By Greg Crabtree, EO Atlanta member and CEO of Crabtree, Rowe & Berger, PC.
The old saying “nothing in life is free” is true when it comes to taxes. For every deduction or credit, you give up something. If your goal is to build wealth, an overzealous desire to not pay taxes will get in your way.
The size of the check you write to the IRS is the best key performance indicator of true wealth creation. That may be an odd statement for a CPA to make, but I have seen so much wasted spending to save taxes. It prevents business owners from building wealth that will sustain them.
There was a lot of hubbub at the end of tax season this year about GE not paying taxes. Some authors described how you can avoid paying taxes, too, but that advice underscores the bad thinking on this subject. It’s true that GE paid virtually no taxes in 2010 due to large losses from their GE Capital subsidiary, but trust me— they would have rather paid taxes than taken the losses.
If you, as a small business owner, take every conceivable deduction, you’d have to spend the maximum allowable amounts on retirement contributions, tuition, health insurance premiums, energy-saving measures and whatever else you can dig up to qualify for all those deductions. Sure, you’d save on taxes, but after all that spending, you wouldn’t have enough to live on.
Take retirement plans, for example. I am all for saving for retirement, but if you are in the beginning stages of your business, you can hardly afford to take the maximum allowable contributions out of your business or starve your take-home pay that much. Entrepreneurs often have a panic attack after meeting with a financial planner because they realize they do not have any retirement. They take crucial working capital out of their business to start aggressively funding retirement plans. Without fixing the primary problems of not being as profitable as you need to be or overspending, they set themselves up for emergency withdrawals of their retirement contributions. They not only pay tax on the withdrawals, but they also owe a 10 percent penalty if they are not yet age 59½.
Hit your profit target, get your consumption under control, and then fund your retirement.
To get the maximum energy credit of $1,500, you have to spend $7,500; and to get the maximum lifetime learning credit of $400, you have to spend $2,000. You still spent $6,000 net cash out of your available funds for the energy credit and $1,600 for the lifetime learning credit. If cash is tight, these expenditures can usually wait. Don’t let the tax saving lure you into a low-value decision.
You can deduct business expenses from your income, but those entertainment expenses you cleverly run through your business are only 50 percent deductible. Assuming you don’t get them thrown out in an audit, you are only saving 17.5 percent in tax, at best (that’s half of the top tax rate, since the expenses are only 50 percent deductible). So that $200 bottle of wine that you splurged on to stick it to the IRS saved you a whopping $35 in tax. If you hadn’t bought the wine, you’d still have the $200 less your tax rate, which is $120 if you pay 40 percent taxes. Spend only on expenses that help you make money, not cut taxes.
It continues to amaze me how many people with the available funds choose to not pay off their mortgage because they don’t want to lose their mortgage interest deduction. That doesn’t make sense. Can you get a higher rate of return on your investments than your mortgage rate? I doubt it. Take the sure thing and pay off the house. Not only will your debt be reduced so you can build wealth, but you can invest that money and make more than the mortgage interest deduction would give you. The added benefit is the security of having a paid-for residence, which gives you amazing staying power in tough times.
Every tax benefit comes with a cost. Spending $1 to save $0.35 in tax is not a good deal. If you want to build wealth in your business (without cheating!), you must generate income that you will owe taxes on. If you are not paying any taxes, you either cheated or you did not make any income. Both are bad!
When you buy into the fact that paying taxes is necessary, you have to adjust your consumption so you can live on less than your after tax net income. Don’t pay more in tax than you should, but those so-called tax benefits can be traps that keep you from reaching your wealth-building goals.