Why do business owners pay too much income taxes?

In my opinion, the reason business owners pay too much in income taxes is because income taxes are not an urgent immediate stimuli.  There are so many choices the business owners have that is difficult to spend time on something that is not an immediate priority.

However taxes are now the biggest business owners expense after labor and materials!!

So instead of making taxes a consistent daily and weekly priority, taxes are ignored until they become a real negative problem.

New Clients who are referred to my firm say taxes creep up and “I only find out about having a major cash flow problem because my taxes are so high in March or April of the following year when it is too late!”  There is a much better and easier way!

First, we need to understand human behavior. I have observed human behavior regarding taxes for 40 years and I clearly understand why taxes are such a problem.

Human beings respond to the urgent although it may not be important.  Human beings have three different brains.

We have the reptilian brain which helps keep us automatically breathing  due to our automatic response system,

Human beings also have the dog brain or monkey brain which responds emotionally.  This brain is thought of as your emotional feelings and your compassion but not the brain that does the thinking.  When you do not like a certain type of food whether it’s healthy for you or not, this part of the brain is responding.

When you owe a lot of taxes, the emotional dog or monkey brain react negatively.

Maybe even the reptilian brain shifts into high gear.

You have a combination of emotions including fear, anger, hopelessness, depression  and sadness.

Maybe you’re going into survival mode which includes fight, flight, and freeze. You might have a panic attack. You could see the IRS taking all your assets including your home.

However there is hope!  There is a better way!

The newer brain which is called the prefrontal cortex is actually the smallest part of the brain system.  Cognitive behavioral therapy works from this brain to change your two oldest brains which are the automatic response reptilian brain and the emotional dog or monkey brain.

What does all this mean for helping you reduce your taxes?

Before you can change your habits, you need to understand that most the time most people are responding from their two oldest brain systems and not from the newer more powerful prefrontal cortex.

So how do you change your thinking so that you can use your prefrontal cortex to help you reduce income taxes and reduce fear flight and emotional responses to own my taxes?

My recommendation is to use a journal and to write down questions and listen to your answers as you read them aloud.  We help clients understand taxes in layman’s language.  We help them understand the importance and the need to make taxes a priority not just once a year but continuously throughout the year.

Many people have a problem doing this kind of journaling but is very very powerful and it does work because it builds new neural networks in your brain which will help you be smarter in the future.

One of the tax laws of nature is that if your business is on a cash basis you need to regularly compare the taxable income of your business to your cash position.  The taxable income needs to be less than 100% of your cash position.

Most business owners do not understand the extreme negative impact of using cash that emanated from operations to be use for non-taxable type personal expenses.

For example if John has very little cash reserves personally and has not taken the time to build up his liquidity and get a line of credit from the bank or there will be warning signs that he may have a problem by the end of year.

John will need to start saving  cash from each years profits and hire a proactive CPA.

In addition, John’s wife Mary needs to stop taking out only 7% in federal withholding when their federal marginal tax bracket is 39%!!

For example if Mary makes $50,000 per year, and only takes out 7% in federal holding only $3500 will be withheld.  Mary should be taking out close to $19,500 per year for Federal withholding!!

In addition, the personal spending needs to be examined and reduced so that there will be adequate cash reserves in case of an emergency and to help prepay expenses to reduce personal income taxes.

Most business owners like John do not understand why they don’t have any cash but have a lot of taxable income.  The most valuable tool that I use for 40 years is the statement of Cash flows.  This statement uses the balance sheet to analyze why there is more taxable income than cash

For example  on May 1, 2014, John’s cash basis business  has$100,000 of cash but has $250,000 of taxable income.    What are a few of the reasons for this big gap?

What I discovered from new clients is that their previous CPA never help them understand how taxes work and why the business owner needs to focus on the taxable income versus cash gap.

John needs to understand with the help of a proactive CPA why there is such a big gap between what is in the bank and what is taxable income.

Here  are a few of the possibilities.

John used $80,000 of cash out of this year’s cash that came from current operations to pay the retirement plan contribution for 2013.  Cash decreased by $80,000 without taxable income for 2014 year going down one cent.

Also John in previous years took out $75,000  to remodel is home.  Although cash went down $75,000, taxable income in the previous year did not go down at all.   This resulted in a $75,000 taxable income to cash gap!

Also John paid out cash of $10,000 life insurance premiums out of his business but taxable income did not go down one penny.

In addition John enjoys going out to sporting events and meals with potential and current clients.  Business purpose Meals and entertainment are only 50% tax deductible.  So cash went down by say $1000 but Taxable income only went down by $500.  This assumes that John has the proper written documentation should IRS audit and scrutinize the meals entertainment deduction.

I know of a secret that will result in 100% tax deduction.

In addition,  in December 2013, John decided to buy a big SUV for $55, 000. John financed the vehicle and began making annual payments of $20,000. $2000 is interest, $18,000 is principal.  So although cash went down by $20,000 in 2014, Taxable Income only went down $2000 because of the interest deduction. There is a significant cash to tax gap.  In 2013 when John was
able to get a big tax deduction for the purchase of the SUV, he noticed he had to pay very little tax due to this big tax deduction but had a lot of cash left so he took that cash as a personal draw.  The negative taxable income to cash gap deteriorated because John’s business is going to have to pay for the nondeductible loan payments for years to come without getting a tax deduction except a minor amount of interest and interest expense

However, if John understood the way taxes work by utilizing a proactive CPA, it would’ve been a different story.

By using the prefrontal cortex and learning new healthy tax reduction habits including the proper tax planning. John will save significant tax dollars for 2014.

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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JBrooks Wealth Advisors, PC.

Certified Public Accountant
Address: 4647 N 32nd Street, Suite B245
Phoenix, Arizona 85018
Phone: 602-292-2009
Email: jeff@jbrookswa.com