In this blog, I cover questions that come up repeatedly as I and my firm talk with our clients and potential clients, typically owners of startups and high-growth companies. Lately, I’ve been hearing a common question over and over from some of LLC companies. While it sounds like a tax question, it’s really about creating visibility and reducing surprises in your personal taxes.
Nobody likes unexpected tax bills. (I find they really tick people off. Go figure.) The thing is, when you own a growing company (as I do, too), it’s just not that easy to keep a watchful eye on your upcoming taxes bills.
Here are two areas that have created problems for other LLCs and a mini-model spreadsheet you can use or incorporate into your own “FinPak” to stay on top of it all.
1. “Safe Harbor” Estimated Prepayments Defer Taxes
One of our clients owns… let’s call it… a tech-enabled services company. That business is quite profitable, growing at a high rate, and their owners are making massive investments for future growth and scale of the company including adding employees, systems, and other infrastructure.
Because it’s an LLC, one of the things the owners’ tax CPAs did was to recommend that they pay their quarterly estimated personal taxes under a Safe Harbor Rule. Under Safe Harbor, as long as you pay 90% of last year’s taxes on a quarterly basis, you are okay. You’re not going to be penalized.
Your CPA says, “Look how I’m helping you! You really owe more tax today, but I’m letting you defer it by putting you under Safe Harbor until the end of the year.” That allows you free reign with your cash until then.
The problem is that many, many business owners forget they are under Safe Harbor. They think, “My CPA is paying my taxes. I’m keeping up. I’m good.” But they’re not paying amounts commensurate with the actual earnings of the business. And they’re only paying 90% of last year.
The surprise happens at year-end because you’ve been “underpaying” for the entire year. If your year-end tax bill takes you by surprise, it can put quite a dent in your domestic bliss.
Certainly, paying more tax sooner is an option, but why not keep your cash? Keep good track of what that year-end tax bill is really going to be so you don’t end up cash poor at tax time.
2. Owner Payments (Withdrawals) Defer Taxes
In another company, the LLC owners were paying themselves guaranteed payments, which is taxable income to them personally. They’re owners, not employees, and therefore there’s zero withholding from their pay. Those guaranteed payments (on top of the business income, above) can create a large unexpected tax liability at the end of the year. And we see that LLC owners often forget to incorporate these amounts in their planning.
To make matters worse, these business owners were investing all their excess cash in their fast-growing business. As you can guess, when it came time to wrap up the year, the CPA said, “Hey, we were so good at deferring a bunch of tax under Safe Harbor. Your tax bill is $385,000.”
The owners said, “Um, we don’t have $385,000 lying around. We did all this other stuff with the cash. I thought we were paying taxes along the way.” (This is so common — I’ve seen owners who think they have spendable cash remodel a bathroom or buy a new car. Come January, that cash is gone.)
At that point, their CPAs could only say, “Yeah, you were paying safe harbor amounts, but not all of it. We were deferring the lion’s share until year-end.”
Ouch. After this $385,000 surprise, we helped these owners create more visibility, not just to their business, but to what flows through to them personally. We helped make sure they were saving enough throughout the year, or at least mentally setting aside what they needed for their tax liabilities at year-end.
This is an all-too-common scenario. Owners either forget or don’t understand that a big chunk of their cash payments are owed in deferred taxes. I’ll give you a tool to monitor this for yourself in a sec.
Set Those Deferrals Aside
In the example above, neglecting to set aside any cash to pay taxes owed on guaranteed payments can create some unforeseen challenges. Let’s say they paid themselves $10K monthly. The owner was living on the $10K, not thinking that about 40% of that $10K needed to go, eventually, to the IRS. They should have been living on $6,000/mo.
We helped them understand the components of their income and create the appropriate amount of payment and savings to stay on top of all deferrals. When their payment cash was transferred to them, they moved 40% to a savings account, keeping 60% operational. At the end of the year, they were ready to go.
Here’s a Mini-model Spreadsheet to Track It Yourself
Deferred personal taxes is simply a fact of being an owner-entrepreneur. But it can be hard for owners to understand what exactly their tax obligations are going to be, based on their business.
What I’ve created for you is a kind of a mini-model to help you avoid tax liability surprises. The link is at the end of this section.
This model helps you figure out what your deferral is, based on your financials, as well as any owner payments made (including guaranteed payments). We add up the total liability that is owed the IRS. (This model is estimated based on a 40% tax rate.)
Then we ask, “What are you paying along the way?” And it allows you to watch your ongoing net liability. Again, this eliminates surprises.
You can forecast ahead as well. Even when you’re forecasting lots of changes in your business, you can know what cash you’ll need for taxes. That, in turn, helps you forecast your working capital better as your LLC business grows.
It’s important to make sure you’re forecasting the distribution side for business owners in terms of understanding working capital. This mini-model helps companies do that in a slick way and makes sure that it’s all incorporated into your overall financial model.
This tool can be incredibly helpful for company owners, again, who are following Safe Harbor to defer taxes, who are receiving guaranteed payments and need help setting aside cash in a methodical way. This tool can be a strong communication between you and your CPA firm to make sure that you are both on the same page in terms of your current and future requirements from a tax perspective.
Here it is: Estimated Tax Tracker