Taxes: Paying Less Now May Cost You More Later

Steve Parrish for Forbes writes: Lately, a popular expression has been “be careful what you ask for, because you just might get it!” I’ve heard it used with issues as diverse as gun control and pet care. As trite as this adage may sound, it remains good advice for business owners. Here are some odd-ball examples I’ve run into recently:

-   Total U.S. sales of laundry detergents fell 2.1% in the last 12 months from March. The Wall Street Journal reports that this is due in part to the fact that Proctor & Gamble introduced pre-measured pod detergents. Apparently, in the past, soap makers could count on additional sales because some consumers poured in too much detergent with each load.

-   Closer to home, I recently heard about a company’s change from standard paper-towel dispensers to automated machines. Wave your hand over the sensor and out comes a pre-measured towel.  Building managers report that money is saved because fewer towels are used with the new technology. However, additional costs are incurred because the dispensers need batteries and require more maintenance and repair.

It occurs to me that this “look before you leap” philosophy can impact tax decisions for business owners as well. Below are examples I’ve incurred where owners, in an effort to save on taxes, hadn’t thought through the consequences of their actions.

Loss of control: Three brothers I worked with, too late I might add, were intent on avoiding estate and gift taxes. They essentially had given up legal control of their family owned business to the next generation through a complicated set of trusts and partnerships. What they didn’t realize, however, is that in saving transfer taxes, they were also relinquishing their vote. Now that the next generation is of age, the brothers may be losing both their generous salaries and their Board of Directors meetings in Switzerland.

When saving tax is a bad idea:  Last week I received documents on a company that has an elaborate business continuation plan. They set up a buy-sell agreement providing that, upon exit, the respective owners must sell their shares back to the company at book value. This is a business with almost no book value. Clearly designed to coordinate with this arrangement, they also have an intricate nonqualified deferred compensation plan that makes substantial payments to these individuals upon departure.  Obviously the idea is to have most of the payments to departing shareholders be tax deductible.  The problem with this scheme is that it is a bad idea. For the shareholder, it wipes out their tax basis and converts long term capital gain into ordinary income. For the company, it is essentially a “kick me” sign for the IRS to attack the tax deduction from a number of different fronts.

No earnings, no sale:  A business owner I know took advantage of what he called “aggressive tax planning” (in other words unreported income and excessive deductions) during the pre-Recession years to drive his company’s taxable earnings down to zero. Then, during the recession, the sour economy pretty much took care of keeping his taxable income at a minimum. His company is back in the black now, but he is having trouble finding an investment bank willing to handle the sale of his business. The long streak of poor paper earnings is making it difficult to package as a profitable business. In this buyer’s market where deal makers are skeptical of claims of off-the-book profits, no earnings means no takers.

The lesson we can take from these examples is that just as a business plan should consider product packaging and expense management, it should also consider the ramifications of tax decisions. Simply focusing on tax savings, without considering other consequences, can have undesired outcomes. Be careful what you ask for!