Preface: “The time to repair the roof is when the sun is shining.”
— John F. Kennedy
Why Tax Planning Should Happen Before Tax Season
There are some surprises in life that are enjoyable. An unexpected gift, a customer calling with a large order, or finding a twenty-dollar bill in an old coat pocket can brighten your day. A large, unexpected tax bill usually does not make the list. Yet every year, business owners reach tax season and discover that their company earned considerably more than expected, their estimated payments were too low, or a transaction created tax consequences they had not anticipated. The business may have had a wonderful year, but suddenly some of the excitement disappears when the owner learns how much cash needs to be sent to the government. The frustrating part is that by the time the tax return is prepared, many of the opportunities to influence the outcome are already gone. The calendar has turned, the books have closed, and the accountant is primarily documenting history. That is why one of the most valuable conversations a business owner can have with a tax accountant may occur months before the tax return is prepared. A good tax projection allows the business owner and accountant to look through the windshield instead of relying entirely on the rearview mirror.
Tax preparation and tax planning are related, but they are not the same thing. Tax preparation tells us what happened. Tax planning asks what is happening, where we appear to be headed, and whether there is anything we should consider doing before we get there. A tax projection generally begins with current financial information and then estimates what the remainder of the year may look like. Perhaps the business earned $700,000 through September and expects another $250,000 during the final quarter. Maybe the owner purchased equipment, increased wages, sold an investment, bought a property, made retirement contributions, or experienced some other significant financial change. By bringing these pieces together, the accountant can develop a reasonable estimate of taxable income and the resulting tax liability. The projection will rarely predict the final tax return down to the dollar, nor is that the objective. Its purpose is to provide enough visibility for the owner to make informed decisions while there is still time to make them.
Imagine driving on a winding country road after dark. Your headlights cannot show you everything between your current location and your destination, but they show you enough of the road ahead to make intelligent decisions. A tax projection works much the same way. Suppose your business is having an exceptionally profitable year. That is certainly good news, but additional profit can also create additional tax liability. If you are making estimated payments based largely on last year’s results while this year’s profits are substantially higher, you may be quietly building a sizable tax obligation without realizing it. A projection can identify that possibility months in advance. Perhaps estimated payments should be increased. Perhaps additional cash should remain in reserve. Depending on the taxpayer’s circumstances and the tax laws in effect, there may also be legitimate planning opportunities involving retirement contributions, equipment purchases, compensation, charitable giving, entity-level tax elections, or the timing of certain income and deductions. The important point is not that every taxpayer should pursue every available strategy. Good planning means understanding the alternatives and selecting those that make economic sense.
This is also where tax planning can save business owners from one of the most common mistakes in year-end planning: spending money simply to obtain a deduction. Imagine an owner considering a $100,000 piece of equipment primarily because someone says, “You can write it off.” A deduction can certainly reduce the after-tax cost of an appropriate business investment, but spending a dollar merely to save a fraction of that dollar in taxes is rarely a winning strategy. If the company needs the equipment, the investment produces an attractive return, and the timing makes sense, the tax benefit may make a good decision even better. If the equipment is unnecessary, however, the deduction does not magically turn a poor investment into a good one. A good tax accountant should help an owner evaluate the entire economic picture, not simply search for deductions. The objective of thoughtful tax planning is generally not to pay the least amount of tax imaginable regardless of the consequences. The objective is to manage taxes intelligently while protecting cash flow, building wealth, and making sound long-term business decisions.
That leads to another important benefit of tax projections: tax planning is often cash-flow planning in disguise.Taxes require cash, and profitable businesses can occasionally be surprisingly short of it. A company might report an excellent profit while its cash is tied up in accounts receivable, inventory, new equipment, loan payments, real estate, or owner distributions. Then April arrives with a significant tax bill. The company was profitable, but the cash associated with those profits may no longer be sitting in the checking account. Knowing months in advance that a substantial tax obligation may be coming changes the conversation. The business can establish reserves, adjust distributions, modify estimated payments, reconsider capital expenditures, or otherwise prepare for the obligation. A known tax liability can usually be managed. An unexpected one has an unfortunate habit of managing you.
Perhaps the greatest value of the projection process, however, is not the calculation itself. It is the conversation the calculation creates. Your accountant cannot advise you about something he or she does not know is happening. You may be thinking about buying a building, purchasing a competitor, selling a division, bringing a family member into ownership, changing your compensation, selling an investment property, establishing a retirement plan, or eventually transferring the company to the next generation. Those decisions can involve tax consequences, and sometimes the way a transaction is structured can matter almost as much as the transaction itself. Unfortunately, accountants occasionally hear about major transactions only after everything has been signed. At that point the conversation becomes, “Here is what we did. What does it mean for our taxes?” A much more useful conversation often begins with, “Here is what we are thinking about doing. What should we consider before we do it?” The difference may appear subtle, but it represents the difference between reporting history and helping shape the future.
Of course, no tax projection is a promise. Businesses change. Customers delay projects. Expenses appear unexpectedly. Investments fluctuate. Tax laws can change, and transactions that seemed likely in September may never occur. An estimate prepared several months before year-end will almost certainly differ from the final tax return. But uncertainty is not a reason to avoid planning. If anything, it is one of the reasons planning is valuable. Business owners prepare budgets even though actual revenue will differ from budgeted revenue. They forecast cash flow even though customers will not pay precisely when expected. They develop strategic plans even though competitors, employees, interest rates, and economic conditions may change. The purpose of planning has never been to predict the future perfectly. The purpose is to make better decisions before the future arrives.
For many business owners, tax planning should therefore become part of the normal business calendar rather than an emergency conversation held shortly before a payment is due. As the year progresses, sit down with your accountant and discuss what has changed. Bring current financial statements. Talk about expected revenue and expenses for the remainder of the year. Mention major purchases, investments, ownership changes, compensation decisions, real estate transactions, retirement plans, and other significant developments. Then ask good questions. Where does our current trajectory appear to be taking us? Are our estimated payments still appropriate? Are there planning opportunities worth considering? Are there decisions that should be made before year-end? Are we considering anything primarily for tax reasons that does not make good business sense? What could materially change our projection between now and December 31? Those questions move the accountant-client relationship beyond simply preparing forms and toward using financial and tax knowledge to improve decision-making.
A good accountant should certainly help you prepare an accurate tax return, but some of the greatest value an accountant can provide happens long before that return exists. A thoughtful tax projection gives a business owner visibility, improves cash-flow planning, creates an opportunity to evaluate legitimate tax strategies, and encourages important conversations before major decisions become irreversible. Most importantly, it can replace surprises with choices. April is an excellent time to determine precisely what happened last year. It is a poor time to discover what you could have done differently. Before the year ends, consider sitting down with your tax accountant and looking forward instead of backward. The most valuable question may not be, “How much tax am I going to owe?” The better question may be, “Now that we have a reasonable idea where we’re headed, what should we do about it?”