All entrepreneurs who are worth their salt wish for explosive success. But most seasoned company builders know that rapid growth comes at a price. Consider the painful experience of Tom and Julie Stewart, siblings who run SportSheets International Inc., a Costa Mesa, Calif., manufacturer of so-called adult novelties. A few years ago their company took off like wildfire. In the mid-to-late 1990s, sales grew by 30% to 50% a year. Profits also swelled in just the way the Stewarts had hoped. They gleefully reinvested every dime of the business's spare cash in growth activities.
What a mistake. Sudden leaps in profits led to large tax liabilities, and Uncle Sam reared his ugly head. "We hadn't planned ahead for our tax bill," says Julie Stewart. As the pair scrambled to find ways to pay the IRS nearly $20,000, they were forced to put all nonessential expenditures on hold and rely on their personal credit cards to help pay company expenses.
Their sacrifices worked, and their $2-million company is back on track. But today Julie, 31, and Tom, 46, don't make any key decisions, from capital investments to sizing their personal paychecks, without taking taxes into account.
This year the Stewarts are introducing a new product line they hope to sell to mainstream gift stores, and once again they're hoping for high-speed growth. But this time they're planning for it, too. Every month, they work with financial adviser Donna M. McGovern, president of Custom Business Results Inc., based in Huntington Beach, Calif. Their goal: to learn the most tax-savvy ways to extend their product lines, expand their customer base, and increase their annual sales by 30%.
From McGovern's perspective, there's one tax deduction that's an absolute slam dunk for any small-business owner: the right, under Section 179 of the tax code, to expense up to $24,000 in equipment purchases. "Bingo!" McGovern says. "You're taking expenditures that your company would otherwise need to capitalize -- meaning, write off over five or seven years -- and getting an immediate tax deduction." Depending on your corporate tax bracket, that could amount to a tax break of anywhere from $3,600 to $9,360.
The newly obsessive tax planners always take advantage of such opportunities. "Julie and I usually sit down some months before the end of our fiscal year and take a look at what we've bought, what we need, and how much room we've got with that deduction," Tom says. "It can really add up -- maybe $1,000 for a computer or $5,000 for new production equipment." In December the partners calculated that they'd used up only about $16,000 of the deductions. Before their fiscal year ends, this month, they plan to shop for a new computer and a press for their assembly shop.
For growth-oriented entrepreneurs like the Stewarts, there's another key issue worth studying: how to lend money to their own companies in the most tax-advantageous way. (With a $100,000 line of credit and plans to control expenses, the Stewarts hope that the need for an internal loan won't arise. But last year Julie had to lend SportSheets $10,000 interest free for six months.)
At first glance, it would seem that the shrewdest course of action would be to simply forgo salary instead of having to pay personal taxes on money that the owners might have to later lend back to the company. But McGovern adamantly warns against such a tactic. "For C corporations like this one, you might wind up paying more money in taxes if you took that approach," she says. "If you left the money inside the company, it would get hit by corporate taxes, at a rate that would range between 15% and 39%, depending upon the tax bracket. Then, once the business no longer needed the money, it would get paid out to the owner and be taxed a second time, on the personal level. It's cheaper to pay the taxes once, the way Julie did last year." Also, owners of companies like SportSheets who need to provide a personal guarantee for their company's bank loan should try to avoid big drops in personal income, which can make lenders nervous.
There are two other ways to save money by reducing taxes. "You don't want to play around with this," warns McGovern, "but if you can make a serious case that some of your outstanding bills are uncollectible -- maybe they're 90 days overdue or the customer is in trouble -- or you can show that your inventory just isn't worth what you're carrying it on the books for, your company can qualify for two current-year tax write-offs."
What if you've misjudged the market and wind up collecting on those bills or selling off the inventory at a higher-than-expected price? You'll owe taxes comparable with the tax benefit you received -- but maybe not for a while. So far Tom and Julie have written off only about $2,000 worth of bad debt, but they watch their accounts-receivable schedules and inventory levels closely.
What about last year's tax-relief bill? Although McGovern likes its shrinking individual tax rates, she doesn't believe many of its changes will help today's cash-strapped owners. "There are great opportunities when it comes to incentives to set up corporate retirement plans, boost your personal retirement savings, or offer a child-care benefit. But you have to spend money before you can take advantage of those tax benefits. Who's going to do that in tight-money times?" she asks.
Not Tom Stewart. As his staff has grown, SportSheets has struggled to handle just its ever-increasing retirement-plan contributions. The company sponsors a SIMPLE IRA plan, which requires that employers make contributions that are typically equal to 3% of each participant's salary. "When I found out that that was going to cost the company $10,000 during a rough year like 2001," Tom recalls, "my jaw just dropped."
Of course, the economy won't remain shaky forever. And when the Stewarts once again pay themselves bonuses, they'll take taxes into account. A couple of years ago, Julie recalls, "we timed our bonuses totally differently because Tom, who is married, had enough personal deductions that he could handle the extra income that year. It made more sense for me to delay receiving the check until the following year so that I could plan ahead for a bigger tax bill."
Uncle Sam, eat your heart out.
Need some help with a financial strategy? Want to offer a tip? Write to Inc finance editor Jill Andresky Fraser at email@example.com.
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