Over the summer I have had several consultations with small business clients and a constant theme that I have come across is that these small business owners have been “reinvesting” their profits into their businesses. I thought it was time to dispel the “reinvestment” mantra. Whatever your passion or business pursuit, you’re likely going to want to grow your business as big as possible, but part of being a small business owners is knowing when you're investing and when you're spending. This week I’m going to attempt to break down the difference between an investment in a business and a straight-up expense. Note for the purposes of this blog, I am specifically excluding the rules related to C corporations, and will focus only on pass-through entities.
What is an Investment?
First, let’s talk about making the initial investment. To do this we’ll use an example. I’m going to assume that my fictitious entity is a newly minted consulting firm known as ConsultCo, LLC “CC”. It doesn’t really matter what kind of consulting services CC provides, just that it is taxed like every other disregarded LLC. The owner decides on day one that she wants to invest $10,000 into CC. So let’s break that $10k investment down a little further. If all she did was deposit the funds into the business’s checking account, then she would have done nothing more than make an investment in her business. Just because she opened a business and transferred her personal funds into a business bank account doesn’t mean that she gets to deduct that amount on her tax return. In fact, in this very simple example, there is no taxable event.
What is an Expense?
Every business has typical operating costs. Expenses for everything from postage & shipping, to business meals, are deductible. The list of deductible items is extensive so I won’t go into much detail but qualified expenses are truly tax-deductible items. Businesses usually also have start-up costs associated with forming the entity, which can be deducted in full (up to $5,000); after that the excess is capitalized over 15 years. But what about when the company starts gaining traction and the owner decides to “reinvest” the profits, how does that work
To understand how reinvestment works we have to understand a little more about how the math works. It's also important to understand that cash usually must change hands for a taxable event to occur. This is key. Even if a business owner has future plans for that cash, there typically has to be some movement of money to receive any tax benefit.
So let's work with another example. If the entity above, CC, provides services and earns $1,000 in consulting fees, and immediately uses those funds to purchase a new computer, then the profits have truly been reinvested. In this example, CC exchanged cash for an asset, and with the proper guidance on how to navigate her tax return efficiently, the owner can make that asset purchases fully deductible at the time of purchase. But if CC instead takes that money and decides to put it in the business bank account for future use, well then she has taxable income. You see, the profits were not actually used for anything else, but were instead set aside for future-use. In this case, the business owner would actually have to pay income taxes on the amount put in reserve. Even if the business owner used profits to purchase assets and not elect to fully deduct them at the time of purchase, that event would also likely create taxable income.
When it comes to taxes, it’s usually all about the cash…
Investment vs. Expense
Some owners find themselves continually feeding funds into their business accounts to keep their business afloat. In theory, as they do this, they should be incurring expenses, or at the very least purchasing business assets, both of which are deductible. But what about when the business becomes profitable, and the owner decides to withdraw cash? This is where it becomes important to track equity contributions and withdrawals, as well as revenues and expenses. It is only with this information that an accountant or CPA would be able to successfully determine to what extent there is truly net income vs. withdrawals and how much of each is taxable. In the majority of pass-through entities this irrelevant because all profits are taxable whether or not they remain in the business. But when it comes to tracking cash-flow (the only thing that really matters), a business owner will want to know how much out-of-pocket cash has gone into their operations and how much is coming out (before and after tax).
I hope you found this brief overview insightful. It’s great to reinvest your profits into your business but keep in mind that your net income is still taxable and setting enough cash aside to cover your year-end tax liability is critical. Just because you are leaving some money in the business does not mean you won’t have to pay taxes on the business net income so be mindful when planning your quarterly tax bills.
Have a question or comment? Feel free to post it below, I’d love to hear from you!