Managing cash is one of the most important things a business owner must do. I generally see 4 main buckets that owners can get into trouble (i.e.owing more taxes without sufficient cash to pay those taxes). They are: paying themselves draws/distributions, buying inventory, purchasing certain property (real estate) and paying off debt. Let’s explore why purchasing inventory can cause problems at tax time.
Most small businesses are on the cash basis of reporting their income and expenses. That means that you record income and expenses when you actually deposit money from a sale and when the expense actually comes out of your bank account or is recorded on your credit card.
It would make sense, then, that purchasing inventory would create a deduction when you pay for it. Unfortunately, this is not the case. Inventory has special treatment in the tax rules which state that inventory is only deductible when you actually sell it. There are certain exceptions to this, but the minimal impact these exceptions have usually do not outweigh the costs associated with tracking and calculating it.
So let’s see this in action. Let’s say your business is moving along at a good pace. Toward the end of the year you have $50,000 in the bank, and you want to stock up on inventory for next year. You take $45,000 of your reserves and purchase more inventory. Tax time comes and the entire inventory you purchased at the end of year is recorded on the balance sheet as inventory instead of on the income statement as a deductible expense. Since this purchase won’t be counted as an expense in the current year, it can cause taxable income to be higher than you anticipated, and leave you without sufficient cash to pay the taxes on your income.
Balancing what you do with your cash during the year is extremely important. It’s best to explore your options with tax projections so you will eliminate these surprises when your taxes are prepared.