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Thinking Like An Entrepreneur
Table of Contents

Chapter 3
Men Are Cheaper Than Guns

Chapter 4
Intellectual Capital And Bootstrapping

Thinking Like An Entrepreneur


Intelligent Reinvestment Of Pretax Earnings

Or: Just How Much Does A 33˘ Stamp Cost, Anyway?

New business owners sometimes have difficulty separating their business from their personal lives. This is especially true of home-based business owners, who work and live at the same location. I'm not talking about thinking about your business when you should be spending quality time with your spouse. Or, even, getting your business work done with all the home distractions, such as the cat being sound asleep on your printer when you need to print a business letter. I'll leave dealing with issues like that to you. I'm talking about keeping your stamps straight.

Most business owners are very conscientious about recording all of their business expenses and deducting them from their income taxes. In fact, some business owners try to record everything as a tax-deductible, business expense. The trip to Jamaica, for example!

But, occasionally, it happens. You have a business letter that must go out, and you write it from home. For whatever reason, you don't have any postal stamps on hand. At least not any stamps purchased by your business. But, in your personal, or maybe your wife's, stamp bowl sits a brand-new roll of 33˘ stamps.

You peel off one stamp. You put the stamp on the letter and send it on its way. You don’t bother to record the stamp as a business expense. You don't reimburse your spouse. You assume it's only a minor expense. And, it is. You don't make it a point to have some business stamps on hand when you write your next business letter.

But, just how much does that 33˘ stamp cost you, anyway? This question is too tough for "Who Wants To Be A Millionaire?" The most unlikely answer is 33˘. Because the stamp was purchased with money that you (actually, your wife) received as personal income, you are paying for that stamp with after-tax dollars.

Assume you are in a 34% income tax bracket (say, 28% Federal and 6% State income tax rates). Of every dollar you earn, only $0.66 remains after income tax. Every personal purchase made actually costs you the purchase amount divided by 0.66 in pretax earnings. That's how much you must earn to buy something.

That silly stamp cost you 50˘. You needed to earn 50˘ in personal pretax earnings to pay for it. That's the stamp's actual cost because you didn’t properly record it as a legitimate business expense. We're assuming the stamp is a legitimate business expense. The stamp's not on a personal letter to your mom, for example!

Now, how much would the stamp have cost you, if you had properly recorded it as a business expense? Here's where the question becomes a bit more complex. Let's assume that your company’s earnings are also taxed at a 34% income tax rate (for example, you're a sole proprietor and your company's tax rate is just your tax rate. Or, you're paying dividends from an S-corporation and your personal income tax rate is then equal to the tax rate of earnings paid out as dividends from the S-corporation. We are not assuming double taxation of both the company earnings and then your personal income, which occurs if you were to pay dividends from a C-corporation, for example. We're just assuming that your company's earnings are taxed at the same rate as your general, personal income.)

Because the stamp is a business expense, it can be deducted from your business income when figuring your taxes. Hence, you get a tax savings of 34% of 33˘ which is about 11˘. This means the net cost of that stamp to you is only 22˘, after allowing for the tax deduction.

The difference between properly recording a stamp as a business expense and failing to record it as a business expense amounts to ($0.50 - $0.22) or about 28˘ per stamp. You're paying about 127% more for the stamp when you fail to record it as a business expense!

We learn several lessons from the stamp.

First, the importance of not absorbing true, tax-deductible, business expenses without recording them. Having separate checking accounts for your business and your personal funds is really necessary for all business owners, as it makes the separation of legitimate business expenses from personal expenses clear.

Secondly, if you work from home, it is important to have a few business stamps and other similar supplies on hand. Of course, you could reimburse yourself for the stamp later. But, it seems easier to just keep a small supply of such business consumables on hand.

In our calculation of the stamp cost, when it properly recorded as a business expense, we assumed the stamp was paid for with pretax dollars. We assumed it cost us 33˘ (and not 50˘) to buy the stamp and, later, we saved 11˘ in income tax which we would have otherwise paid.

This brings up the question: "Was the stamp in fact purchased with pretax dollars? Or did it really cost us 50˘ with a tax savings of 11˘ for a net cost of 39˘? In other words, was it purchased with after-tax dollars or pre-tax dollars?"

It depends. Consider two scenarios.

Scenario 1. It is the beginning of the tax year, and no revenue has been collected by your company yet. The stamp is purchased using retained earnings from last year, which have been taxed as company earnings. Or, else, the stamp is purchased with money paid into your company as equity (owner investment), which has already been taxed to you as an individual. In this case, the stamp was purchased with after-tax earnings, and you ultimately needed to generate 50˘ to purchase the stamp.

Scenario 2. Suppose your company has generated revenue via sales. Suppose a customer pays you 33˘ for a rather low-priced product. You buy and use a 33˘ stamp using the money from the sale. It is a legitimate business expense. At the end of the year, your taxable income, given the one sale and one stamp purchase, is zero. In this case, you have paid for the stamp using pretax earnings. You never had to generate 50˘ to buy the stamp. You only had to generate 33˘ to be able to buy the stamp.

The second scenario is how most businesses pay for their expenses. They pay for their expenses using current cash flow and pre-tax earnings. They buy cheaper stamps!

Generally, tax-deductible expenses are thought of as costs necessary to market, sell, produce, and deliver your product to the customer. The matching principle of accounting says expenses should be pair up with the resulting revenue that they generate.

However, some items which are legally classified as currently tax-deductible expenses do provide future benefit. A common example is year-end marketing efforts. Suppose it is approaching year end, and your company will have great earnings for the year.

Suppose your company is going to launch a direct mail campaign to locate new customers. Neglecting seasonal effects of responses to direct mail, there is a clear advantage to launch the marketing campaign before the current tax year ends.

By launching the campaign before year's end, you acquire a current tax deduction lowering your reported income. The stamps cost you 33˘ rather than 50˘. You are paying for the promotion with pre-tax dollars. Hopefully, the effort will increase next year's profit!

The lesson is that currently-legitimate, tax-deductible expenses which are investments creating future company value are especially valuable and should be sought.

Notice, while tax effects are significant, the decision whether or not to undertake the marketing promotion (or any other business decision, for that matter) is only dependent upon whether or not the promotion will likely be profitable, neglecting all tax effects. If you spend $1 pre-tax on the promotion, the result had better be that you generate more than $1 pre-tax in the resulting earnings.

For more information on tax-deductible business expenses, I suggest getting a copy of IRS Publication 535, "Business Expenses."

Peter Hupalo