How Small Business Owners
Go Out of Business
Three Pitfalls to Avoid
For over 17 years, our firm has been working with entrepreneurs who start their own business. During the initial meeting with the entrepreneur and discussing his/her plans, or meeting with a struggling business owner, we can often predict with reasonable certainty as to which businesses will succeed and which will fail due to the years of experience of working with such persons.
Our determination of ownership success is often centered on the following three items:
Cash is king, and knowing a business’s cash flows is a MUST if a business is going to be successful. New business owners need to incorporate a cash flow analysis in their business plan. We suggest that a five-year cash flow projection be done. While many entrepreneurs will do an annual cash flow, we recommend (at a minimum) that a monthly cash flow be done for the first two years as those are critical years.
A good cash flow needs to be prepared on a conservative basis. That means you need to implement worst case scenarios into your cash flow projections. In other words, when looking at the range of income and expenses the business may experience, use the lower projected revenues and the higher expense range. New businesses will experience unexpected expenses, so having a conservative cash flow projection will hopefully enable you to weather those unexpected expenses.
Keep in mind that when opening a new business, it can take weeks or months before you can open your doors due to finding a suitable location, contract delays, landlord negotiations, zoning laws, inspections, etc. Once you are open for business, customers need to find you. That can create a revenue delay of several weeks or months. And during these delays before your full monthly revenues are generated, you need to meet payroll, rent, loan payments, etc. In other words, positive cash flows usually take much longer than originally participated. Hope for the best, but plan for the worst.
A good business plan has a reserve of capital that can be drawn upon for those unexpected cash delays. This could be bank CDs, retirement funds, or family and friends who could lend money. If these capital reserves are non-existent, the business will be placed in a troublesome position.
When the entrepreneur’s business plan shows that a salary or a distribution is being paid to the business owner during the initial months of operations, it is a signal that the entrepreneur does not appreciate the cash flow challenges his (or her) new business will experience. The entrepreneur needs to have capital reserves to pay his personal living expenses while the business is starting.
Even established business owners need to periodically monitor their cash flows. Depending upon the type of business, inventory turnover ratio, receivables turnover ratio, sales revenues, etc., this periodic review could be daily, weekly, or monthly.
Trust Fund Taxes:
If you want your business to fail and experience personal financial ruin, here is what you need to do.
If the business sells products, it may have to collect and remit sales tax. If employees are hired, there will be payroll taxes that must be withheld and remitted to the federal, state and local tax jurisdictions. The sales and payroll taxes being withheld do not belong to the business, but are held in trust by the employer to be paid to the taxing jurisdiction. The business owner is simply the custodian of these funds for a relatively short period.
When a business has insufficient cash, it sometimes results to “borrowing” these trust fund monies. The owner tells himself that he has a temporary cash flow shortage. So instead of remitting the trust fund taxes when due, he uses those funds to run his business. He tells himself that when the business picks up the following week, he will then remit the past due and current trust fund taxes to the tax jurisdictions and all will be well.
Some owners erroneously think that they can game the system by not filing any sales or payroll taxes. After all, if no returns are filed, the tax jurisdictions won’t know that taxes are due. Likewise, some owners attempt to increase their cash flows by not fully reporting their sales.
What often happens is that the temporary cash flow shortage lasts longer than expected, and the business continues to use the trust fund taxes to fund the business operations. States have audit procedures that include industry standards and algorithms to identify businesses that underreport their revenues. Soon the business has a significant tax liability, penalties for failure to timely remit the taxes, penalties for failure to file and interest due on the unpaid taxes and penalties. Another potential problem could be that the business owner faces criminal prosecution for fraud.
While the IRS has a reputation for its inflexible and demanding collection efforts, its collection efforts pale to those of many state jurisdictions. Some states will take action to withdraw the business’s sales tax license, confiscate its assets and even close its doors.
A business owner who finds himself in this position will learn that he is personally liable for these taxes, and that the IRS and states can levy his personal assets. If the business owner thinks that he can walk away from this liability by declaring bankruptcy, talk to a good bankruptcy attorney as these taxes are likely not dischargeable in bankruptcy.
Find an Excellent Accountant (and Understand How to Use Him/Her):
This is not a self-serving statement: It is imperative that the business engage an experienced and qualified bookkeeper, accountant and tax professional (or someone who provides all of these services). If you plan to have a business, run it as a business. Your nephew who graduated with an accounting degree, your spouse, best friend, or managing your own books is short-sighted. These persons do not have the background and experience that you will need to have a successful business. You cannot right a ship if you don’t know where it is going.
When creating your business plan, be sure to include a monthly fee for your accountant. Why a monthly fee? Another indicator of a business that is more likely to fail is a business owner who has no idea what the business is doing financially. Gut instinct is not enough. When a lender asks to see your current financial statements and you tell him/her that your annual tax return is not yet due for several months, you are sending a message to that lender that your lack of attention to the business operations is a risk the lender needs to consider.
If you engage an accountant to simply prepare your annual tax return, think about what you are missing. Assuming that your business has a calendar year end and your tax return is filed by March 15, you will have operated your business for 15 months without any type of review by an experienced accountant. If the business has a financial metric that is causing hardship for the business, you have just operated for over a year without taking corrective action and you are squandering your cash reserves. In addition, an accountant who is engaged to prepare the business tax return only has one obligation – to prepare the tax return. The preparer is under no obligation to share his (or her) observations with you as to how your business could be more financially vital.
Getting back to the monthly fee and how best to use your accountant, an experienced accountant who is engaged to review the monthly financials will share his observations as to how the business is performing on a monthly basis. If corrective action is needed, it is implemented as early as possible rather than after the fact. An experienced accountant is the health consultant for your business. He will monitor your cash flows, accounting policies and procedures, and be able to compute the break-even point for your business as to when you will achieve positive cash flows.
Another benefit is that when the accountant is used only to prepare the annual tax return, the business owner is often surprised by the amount of taxes due and furtively asks “What can I do to reduce the taxes I owe?” Not only does the business owner owe income taxes, but often he is introduced to self-employment taxes and finds himself in a position where he does not have the financial resources to pay the taxes due and winds up in IRS collections. Unfortunately, once the tax year is closed, there is little that can be done to reduce the taxes due. If the accountant Is reviewing the monthly financials of the business, he can also provide the owner with the estimated taxes that need to be paid to ensure that there is no significant balance due come April 15.
To learn more about how to start a successful business, read our book “EMPOWER Your Business to Reach Its Full Potential: Your Road Map to Planning and Executing a Successful Business.” Another must reading recommended by our attorney friend, Eric Green, is Grant Cardone’s “The 10X Rule: The Only Difference Between Success and Failure.”
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA office to discuss your situation. You can also schedule a consultation at Click Here.
Copyright © 2018 Keystone Financial Solutions, Inc. All rights reserved. BE SURE TO READ THE DISCLAIMER PAGE: Content in this blog is for educational purposes only and should not be considered as the rendering of tax, legal or investment advice. The publisher of this blog makes no representations as to the accuracy or completeness of any information herein, will not be liable for any errors or omissions, and shall not assume liability for any losses, injuries, or damages from the display or use of this information.
About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems