I recall hearing that under a profit tax regime corporations do their best to have zero profits, i.e. spending everything they earn. Now, suppose the corporation wants to undertake a major expenditure and needs to save up money for it over a period longer than a fiscal year, fiscal quarter or something of this nature. Wouldn’t they get immediately hit with the tax in such a situation since money has remained unspent? What techniques are used by corporations to build up cash assets, such as for instance Microsoft reputedly building up many billions in cash assets?
are you the same one who thinks that you can’t deduct business expenses if you aren’t an incorporated business entity?
to answer your question: how do you save money when you have unspent money at the end of your paycheck?
p.s. showing 0 book profits doesn’t mean the company didn’t “make money”
The company would probably use debt for any major expenditures.
You certainly can build up cash assets, though. And most companies do not have zero profits for the year – their stockholders would not be happy. But there are ways to shield profits from tax.
you heard wrong
CEO of a tiny CA corp here.
Earnings are taxed, simply having money in the bank is not earnings, even for a corporation. This is how a corp can operate at a loss, either by taking out loans or burning cash reserves. The nice thing is, you can carry over losses from one year and apply them as expenses to a more profitable year for tax purposes.
A company with large cash reserves is a healthy company. I can operate for about 2 months with zero sales before I would need to close up shop. Even with a slow decline in business it would probably take a year for cash flow to become critical.
No, see Retained Earnings. If what you heard were remotely true, the concept would not exist.
However, self-financing via retained earnings is not usually the most efficient way to finance major expenditures. Debt or new equity might be raised.
You pay your tax on your earnings, adjusted for whatever tax regime, dividend as required under the firm’s dividending policy, retain the rest as “retained earnings” which are then kept in a “treasury” (or alternate term, anyway, liquid account) as needed (or reinvested). There is a whole sector of short-term cash asset management services for corporations in this area to maximise the effectiveness of their cash holdings.
Interesting. I’m no expert at corporate finance, but maybe a small company is different than a big one. I worked for a very large IT consulting firm (90,000 employees) and attended an internal management training class many years ago. They said that their division presidents were evaluated based on cash flow, revenue, and profit, and cash flow was the most important. I was surprised that cash flow would take precedence over whether the company was actually making money for such a large company. I don’t know what cash reserves they had. Then when I worked for a major domain name company, I heard the CFO say, “Cash is king!” more than once.
In my business classes we generally learned that having cash sitting around does not help a business to make money as much as spending it to grow the business.
There are a couple of things you have to consider to understand this mentality.
A Company can be insanely Profitable, at least on the books, but if they do not have cash coming in they can not operate. You need actual money to pay bills, rent, loans repayments, Tax’s etc. and If you are unable to meet those obligations you are likely to wound up / end in receivership / bankrupt.
Also when a company says Cash, it does not just mean how much money they have in a bank. It can include any other Liquid (Easily convertible to cash) assets. So While a company may have large cash reserve, they are likely to put them to work investing in FD’s, Bonds, etc that are easily convertible or trade able.
Also, the Word “Profit” in itself is highly subjective. It can and is prone to manipulation, so much so that Tax authorities usually have a list of things that can legitimately be claimed as expense and which have to be excluded. So for a company the “Tax Profit” figure can often be very different from the Actual “Accounting Profit” as different expenses, depreciation, deductions, etc.
Code_grey, you might also be thinking of rules related to Personal Holding Corporations. These tax rules penalize companies that may have been set up by wealthy individuals as a strategy to pay lower tax rates on investments. However, the way the rules are written, it’s possible for a company to “accidentally” accumulate enough additional assets to fall under the PHC rules and get stuck with a tax penalty they didn’t expect. The solution to avoid the PHC tax is usually to pay out some dividends ASAP.
