thing" I buy when I buy a business. (Imagine I'm buying a huge diamond instead of a restaurant/etc.) OK, so I buy a restaurant from someone else for 500k. I borrow 500k over 15 years to repay this debt. The first year, I pay a total of 70k in loan payments -- 40k towards interest and 30k in in principal. That INTEREST is a deductible expense. However, the principal payments are NOT a deductible expense and essentially that income "passes through" (at least in most very small business corporation classes) to the owners as ordinary taxable INCOME. So, me, the restaurant owner has ON PAPER earned an extra 30k this year because we/I (the business that I own) has paid down some of the debt. This makes sense since I, the business owner, now own 30k more of my business than I did last year . . . I have 30k more equity . . . So I'm 30k "richer". It does not "make sense" in the fact that I, the business owner, never actually see that money. It is "on paper" only, until, someday, I sell that business. Keep this up for 15 years. Each year, the owner pays down more and more principal and so, on paper, is more and more rich, and all along is paying more and more taxes. Overall, it makes sense IMHO, but it is a huge PITA during the pay down period, as you don't FEEL richer since you aren't getting any more money to SPEND but you are owning a bigger and bigger part of that restaurant/diamond/whatever, which is a good thing overall (and can be cashed out someday). 

 

That "on paper" income has to be FULLY paid taxes on, including popping you up into higher brackets, losing income-based deductions such as child care, student loan interest/ IRA eligibility/ etc. So, even if the business owner is actually only taking, say 40k/yr out of the business in cash for herself to live on, she's paying income-taxes based on that 40k+principal pay down, so maybe 70k-90k as the years progress in the above example (as later loan years will have greater part of the loan payments be principal while the interest part goes down). As you can imagine, there is a HUGE difference in tax rates for someone who earns 40k vs 90k. So, that 40k cash salary might need to pay for 15k-20k in taxes (state, federal, etc.) Leaving them 20-25k to LIVE on despite a paper income of 90k. Yikes!!!

 

This is *exactly* the scenario that caught me off guard around our second year of business ownership. It still causes us trouble, but we now just accept/understand/plan for it . .. and is largely the reason why we can NOT afford the Estimated Family Contributions that the various calculators suggest we should be able to for our kids' colleges. Each year, we get (a good bit) richer (ON PAPER) due to principal pay down on our family business. So, we pay taxes on all that (as we should, really, because someday, when we sell, we'll have that equity to cash out) . . . So, we pay a big part of our take-home pay back out as taxes, making our take home even smaller than you'd think. Add in retirement contributions (given our ages, a necessity), and your actual cash available to spend is (much) lower again. Add in that we don't get nearly any deductions/etc that are income-phased out because of that huge part of our income that is phantom paper-only income . . . Alright, this is all fair, IMHO, in the grand scheme of things. HOWEVER, the FAFSA, etc doesn't care that most of that income is "paper only" until/unless we sell the business (which is our entire livelihood and supports all of us, so not an option) . . . but FAFSA doesn't give a hoot. So, FAFSA thinks we should be able to SPEND that paper income on our kids' colleges. Indeed, we *could* but ONLY if we took more loans, since that paper income is not at all accessible. It's like saying "you have a 500k house . . . so you should be able to spend some of that value each year" We all know that the only way to spend a house's value is to BORROW against it. It's not like cash in the bank that you can just withdraw. So, anyhow, this is why our kids can't go to elite colleges that don't give merit aid. Period. Because the only way to pay the EFC is to borrow against the value of the business . . . Which at 70k/yr for 3 kids x 4 years would wipe out just about exactly the entire value of a lifetime's work by the end of their undergrad. No thanks. 

 

SOOOO, anyway, IME, the trick of this sort of thing is that, yes, it's great to, over time, gain wealth via business ownership/principal pay down. The big negative IME is these complicated tax/financial consequences of the "paper/phantom" income while you pay down principal. If you never BORROW money to acquire the business, then this shouldn't happen quite so badly. But, if you borrow big to buy a business, then the entire period of principal pay down will involve a lot of phantom income that makes you FEEL like you have outrageously high taxes/EFC/etc. In our case, we just accepted the fact that we can't truly afford our EFC (truly affording our taxes isn't an option, lol, or we'd pay less in taxes, but we have no choice there, lol). Our kids can't go to colleges that we can't pay cash for the entire amount -- no need based aid period -- merit aid is our friend. We look forward to the day our last large business debt is paid off (5 years 3 months, but who is counting . . . ) because then, the last of the phantom income becomes actual cash in our pocket . . . and then we will be able to afford the things the various taxing authorities/colleges/etc have THOUGHT we could afford all along . . . during the first, oh, 18 years of business ownership, lol. 

[ktgrok]

Yeah, when you said the business "made" 40K, he thought you meant in net profit. You didn't you hadn't subtracted the cost of the inventory yet. That's the issue.