Immediate Expensing For All Expenses
Deducting business expenses from revenue to determine net taxable income is something that is well known to all businesses. Without the ability to deduct legitimate expenses from revenue, every business would swiftly be out of business due to the enormous tax burden that would result. What is less well known is how the government taxes unsold inventory. In fact, many of the companies who suffer and go out of business from this hidden tax, never even realize what happened to them. The culprit is COGS.
The Cost of Goods Sold (COGS) equation that all product-based businesses must use for calculating net income, was originally used (prior to the start of income tax in 1913) for aiding business owners in seeing the basic profitability of the products they sold during the course of a year. However, when used in tax accounting, it becomes a simple yet deadly equation, even taxing inventory that has not yet been sold.
While this statement may seem outlandish at first glance, consider the following: The COGS equation is: (Beginning Inventory + Inventory Purchases) – Ending Inventory = COGS. Nothing mathematically wrong with that. However, if the business has more Ending Inventory than Beginning Inventory, they get taxed on the value of increased inventory at full income tax rates. Keep in mind that the business hasn’t even sold this excess inventory nor made any money from it. To the business, it’s an expense, not income. And when the inventory is eventually sold the following year, income tax is due again on the profits… effectively a double tax.
As an example of the negative impact of this, look at 2008. The year was cranking along economically, so businesses stocked up on inventory in anticipation of a booming 3rd and especially 4th quarter. (Financial industry people knew better, but the average merchant had no idea what was coming.) Then everything hit the fan in the latter half of September with the stock market crash and everyone stopped buying just about everything, leaving businesses with massive inventories at the end of the year which they then had to pay income tax on. Why so many lay-offs and businesses going under in 2009/10? Between the credit crisis and this tax penalty on increased inventories, even normally healthy businesses could barely survive. Many did not.
In summary, the problem with current COGS accounting rules is that businesses have to pay income tax, in cash, when that cash is tied up in products sitting in the warehouse. This is especially painful for first year startups, as their beginning inventory is typically zero, and their cash flow is being robbed by the IRS just when they're starting to get off the ground. The inventory is an expense to the business owners, but the IRS effectively considers it income. This causes businesses to hold back ordering more products for Q4 which can lead to shortages in that normally strong sales quarter. It can also lead to businesses dumping excess inventory at the end of the year by slashing prices and cutting their profit margins. A very unstable business cycle results either way.
A small business that I own has experienced the “COGS Penalty” repeatedly. Here are the results of it over a 10 year period:
So that's how COGS can hurt a very small business. Let's see how bad it can get by looking at a very large business. Here is the COGS penalty that Wal-Mart has had to endure over a similar 10 year period:
That's nearly $4 Billion dollars in additional income taxes Wal-Mart has paid over the past ten years, simply for the privilege of growing their business. This was income tax paid not on income, but on unsold inventory. And then they had to pay income tax again, once the inventory was sold the next year. Imagine how much Wal-Mart could have grown their business and how many more people they could have employed if the IRS didn’t take that $4 Billion from them.
OK, getting back to figures that mere mortals can relate to...
I have another personal example of how COGS hurt my small business in December, 2010. At the end of that month, our ending Inventory wound up being $164,562 higher than our beginning inventory. Our business had grown a lot in 2010 and we didn’t want to get caught being out of stock of our best-selling products at year end as happened the previous year. In order to grow with product demand, we had to stock up as compared to the prior year. However, we ended up paying the IRS over $57,000 ($164,562 x 35%) for the privilege of increasing inventory and growing the business. And that $57,000 was not tax on profits; it was strictly a tax on products sitting in our warehouse. Because of this, we nearly cancelled construction we were planning for our warehouse space to add second floor offices and a showroom. The cost of the build-out was about $100,000. If we had cancelled the project, the contractors who were hoping to get a nice boost to their business in what is normally a slow month would not have gotten it. The suppliers of building materials would not have gotten a boost either, and on down the line. The project did get delayed a bit, but it was completed later in 2011. Of course, with 39-year depreciation, we ended up paying income tax for 2011 on most of that $100,000 as well.
Eliminate Depreciation - Expensing Assets
Businesses cannot just "expense" asset purchases including inventory, equipment, buildings, etc. When a business spends money on assets, that money comes out of the business bank account, just like with normal operating expenses. But due to double-entry accounting rules (which go all the way back to 14th century Italy), asset purchases are merely considered an exchange of one asset (cash) for another asset (building, equipment, etc.). And that makes sense on a balance sheet. But it does not make sense on an income statement used for calculating income tax. Here’s why…
Under tax law, the business can only “depreciate” an asset over a period of years (for tax deduction purposes), even though the business takes the hit to its cash flow only in the year it spends the money. The business really needs to get the expense deduction (to lower its net income) in the year the expense happened in order to maintain a healthy cash flow, but the IRS doesn't allow that. Of course, the IRS will grant deductions over a period of years, but by then, the business might be out of business due to poor cash flow.
For example, if a business pays $500,000 cash for a new building (or the down-payment on one, as the case may be), the business should be able to deduct the full $500,000 in that tax year. Why? Because in terms of cash flow, it’s an expense, not income. Unfortunately, businesses are forced to use a 39 year depreciation cycle, effectively nullifying any tax deduction for the huge expense of a new building (the same is true for capital improvements to an existing building, by the way).
So, let’s say that $12,821 (1/39th of $500,000) can be deducted from revenue (a.k.a. “expensed”) for the first tax year. That leaves $487,179 that will be taxed at full income tax rates, assuming it was earned in the same year. The new tax laws will tax that amount differently depending on whether the company is a corporation or LLC, but it’s going to be a lot of cash going to the IRS either way… cash that is tied up in the building, not in the company bank account. The business is getting taxed on a cash outflow… you could even say it is getting taxed on an expense. Yes, the business owns the building, so it’s not an expense in the traditional sense. However, if the building increases in value, the business would pay capital gains tax when the building is sold. And they would actually have the cash at that point to pay the tax.
What about Section 179 and Bonus Depreciation? Those help to reduce or eliminate the depreciation penalty, right? Yes, for certain types of equipment in certain situations, but not for real estate nor even improvements on real estate. While it’s great to have Section 179 in the tax code, it is only a temporary section that can be removed at any time. If Democrats control Congress again, it’s gone. And as with any business-friendly rule in the tax code, it comes with many exclusions and qualifications, complicating that which should be simple. Mandatory depreciation of all asset purchases, whether for a new building or a computer, should be permanently eliminated from IRS rules.
This is not about avoiding income tax. It’s about applying income tax appropriately only on cash inflows. So called “cash equivalents” (depreciation, accounts receivable, etc.) may have real value to a business and therefore should be included in determining net worth, but the U.S. Government does not accept payment of taxes in cash equivalents. Taxes can only be paid with cash. In a nutshell, depreciation and COGS fail in tax accounting because taxes cannot be paid with fixed assets or even non-cash liquid assets.
For information about the history of Depreciation, click HERE.