Still, even a PHC is allowed to accumulate as much as it wants to - it just pays a higher tax rate than it would otherwise.
wwait, people, we gotta fight ignorance here in a more systematic way. My understanding so far (quite likely flawed, but nevertheless) is that a corporation is taxed on profit, which is the difference between income and expenditure. So e.g. if the corp spends all of its income on bills and salaries, there is practically no profit and nothing is taxed. This (flawed) reasoning suggests that if the corp fails to spend it all, it will accumulate a profit that will be taxed.
Well, so if the above is incorrect, can you explain to me how does the profit tax actually work? What determines how much taxable “profit” a corporation has?
And what about those “retained earnings” that wmfellows brought up, from tax standpoint? Can the corp just declare all that extra money they made “retained earnings” and in this way keep it untaxed until the next fiscal period when they will invest it in business expansion?
I believe rather you should follow the link I provided and do some basic reading. I have the impression your ignorance is such that a proper course in general business theory is needed.
Profit may be defined, as noted above, differently for different purposes.
An accounting profit may be slightly (or massively) different from a Tax Profit (relative to whatever national tax authority standards may exist) re “allowable” expense deductions (this to stop a gaming of the system).
But generally taxable profit is Revenue less Expenditures (end profit of course is less the taxes). Expenditures are Inputs (in industry whatever is needed to Make Stuff, including Labour and materials, etc etc ) plus things like interest expenses on outstanding debt, etc.
A passing knowledge of the tax code, some accounting principles and basic addition and subtraction.
Of course trying to game your expenses can get you heavily fined.
But on the other hand, for anything other than say a Partnership (where the Owners and the Managers are the same people), the Owners do have a serious interest in seeing post-tax profits.
I suggest you click on the link to a fairly straightforward yet lengthy explanation of Retained Earnings as, your next line shows you did not read that discussion yet:
No, read the link. Retained earnings are non-distributed post-tax profits.
Look, it’s really simple
Profits = ( Revenue - Expenses ) - Tax
this is a gross simplification that brings everything a company spends under the concept of “expenses” but it’s enough to explain to you.
there can be no tax rate, other than a 100% marginal rate on your first dollar of profit that does not leave you with money left over after paying taxes
money left over after you pay taxes is never re-taxed (in the United States). only the “profits” on the use of *that *money are re-taxed (excludes other types of taxes).
this isn’t even a business question regarding retained earnings and cash flows or anything. it’s a straight question regarding how taxation works.
Something that has been alluded to above needs to be said explicitly.
**Financial accounting **is designed to determine the financial health of a corporation. These rules give us what most people think of as a company’s profit/loss position. This is also what you see when you look at a company’s books or financial statements. GAAP (generally accepted accounting principles) gives a fair amount of leeway
The IRS rules are designed to determine a company’s tax bill.
They are two entirely seperate things that do not have to give the same answers.
And positive cash flow does not make you profitable. Over short periods of time (2 years perhaps) you can have positive cash flow and yet be nonprofitable, and vice-versa.
An example of what this difference between the two sets of rules can be found in how depreciation is handled. In financial accounting depreciation can be set up in about any manner that is, “reasonable and consistantly applied*.” The IRS, on the other hand, has all assets divided up into, I think, 7 types that are depreciated over 2 to 30 years. Computers, for instance, are depreciated over 2 years, building over 30, etc. It’s been a while since I’ve worked with this and things may have changed
*A mining company I worked for in Wyoming depreciated everything based on the number of tons mined.
I would like to restate my question because it seems that people are either not understanding it or are deliberately ignoring it. If the tax is computed on the (income - expense) value, the bigger the expense, the lower the tax. This means that if the company is not interested in demonstrating profitability and wants to reduce the tax, it can continually reinvest the money into building bigger and better things, such as by undertaking new projects, hiring new people (or increasing salaries for present ones), buying new inventory etc.
Is the above statement valid? Are there reasons for a corporation to not do what I said and instead report a taxable profit and pay a tax on it?
I haven’t read the links other posters have provided, but note that expenditures is not the same as expenses.
