Here's a pop quiz: Closely held companies are run for profit:
( )Yes ( )No ( )It depends.
If you guessed "It depends," you guessed rightit depends on what you mean by "profit." Is that new branch office at Aspen a business expense or is it profit? That depends on whether you are more likely to be selling ski equipment or using it. What about the company maintenance crew that keeps the shrubs trimmed and the garage painted at the house? That depends a lot on the size of the home office and, maybe, finding a way to get the neighborhood commercially zoned. Then there's that corporate aircraft, membership in the Young President's Organization, the country club dues, attendance at the Soda Straw Association meeting in Cancun. Business expenses? Profit? Again, it depends.
Truth is, it's not smart to show too much accounting profit. That gets taxed; business "expenses" don't. It makes sense to break even, higher and higher every year. Or so it seems.
I once worked with a furniture retailer in the Southwest who had a unique approach to blurring this line between expense and profit. When Grandpa and Grandma founded the company, they realized furniture inventory could either sit in their warehouse or in their house. So, what the heck, they figured, use the house. Of course, that filled their rooms, leaving no need for them to buy their own furniture. But shucks, what was a little sacrifice?
Their pseudo warehouse space increased proportionately with the employment of their five children. The same reasoning became a family tradition. By the time I met them, some members of the third generation were involved in the business, and others were considering the possibility. Predictably, they all wanted their piece of the "tradition." This would have been fine, except the growing business now needed furniture in the warehouse.
Tension was growing. The most recent family hires were getting less "warehouse" furniture than their older cousins who, in turn were reacting like Social Security recipients: We got ours;you might not. What a shame. A pre-tax "perk" that was a good idea 50 years before was beginning to chill a family's soup.
Most business owners know very well what I'm writing about here. For some, tax avoidance grows into a profitable, almost mesmerizing, hobby: a challenging, absorbing, serious game, played for real dollars by people who have a lot at stake. Not everyone goes as far as Leona Helmsley, but some indulge in a little sleight of hand and loose interpretation.
I have seen businesses support flying hobbies, show horses, race cars, art collections, and all sorts of defensible "expenses," each of which enhances the lifestyle of the owners, is free of personal tax, and is deductible by the business. If I've seen a lot, you can be sure the IRS has seen much, much more. It's sort of the American way. This is, after all, a nation that grew out of deep agricultural roots, and who's better than the American farmer at maintaining a lifestyle on what appears to be no cash income at all?
My clients were simply taking one of the few tax advantages available through their business, a little economic benefit to help offset the heavy personal tax bite. The benefits of G&A dividends are obvious. Many companies survive them very well indeed. But these survivors remind me of the panel cartoon depicting a king telling his son, "If you're very, very careful, Son, absolute power corrupts only a little bit."
Using pre-tax dollars for personal benefit is like taking mild "recreational" drugs. In theory, the practice can seem innocuous. In reality, it can develop into financial substance abuse: damaging businesses, fraying business relationships, demoralizing employees, even destroying families.
The alternativeplaying it straight above the bottom linehas a major disadvantage: You pay more taxes. But the benefits of going straight can be significant. You can set real expense and profit targets for your managers; you can use your accounting system for managing rather than for confusing prying eyes. You can show your financial results to the people who need to see them. You can base a compensation system on business performance without key people resenting the owners for depressing profits.
Perhaps most important,you can begin to separate family needs from businessneeds, making it clear toeverybody that the mostfruitful financial future lies ina growing, profitable business,not in a pre-tax personalbenefit scheme.
For the furniture retailer,the symptoms of abusebecame evident: Familymembers were hiding newfurniture pieces, were strickenby periodic amnesia aboutwhole rooms full of furniture,and were putting the "tradition" ahead ofthe best interests of both family andbusiness.
Fortunately, the addiction was recognized before the situation deteriorated beyond repair. Once recognized, it was simply stopped. Cold turkey. Some family members came close to falling off the wagon a number of times, but they held on. And survived.
It's our decision, of course. We can play with pre-tax dollars if we want, but we had better respect their power to destroy. At the very least, we should keep our eyes open for signs of financial substance abuse. When they come, common sense says bite the bullet, pay a little more tax, and run the business clean and straight, like a real business, not a personal tax shelter.