Stupid Tax

#25 - The Small Business Tax Trap

Mar 4, 2024

The podcast discusses the tax trap faced by successful business owners with rapid growth, using a scenario of a business owner's shock on tax day due to underestimating the tax bill. It emphasizes the importance of careful planning and saving to cover tax liabilities. The episode explores IRS safe harbor rules for quarterly tax payments and the challenges of navigating tax implications for small business owners. Practical advice is shared on managing cash flow efficiently, avoiding self-created problems in business decisions, and adjusting prices to navigate market demands and inflation.

40:44

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Episode guests

Scott Hambrick

Mitchell Baldridge

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Episode notes

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Quick takeaways

Business owners must pay 110% of prior year's taxes to avoid IRS penalties.

Prudent financial planning is crucial for sustainable business growth and avoiding setbacks.

Deep dives

The Importance of Safe Harbor Rule in Tax Payments

Understanding the Safe Harbor rule is imperative for business owners to manage tax payments efficiently. By paying 110% of their prior year's total taxes throughout the year, business owners can avoid penalties and stay compliant with IRS requirements. This rule simplifies the tax payment process, ensuring a smoother financial management experience and reducing the risk of underpayment.

Introduction

4min

Navigating Business Growth, Bookkeeping, and Tax Regulations

2min

Navigating IRS Safe Harbor Rules for Quarterly Tax Payments

6min

Navigating Tax Implications for Small Business Owners

22min

Navigating Business Decisions and Avoiding Self-Created Problems

2min

Navigating Price Adjustments and Inflation in Small Business

5min

Mitchell and Scott discuss a common problem that successful business owners encounter in their first coupe years of operation -- an income tax trap caused by rapid growth. Here's the scenario: our young business owner Connor leaves his low paying W-2 job to start a business, and it's a hit! He generates $150k in profit in his first year of operation. He leaves $50k in the business, and distributes $100k to himself. The newfound income is a windfall for his family. But... the looming tax bill is greater than you think, and requires careful planning to make sure you have enough cash to cover it.

As Mitchell explains, in order to satisfy IRS safe harbor requirements, Connor must pay 110% of his prior year's taxes during his first year of operation. This 110% amount, of course, will be based on the salary at his low paying W-2 job, let's say $40k. When April 15th arrives on the following year, however, his taxes due for the year will now be based on the $100k he distributed to himself from his new business. Connor has paid estimated taxes based on his $40k salary from the previous year, but will owe a far greater amount because his actual income was $100k. If he didn't save extra money to cover this tax bill, the shock on April 15th can make your stomach turn!

This scenario is the result of success, but it far too frequently becomes the business owner's undoing. Not only do you owe the larger amount on April 15th for the previous year's taxes, you also owe estimated tax for the first quarter of operation in the current year. Business owners who take home a large chunk of cash from the business and then spend it on lifestyle improvements can find themselves in a big hole, sometimes unable to get out. This scenario will play out again in the second year of operation, if the business experiences more growth.

Mitchell and Scott walk through the math of Connor's tax dilemma, and identify the cash flow pitfalls busines owners need to navigate in their first couple years of business. With good planning, a good CPA, and discipline withholding cash for future tax bills, you can make it through the minefield and come out the other side with a successful, highly valuable business.

Ask Mitchell and Scott a question:

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Mitchell Baldridge

Twitter: @baldridgecpa

https://baldridgecpa.ck.page

https://baldridgefinancial.com

Scott Hambrick

Twitter: @hambrickscott

IG: @ogscotthambrick

https://onlinegreatbooks.com

https://scotthambrick.com