Reducing Taxes without Reducing Earnings

When I was pursuing my professional degrees, my professors stated “avoid clients with two sets of books.” That is the mindset of the world of academia. Let’s face reality. If you are a company that has had to present tax returns and reviewed or audited financial statements, guess what? You presented two sets of books for the same company. How dare you! But wait, the banks and surety bonds REQUIRE it. They require a tax return and financial statements. Your tax returns are prepared according to the U.S. Tax Code. Your financial statements are prepared according to Generally Accepted Accounting Principles.

Most banks will use your federal income tax return for approval of loans and lines of credit extensions. The U.S. Tax Code allows you to depreciate 100 percent of the value of most assets you purchase during the year. You also have the discretion to expense these same items if the value of each item is below $5,000.

Here is the defining question: Why does it matter?

They both result in no taxes being paid on the cash outflow. But banks do not consider depreciation and tools expense the same. When analyzing your cash flow to service debt and future loan and LOC requests, they add back in your depreciation expense to your cash flow and debt-service ratios.

So if you purchased $100,000 of tools that have a useful life of more than one year, in the strict interpretation of IRS Code Section 263, you are required to capitalize these individual assets. You capitalize these assets, add them to your balance sheet and provide the ancillary benefit of potentially increasing your construction/trade license limits renewal. But wait, my taxable income is now $100,000 higher because these items were not expensed.

Pursuant to the tax law changes in the Tax Cuts and Jobs Act of 2017, the IRS allows you to deduct the full $100,000 as bonus depreciation in the first year of purchase (certain requirements have to be met). So no taxes are assessed on the $100,000, and the write-off does not hurt your debt-service ratios.

When it comes to recording cash flows, the organization has flexibility for categorization and recording. The organization just needs to have written policies and adhere to these policies. The organization also needs to have a clear understanding of what story it wants to tell through the tax returns. Are we a positive cash-flow company that chooses to re-invest in assets and equipment, or are we running on the ragged edge of profitability and net losses with virtually no assets? The cash flow is the same; just the stories are different.

About the Author

Tab Burkhalter, JD, MBA, CPA
Tab Burkhalter, JD, MBA, CPA, is owner of Numbers House.

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