Joe Schmo’s [cash based] business did exceptionally well during the year. He closed the biggest deal of his life and collected a large amount of cash. Joe was very pleased with his performance and knew he deserved a reward for all his hard work.
Now Joe had always wanted to own a BMW. The problem being, the fully loaded price of Joe’s dream car was approximately $100,000. For the first time in his professional career, Joe felt he could indulge in his dream and buy the expensive car. So sometime in the year, Joe headed to the dealership where on behalf of his company he skillfully negotiated a pretty good price on that expensive car. And by the end of the day, Joe had written a check that paid for his dream, and substantially reduced the balance in his business bank account.
With his wealth of cash, Joe felt he should get some other things he wanted too. So one day when the summer heat was causing him to sweat through his suit, Joe decided to purchased a new air-conditioning unit along with some other building improvements for his office – the cost $50,000.
Joe also learned that his computer system needed an expensive overhaul, the cost of which would be approximately $75,000. Although Joe had the system installed by December, he didn’t get around to actually writing the check until January of the following year. Pulling out his checkbook, he wrote a check making sure to back date it to December 31. With that, he had successfully spent all the remaining money in his business account.
But was Joe worried about the lack of funds in his account? Nope.
Joe remembered that in previous years his tax advisor had counseled him to determine what items he needed to purchase for his business and to make sure he bought them by the end of the year. This would reduce his taxable income, and hence no income taxes would be owed. He certainly didn’t need to pay his advisor to give him the same advice each year. Spend what you make – he had no problem doing that.
Poor Joe, was he in for a shock. When he met with his advisor, he learned that he owed a substantial amount of tax with no way to pay it.
“Why,” he asked his tax advisor. “I spent all the money I made. I have nothing left. How can I owe taxes?”
“Because,” his advisor explained. “You didn’t consult with me on what things to spend your money on.”
As it turns out Joe didn’t understand the tax rules and therefore made poor “tax” choices. His advisor laid it out:
1) Because of the tax rules, only a portion of the amount that Joe had spent for his new car, and the air-conditioning unit would be deductible on his current tax return. The balance of the cost would be deducted over a number of years based on depreciation rules – sadly, the special section 179 depreciation deduction that may have applied to other purchases, and would have allowed for a greater deduction in the current year, did not apply to his purchase of the car or the air-conditioning unit.
2) Because Joe didn’t deliver [or mail] the check by December 31, the amount spent on the computer system would not be deductible until the next year.
“You know Joe, I don’t begrudge you a new car,” the advisor told him. “But had you consulted with me first, we could have figured out a better cash plan for the purchases that you made.”
What a gloomy outcome for Joe.
So how about you, did you complete some tax planning or consult with your advisor about major purchases during the year?
If not, now is the time to contact your advisor to determine how you might pay any potential tax obligation. No need to be a Joe Schmo.