Classify Accounts Correctly - Turn Uncertainty into Opportunity
I talked last week about the psychology of tax pain, and how reducing any uncertainty that you have about books and taxes is how you alleviate it. Small businesses are taxed based upon their financial transactions, so the first step to knowing exactly what that tax is at any given point is to record every and only every financial transaction. The next step is that you must confirm and classify those transactions accurately.
There is room for interpretation with this. And there’s, unfortunately, no formula or wave of a wand that I can do to give you the best way to do your accounting, and to treat your transactions, I can show you the freedom you have with classifying transactions in general, and how you to use it to reduce your taxable income.
Why we Do Account Classifications
“He who controls the past controls the future.” – George Orwell
This is not a post on tax planning. I am not telling you how to arrange your affairs or change your behavior in order to minimize your taxes. Although important, tax planning deals with the future and present. When we classify recorded transactions, we deal with the past. What we’re doing here is looking at what already happened in your business, whether a second ago or more, and compliantly framing it in a tax efficient way.
In general, here are the 4 broad tax treatment for business financial transactions with examples:
Taxable Inflow – income
Deductible Outflow – contractors
Non-Taxable Inflow – loan payable
Non-Deductible Outflow – loan receivable
To reduce your taxable income and increase cash flow, you want to maximize 2 and 3, while minimizing 1 and 4. You’re looking to see if taxable inflows can be reclassed to non-taxable, and if non-deductible outflows can be reclassed to deductible.
Caution: this does not mean that you want to do anything fraudulent. Stay within the boundaries of compliance, and consult with a tax professional if you have any doubts about what you’re doing.
There are two ways to find tax savings in your books. The first is just doing it correctly, and the second is adjusting your accounting methods to allow you to classify things more favorably.
Doing Things Right – How it Saves you Money
Odds are, if I ask you how much last week’s sales were, you can give me a pretty quick and accurate answer. But if I ask you how much you spent, there’s more uncertainty. This is because most business owners are really good at knowing how much money they made. But they don’t focus as much on what they spent, much less how much of it is eligible for tax deductions. It’s natural to focus on income and ignore the pain of expenses, but the tax code punishes this behavior by making it harder to claim the tax benefits of these expenses. Understanding that every business expense that you can prove puts tax dollars back in your pocket makes it easier to dig into it, and opens your eyes to the tax write-offs that are hiding in plain sight.
Here are some transactions that you want to ensure you classify correctly, how they’re often misclassed, why it increases taxable income, and how to prevent it.
Loan Proceeds – These are deposits to the bank, and without context, these are assumed to be income by most people who see them. If you’re reviewing your income and see a loan in there, reclass it to loan payable to avoid overstating gross receipts
De Minimis Purchases – when you spend less than $2,500 on repairs, improvements, or equipment, then this qualifies as a tax write off in full. If you put this on the balance sheet as an asset, then you only get a portion of the deduction each year in depreciation. Laptops are an example of this. A $500 laptop is a $500 deduction, but if you put it on the balance sheet, then it depreciates over 5 years, and only yields a $100 deduction each year. Record expenses like these as office expenses so they can reduce taxable income in full.
Unreimbursed Business Expenses Paid Personally – distributions are generally non-taxable and non-deductible, but if you use that amount to pay for a business expense, then you will want to take that as a write off on your books. If not, then you will be understating deductions, and therefore overstating taxable income.
Accounting Methods that Can Reduce your Taxable Income
There are two broad methods of accounting: cash and accrual basis accounting. Cash basis only records transactions when cash swaps hands. Accrual basis accounting records transactions that create obligations, such as accounts payable and receivable.
Cash basis is generally less flexible than accrual basis accounting. For example, if a deposit from a customer hits your account, it would be hard to prove that it’s not taxable on the cash basis. However, on the accrual basis, customer deposits are not taxable until you perform the services.
For example, if a customer prepays you for services in December year 20X1, and you perform the services in January 20X2, then they would not be taxable until 20X2. On the cash basis, this would be entirely taxable. We call this deferred revenue, and they are recorded as liabilities. So if you’re classifying your income transactions, then you can look to see if you can reclass any income transactions to deferred revenue to reduce your taxable income. To capitalize on this method, you must be on the accrual basis of accounting, and if you are not on the accrual basis, then you need to make the switch my filing a form 3115 with the IRS.
Sometimes the cash basis is best. For example, if you are making large sales, and have a large amount of accounts receivable, then those amounts would be taxable on the accrual basis of accounting, since you performed the services for those customers, even though you haven’t gotten paid yet. On the cash basis, you only record income once cash swaps hands, so receivables wouldn’t increase your taxable income.
It's worth discussing with your tax advisor which method of accounting would be best for you, and if it would be worth it to make the switch.
Accounting for Uncertainty – Knowing What You Don’t Know
Classifying a transaction is a simple matter, but it’s not easy. You look at a transaction, whether from a bank statement or in QuickBooks or wherever, and simply claim its treatment. The problem comes from the fact that there are two types of transactions:
Those that you understand
Those that you don’t understand
Most of your battle will be correctly identifying which transaction is which. Because the worst thing you can do is to incorrectly assume that you understand a transaction that you simply don’t. You don’t know what you don’t know.
One of the best answers to any question in life is “I don’t know.” It shows humility and an appreciation for the complexity of the question. It also opens the door for other people to help. This applies in the world of accounting as well. If a transaction is perplexing you, then it requires special attention. If you have a bookkeeper or tax advisor that you can rely on, then you’ll want to provide them with context and let them help you. If you don’t have that kind of support, then you’ll want to do research on the transaction and figure out the different options that you have.
If you’ve gone through classifying every transaction and are unsure about anything, then you’d put it in an account called “ask my accountant” or “unclassified” or something. Accountants and bookkeepers must do this too for transactions that require further explanation from the client.
This is how we account for uncertainty, and this is the stuff that you are consciously saying that you want to discuss with your bookkeeper or accountant. If this is zero, then you are essentially saying that the books are complete to your knowledge. This isn’t always a bad thing, but it’s worth knowing that guess work doesn’t pay off. If you’re unsure about something, put it in an uncertainty account so you can classify it correctly moving forward.
Doing this well leads to the conversations that change your accounting systems, increases the certainty you have around your books, and opens the doors to tax efficient accounting.
In Conclusion
In having pain free books and tax efficient accounting, classifying transactions correctly is the first step. After that, you have the ability to adjust your accounting methods to control how transactions are treated. Using accounting systems like these are not only smart, but totally legal. But of course, there will be things that you don’t know, and transactions that give you pause. These require special attention, and by isolating them, you invite the possibility of discovering something that makes the process of accounting less painful, and more pleasant.
And if you are looking for any help with classifying transactions or changing your accounting systems, then feel free to book a Complimentary CPA Call with me and I’d be happy to discuss it with you.
In any case, I really hope that you got some value out of this and I wish the best for you and your business.
Best Regards,
Jonathan Sussman CPA
