I get this question a lot. You have a small business, barely staying afloat, and come tax time you’re told you have a profit! How can that be? You have no money in the bank?! To answer this question, we have to look at two of the most widely-used financial statements: the profit and loss statement and the balance sheet (please click on the links to open the sample forms in PDF).
Profit & Loss Statement – Sample P&L
The profit and loss statement, or P&L, is a look at the company’s income and expenses for a range of time (in this example, a year, from January – December, 2018). The statement lists out different income and expense accounts, and has a net income figure at the bottom. This figure (in our super-simplified example) is close to what the taxable income would be on your tax return.
Things on the P&L statement exist for the year, then they reset. The income and expense accounts keep growing during the year, and then on January 1, they start back at zero. There’s no carryover from year to year. That $15,000 you paid for rent in 2018 gets reported as rent expense on your 2018 tax return, then it starts over again in the new year.
The example I’ve posted here shows a net income, or profit, of $15,000. For a sole proprietor that reports business income on a Schedule C on their individual tax return, this is the amount that would be subject to self-employment tax, in addition to regular income tax. For a profit of $15,000, self-employment tax is $2,295 (15.3%). Again, you say how can I have tax due when I don’t have that $15,000 in the bank? Allow me to introduce the balance sheet.
Balance Sheet – Sample Balance Sheet
The balance sheet is a look at the company’s assets, liabilities, and equity at a single moment in time, like a snapshot. In this example, the moment in time is as of December 31, 2018. The balance sheet moves along from year to year and doesn’t reset on January 1 – things merely move around on it from account to account. The top section reports the company’s assets, and the bottom section reports the company’s liabilities and equity items. The top half, total assets, MUST equal the bottom half, total liabilities and equity: thus the name “balance” sheet. Let’s break it down:
Anatomy of a Balance Sheet
Assets: these are good things – money in the bank, inventory, accounts receivable (money owed to you), and fixed assets (larger items you’ve purchased and are depreciating over time, such as equipment and vehicles). These goodies are reported in the top section of the balance sheet. Assets are classified as current or fixed. Current means you have them pretty much readily-available to use (money in the bank, etc.). Fixed assets are things you own, that you’d have to sell to turn them into money.
Liabilities: these are not so good things – balances due on credit cards, balances due on business and vehicle loans, taxes owed, accounts payable (bills you haven’t paid yet), stuff like that. Basically, items that will eventually require your money. Liabilities are also classified, into current liabilities or long term liabilities. Current liabilities are liabilities you expect to pay within 1 year, and long term liabilities are liabilities you expect to take more than a year to pay back.
Equity: equity items are the owner’s interest in the company. These are things like net income (from the P&L statement), retained earnings (from prior years’ profit or losses), and owner’s draws (money the owner takes out of the company for personal expenses).
How Things Move on the Balance Sheet
Although the P&L and balance sheet are related, they might not work the way you think they do. Let’s use your $5,000 credit card balance (in the liability section) as an example. Let’s say in 2017 (the prior year) you purchased $5,000 of office supplies on your credit card. Those purchases would create the following entries on 2017’s statements:
- P&L – Office Expenses/Supplies would increase by $5,000 (to show the purchase of all those office supplies, and expense for 2017)
- Balance Sheet – Wells Fargo Credit Card balance owed would increase by $5,000 (to show that you owe money on that credit card)
Let’s say money was especially tight in 2017, so you used your credit card quite a bit. At December 31, 2017, your credit card balance owed was $10,000. All those expenses ended up on your P&L, even though you hadn’t actually paid for them yet; but, that $10,000 balance due on your credit card rolled right on in to 2018 on your balance sheet.
Things picked up in 2018, and you were able to pay $5,000 on your credit card balance (so your balance at December 31, 2018 is now $5,000). These payments would create the following entries:
- Balance Sheet – Checking account balance decreased (to show money being paid to Wells Fargo Credit Card)
- Balance Sheet – Wells Fargo Credit Card balance decreased (to show that payments were made on it)
But what about the P&L? Doesn’t he get any love from these transactions? Nope! You already expensed the office supplies you bought with the credit card when you purchased them in 2017. No new expense is created by paying on the credit card balance due. Your bank account feels it, but there isn’t a new expense. This is a hard concept to grasp. The only new expense you get to book for 2018 is any interest expense your credit card charges you. In our example, let’s say your credit card charged you a total of $300 in interest for 2018. These interest charges go on your P&L in the Interest Expense account. You can see in the example that the total interest for 2018 is $1,200, so where did the rest come from? Keep reading!
Now let’s look at that $10,000 business loan you have in your liability section of the balance sheet. You just got this loan in January of 2018, and the full loan amount was $22,000. When you first got the loan, it created the following entries:
- Balance Sheet – Checking account balance increased (to show the loan money being deposited)
- Balance Sheet – Business Loan was entered as a long term liability in the amount of $22,000 (because you have to pay it back!)
Again, no P&L love in this transaction! Even though you deposited money into your bank account, you didn’t have income. Loans don’t make income, and you’re not taxed on money you get from loans. Conversely, making payments on a loan balance doesn’t create an expense. Let’s look at what loan payments look like on your financial statements:
Each month, you pay a total of $1,075 on your business loan, and of that amount, $1,000 is loan principal and $75 is interest. For 2018, that means you had a total of $900 of interest expense (hey, there’s that additional interest, for the total of $1,200!) and $12,000 paid on your business loan. This activity creates the following entries:
- P&L – Interest Expense increased by $900
- Balance Sheet – Checking account balance decreased by $12,900 (total amount paid on business loan)
- Balance Sheet – Business Loan liability decreased by $12,000 (amount of principal paid on loan)
The only P&L item here is the interest expense. That additional $12,000 that is no longer in your checking account is NOT an expense! It merely moved from one balance sheet account to another.
How Does This Affect My Taxes?
For our 2018 example, you paid $12,000 of loan principal and $5,000 of credit card debt, for a total of $17,000; however, you don’t get to expense these items. That means that even though the money is gone, it didn’t affect your P&L statement. Your bank account balance is a measly $1,800, but that doesn’t prevent your P&L from showing a $15,000 profit for the year.
While you may not like this outcome, I hope that this long and drawn-out blog post at least helps you to understand how it happens.
Call or email today if you have questions or would like to talk about some tax planning strategies!
See you soon! Anne