My Business is Killing It. Why am I Broke?

One of the questions we get most frequently at Benjamin Leo + Associates from small business owners is "My reports say my business is making a profit. So why don't I have any money in the bank?"

The answer, most simply, is that you spend money on some things that are not technically expenses. This can be very frustrating, because it is hard to live without money, and because you owe taxes on your business' profits. In this article I will provide the simplest explanation I can of how this works.

There are three primary ways you can spend money without it being counted as an expense.

  1. Make large purchases (increase assets)
  2. Pay debts (decrease liabilities)
  3. Pay yourself (decrease your capital account)

Making Large Purchases

The main types of large purchases that don't count immediately as expenses are inventory, furniture, and equipment purchases. For example, if you have a toy store and you spend $25,000 on toys to sell in October, that is not an expense for October. Instead, it goes into your inventory. Three days later, when you sell one of those toys for $25, the $12 you spent on just that toy becomes an expense (cost of goods). So by the time you've sold all of the toys you bought in October, you have counted them all as an expense.

For furniture and equipment it works a little differently. If you have a restaurant and your oven breaks down to the point where it can't be fixed, you have to shell out $14,000 (or more) for a new one. However, you are going to have that oven for a long time. For accounting purposes, it is assumed you will have it for seven years. So instead of having a $14,000 expense the day you bought the oven, you have a $2,000 expense at the end of each year for seven years. This is called depreciation.

The rule of thumb for furniture and equipment is this: if you spend less that $2,500 it is an expense. If you spend more than $2,500 it is not. It is an asset, and you will depreciate it. Some of these sorts of items are eligible for accelerated depreciation. That means instead of expensing it over seven years you can expense it all the first year you have it.

Paying debts

If you borrowed money and are paying it back, that is not an expense. The loan was not income when you received it, so it is not an expense when you pay it off. The interest and fees are expenses, but the principal is not.

This goes for credit cards as well. When you buy something with a credit card, it is expensed right away. When you pay the credit card, that is not an expense, because then you would be expensing everything you bought with the credit card twice.

For some businesses (those filing on accrual basis as opposed to cash basis) paying bills works the same as the credit card. When you receive the bill it is an expense. Then, when you pay the bill, or a group of bills, it is not an expense. That would be expensing the bill twice.

There are other liabilities that are not exactly debts. Some prime examples are sales tax, and tips paid to employees. For most retail sales, you have to collect sales tax. However, for accounting purposes, the sales tax is not income. In New York City if you sell someone a magazine that costs $10 they have to give you $10.88. For you, the $10 is sales, and the 88 cents is for the state and city governments. You didn't earn that 88 cents. You're just holding it for the government. So when you pay your sales tax, it isn't an expense. You're just handing over the money you were holding.

It's similar with tips. If you own a restaurant and your customer uses a credit card to pay $100 for the meal, $8.88 in sales tax, and a $17 dollar tip, you only made $100. The whole $125.88 goes into your bank account (minus cc fees) but $100.00 minus the fees is yours, $8.88 belongs to the government, and $17.00 belongs to your employees. When you give that $17 to the employees, it is not an expense. That was never your money.

Paying yourself

This one is a little trickier.

If your business is a C-Corp then paying yourself is an expense, and should be done through a payroll system. If it is an S-Corp, LLC, LLP, or sole proprietorship, paying yourself is generally not an expense.

When, at some point, you decide your business has more than enough cash in the bank to operate, you can decide to pay yourself (distribution of profits). This is not an expense. It doesn't reduce your profits. It is you taking your profits.

If you have partners you should also pay them at the same time. So if there is $10,000 in the bank that you have decided is extra money, and you have a partner who owns 10% of the business, you should give yourself $9,000 and give your partner $1,000. Again, none of this is an expense.

However, if you spend a lot of your time working at your business and your partners do not, it may be agreed that you should receive a salary of sorts (guaranteed payments). These are usually set up as monthly or bi-monthly payments to you for the same amount each time, regardless of how much profit the business is making. These payments are expenses to the business.

Conclusion

In short, if you are going to use something up quickly, or if you didn't spend a lot of money on it, it is an expense. If you are going to use it over time, and you spent a considerable amount of money, it is not. Also, if you spend money on an arrangement (a loan, a credit card, sales tax, etc) it is not an expense. Either you already counted the expense, or the money was never yours to begin with.

Please let us know if you have any questions or comments about this article. This really just scratches the surface. We will be posting follow up articles in the coming weeks.

Ben HoutComment