Expenditures are cash outflow, and expenses are when an asset gets “used up.” Depreciation is an expense but not an expenditure. Buying a factory machine is an expenditure but not all of that cash is an expense in the year of purchase. Many consumable assets (e.g., office supplies) are just considered an expense when the cash is spent for simplicity’s sake, rather than trying to track when every pencil actually gets used.
A company that faces the prospect of making a profit on its operations in a given year can, as you suggest, avoid making a profit and instead break even or lose money by, for example, increasing its payroll costs.
If it does this, the company’s owners will be worse off than if it makes a profit and pays tax on that profit.
The company’s owners will likely be unhappy with this outcome and may wish to fire the company’s executives (whose job is to maximise shareholder value) and replace them with executives more committed to profitability.
A company will often choose growth vs. profits, though this strategy is not usually driven by tax implications. In a growing startup tech company, the owners would be only too happy to watch earnings plowed back into growth so that their ownership stake inflates. Sometimes this implies that the company may take years to see a profit. This is true of many of the startups that survived the tech bubble; Amazon and Google are probably examples, though I have never studied them. OTOH, not too long ago Microsoft starting paying a dividend, IIRC, which is a way of distributing profits directly to shareholders, rather than reinvesting it back into growth. This was actually seen by many as being negative with a tech company that should be expected to innovate and grow. Dividends have always been most commonly associated with large, stable companies that turn a reliable profit but don’t grow much.
My point is that some companies put earnings back into the company, some save it up and pay dividends, but nobody makes their business strategy revolve around tax implications.
You forgot an alternative, that you in fact have not been understanding the replies.
This would in fact be the most likely alternative.
As another noted, expenditures and expenses are not a precise identity.
If for some queer and peculiar reason a company wished to minimize direct taxation paid on its corporate income, it could invest in tax-driven expansion, although rationally speaking that would likely lead to wasteful, suboptimal uses of capital, that would in the near to medium term destroy wealth. Similarly pricing up its salary base would surely in the medium term render it non-competitive.
I suppose
Excepting ignoring the real economic consequences of such a myopic focus on tax, vaguely. It might even be vaguely valid for some kind of proprietorship where Owners and Managers are the same (although generally speaking increasing their direct salaries rather than taking corporate income - depending on the tax regime and its favourable treatment of such - probably is less tax efficient, and certainly highly distortive of business judgement).
Management being incompetent fools? Wishing to stay in business for the long run and maximise economic profit?
wmfellows,
why don’t you do less name calling and more clear exposition of facts? In what way would paying bigger bonuses to employees, some of them owners, cause bad business judgment? What’s wrong with re-investing of money?
Incidentally, what is the typical taxable profit reported by various types of businesses nowadays, e.g. categorized by their size or industry? Are there some industries notable for usually reporting lots of profit? Are there others notable for usually reporting practically no profit?
Since you feel people aren’t answering you clearly enough, let me try to be really clear: There’s nothing about your statement that’s invalid. It’s just not good business per se and when it is good business it’s not good business because of the tax implications.
CookingWithGas pointed out that tech startups usually have so much growth opportunity that they spend well beyond their earnings and would have heavily negative cashflow if not for financing activities.
Normal companies COULD peg investments to intentionally zero out earnings so your idea is valid, the problem with it is nobody would do that just to avoid taxes. It doesn’t make any sense.
As an analogy, personal income tax differs from corporate income tax in that only certain expenses are deductible for indviduals whereas all are for corporations. But imagine that’s not true and on 12/15 you realize you’ve spent $35,000 less than you earned in 2009. Could you spend $35,000 on a new car to avoid paying any taxes in 2009, because your earnings for the year would be $0? Yes, it’s a valid idea. But nobody would buy a brand new car just to avoid paying income tax. You buy a new car because you can afford it and you need it.
(not to imply taxation isn’t an important consideration to a business or a person, but you’re basically proposing it be the primary motivator)