If you are the owner of a small business, you may think it is convenient to compensate yourself using cash. If you own a small shop, for example, you might be tempted to simply empty out the cash register at the end of each day and pocket the earnings. When deliveries arrive at the back door, you pay COD. The rest you take home and spend, or put in a bank account. If you are the sole owner, it is all your money anyway, right?
Wrong. A portion of the money belongs to the IRS and local taxing authorities. For that reason alone, you should avoid a cash compensation system, but there are other reasons as well. Maintaining a payroll and accurate records are necessary for making effective business plans, projections, and valuations.
Strengths of Compensating Yourself with Cash
Compensating yourself with cash is convenient. If you keep careful records, then it might be appropriate in some circumstances. Too often, however, cash compensation arrangements lead to ineffective bookkeeping practices. It becomes too easy to merely take company cash without properly recording the transaction. If you don’t know where the money came from and where it went to, you can’t determine your income, your tax liability, your labor costs, your profitability, or the value of your business.
Tradeoffs of Compensating Yourself with Cash?
No Way to Calculate or Verify Income Tax Liability
If you merely take cash out of the register as needed and fail to properly record each transaction, then you will have no accurate record of your earnings. If you are audited, you may have to pay overdue taxes, interest, and penalties on amounts taken as earnings but not claimed.
Example(s): Ken owned a coin-operated laundry. Every day, he emptied the quarters out of his machines, rolled them, and took them across the street to the bank where he cashed them in for currency. He banked a portion of his earnings, paid many of his expenses with cash, and squandered the rest on his flamboyant lifestyle. At the end of the year, he told his accountant that he had only earned $40,000 from the business. He wasn’t sure exactly how much he had earned because he didn’t keep records. During an audit, the IRS examined the laundry’s water bill from the previous year. Based on the number of gallons of water used, the IRS was able to determine how many wash cycles had been run at the laundry during that year. At $1.50 per cycle, the IRS determined that Ken had earned approximately $70,000 after expenses. Ken had to pay tax, interest, and penalties on the additional $30,000 of income.
Caution: If the IRS determines that you earned more than what you actually took out of the business, then without proper records, you will have no grounds to dispute its assessment.
No Way to Prove Profitability of Business
If you are trying to sell your business for top dollar, you must be able to show a potential buyer how profitable your business has been in recent years. You must have accurate earnings records. If you have been paying yourself out of the company cash till, and not keeping good records, then you are not likely to impress a potential buyer. You also need to provide earnings records when applying for a loan. You must illustrate to the lender that you have the ability to service the debt.
Example(s): Bob owned a video arcade. Every day, he emptied the quarters out of his machines, rolled them, and took them across the street to the bank where he cashed them in for currency. He banked a portion of his earnings, paid many of his expenses with cash, and squandered the rest on his flamboyant lifestyle. At the end of the year, he told his accountant that he had earned only $40,000 from the business, when in fact he had earned about $70,000. Bob wanted to sell the arcade and move to Florida to retire. He told the buyer that the arcade had earned him $70,000 per year in previous years. The buyer asked to see earnings records. The only records Bob had were his tax returns, which showed annual earnings of only $40,000. Bob lost his shirt on the sale of the arcade because he was unable to verify the business’s profitability.
Potential Loss of Corporate Limited Liability
If you own a C corporation, chances are you chose that form of business entity to gain limited personal liability. The reason that owners of C corporations enjoy limited liability is because the corporation is deemed a separate legal entity. However, status as a separate legal entity can be revoked by a judge if the business owner ceases to treat the corporation as a separate legal entity. If an owner regularly transfers money in and/or out of corporate accounts for his or her own use, without a sound business purpose, and without documenting the transfers as wages or distributions, then it could be determined that the owner is treating the corporation as his or her own personal piggy bank. A court can rule that the corporation no longer exists as a separate legal entity. At that point, the owner is personally liable for any claims brought against the corporation.
If you have questions, contact the Business Experts at Henssler Financial: firstname.lastname@example.org or 770-429-9166.