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  • Cash vs. Income

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    When you have a small business, you need to maintain accurate records of business financial transactions. If youve separated your personal and business bank accounts (which you absolutely must, no matter how small you think your business is), this should be relatively easy; however, not all of these transactions affect your taxes the same way, so how do you know what matters for taxes, and how do you know if your business is doing well? Youll find these might be two very different questions with very different answers.

    You pay taxes on income

    The United States, and many of the states in it, have an income tax. That means, simply put, when you make money, you might pay part of that money you made in tax. You see this directly on a paystub or your W-2. If you have a business, and the business makes a profit, you have taxable income. You also pay tax when you report a gain on an investment, say, from gaining interest on savings or selling stock that has risen in value.

    Note, though, that you dont pay any tax until you sell that stock. You can own shares of a successful company that have risen in value tenfold since you bought them, but as long as you hold the shares, you dont pay any taxes. You could hold those shares for 100 years (well, your heirs could), and never pay any income tax on the investment; in fact, estate planning attorneys and accountants spend a lot of energy and time trying to find ways to move assets from one generation to another while minimizing taxable income in those transfers.

    You live on cash

    Day to day, week to week, we focus on the balance in our checking accounts. We need to know how much cash we have so we can get more of the stuff we want and need. When we need stuff, we dont care how the money got into our checking accounts; we just need to know its there.

    The same holds for businesses. As long as the cash sits in a bank account, it isnt taxable. Notice I said a bank account. Moving the businesss money from its account to your personal account does not make it taxable, because its cash, and we dont tax cash.

    But isnt moving the money a transaction? Sure, but you own the business, so you already own the money the business has. Moving money from a business account to your personal account is, in terms of income tax, the same as moving money from your checking account into a savings account. (The only exception is if you take more money out of your business than you have equity in it, which would lead to capital gains taxes, but we can help you make sure that doesnt happen.) That also explains why leaving cash in a business account wont prevent you from having to pay income tax on the pass-through income (if you have an LLC or S corporation).

    To sum up, we tax income, but we do not tax cash. Recognizing the difference between income and cash can help clear up a lot of frequently asked questions, such as the difference between wages you pay yourself from your business (deductible expense for the business and taxable income to you) and distributions of cash (not deductible for the business but not taxable income to you).