Clearing up some common Cash Flow Misconceptions
Draws Versus Taxable Income
Business owners often believe that they get taxed on the cash they withdraw from a business. Generally speaking, withdrawals (aka draws, distributions) don’t drive taxation. Rather, taxable income is driven by the profits earned by the business, whether distributed or not. The one exception to this rule is when distributions exceed a taxpayer’s “basis”. In its simplest form, basis is the accumulated (and previously undistributed) profits and capital contributions sitting in a business. When distributions exceed basis, the IRS looks at these as profits withdrawn prior to them being earned, and penalizes that distribution at capital gains tax rates. Here are some examples to illustrate:
|Profit||Taxable Income (= Profit)||Cash Distribution||Basis (accumulated profits not previously withdrawn)||Distribution in Excess of Basis (If Distribution > Basis)|
Profits versus Cash Flow
If you looked at Scenario 3 carefully, you might have noticed that the owner distributed $375,000 of cash, but only had a basis of $300,000. How can that happen? How could cash in the bank exceed accumulated profits? The reason is that in the eyes of the IRS, profit is calculated slightly differently than cash is collected. Specifically, there are three common items that affect the net profit on a dental practice’s P&L (profit and loss statement), but affect cash much differently:
- Depreciation – Depreciation is the expensing over time of a long-lived physical asset. Airlines would have terrible earnings some years and great earnings other years if they included the full purchase price of a jet as an expense in the year of purchase. Instead, they “depreciate,” or spread the expense over the revenue-generating life of that large asset. So depreciation reduces net income over several years, but the cash (or financing) occurred on day 1. Hence a P&L doesn’t always track the direct movement of cash.
- Amortization – Amortization is very similar to depreciation, but typically applies to large intangible assets that are purchases, like a practice’s goodwill. The cash purchase happens on day 1, but the P&L amortization expense happens over 15 years.
- Principal Payments – when you make a loan payment, some of that payment goes to interest and the rest to principal. The full payment reduces your cash balances. But only the interest reduces net income on the P&L. So cash changes and P&L changes aren’t in step.
As a result of how these items are handled slightly differently on the P&L versus true cash flow, a business’s bank balance may sometimes exceed its distributable profit, or vice versa. It’s best to check with your CPA before making distributions in order avoid tax penalties.
Greg Maravilla | PracticeCFO