Most business owners pay too much tax. Nearly the same number of business owners don’t understand their Financial Statements. Specifically, they don’t understand their Current Accounts.
The lack of understanding and paying too much tax go hand-in-hand.
In our experience, the best way to reduce tax is to fix that understanding.
What’s on the line is more cash going to the taxman, which will in turn affect your plans to reinvest in your business, increase staff wages, or take your much-needed holiday.
In this article, we’re running through what a Current Account is, and why transactions going through this account are about 30% more expensive than your regular business expenses.
It’s like a bank
When a business is short on cash, they usually get it from one of two places. They either go to the bank and get an overdraft, or they go to the owner and get cash from their personal savings (or personal overdraft…).
So, think of your Current Account as being like a bank loan from you to your business. It’s the cash you’ve chipped into your business over time to get it off the ground.
Put another way, the business could have gone to the bank in those down times but instead they came to you, the owner. Instead of calling it a Loan Account with the bank, it’s called a Current Account with the owner.
And it often doesn’t get repaid
Often, Current Accounts don’t get repaid. The business needs more and more cash to keep going, instead of having free cash it can use to repay the owner.
A bank would demand that a Loan Account got repaid overtime (with interest). Shareholders, on the other hand, are usually more relaxed and don’t demand repayment on their Current Accounts.
Now, this isn’t necessarily a bad thing—it just indicates a business owner who doesn’t take an investor’s attitude towards their business. Ultimately, the shareholder is making an investment in their business on terms that their a bank wouldn’t be willing to. But why would you invest with no/little prospect of repayment?
Plus, when repayment does come, it’s often an expensive repayment that causes an additional tax bill (more on that soon).
Things on your P&L that reduce tax
Let’s go back a step for a second. If an expense is on your Profit & Loss report, then it’s keeping your tax bill down. Or, if you’re paying for something and it’s on your P&L, then it keeps your tax bill down.
If it’s hitting your Balance Sheet, then it’s not reducing your tax bill. Anything through your Current Account is hitting your Balance Sheet, so it’s not keeping your tax bill down.
Often, a “holiday” gets put to the Balance Sheet through the Current Account. It’s put into the Current Account to repay the owner for the funds they’ve put into the business over time.
It’s either put there by a business owner who doesn’t understand what their Xero account is doing automatically, or by an accountant who’s not asking the right questions (whether it was a holiday or business trip).
To recap, the art of reducing your tax is to move things from the Balance Sheet to the P&L. This means moving appropriate transactions from your Current Account to the P&L.
What we’re trying to do is avoid repaying the Current Account with small rats and mice transactions (like the holiday), and repay with meaningful cash transactions. These meaningful transactions can then be used to build wealth outside of the business, rather than being squandered.
So, what can I move?
If there’s a connection between the money going out of your bank account, and your business earning income, then you’re (generally) entitled to claim it on your P&L (*).
So, if it’s a family holiday then it needs to go to the Balance Sheet – it’s not connected to you earning income, it’s connected to you having a break. If, on the other hand, it’s a work trip, then it’s definitely connected to you earning income.
Now this is a relatively black and white example, but there are plenty of other transactions we see going through people’s Current Accounts which are a shade of grey. If you can justify moving the grey to your P&L instead of the Balance Sheet, then you’re able save (roughly) a third off your tax.
* Unless it’s an asset or a non-deductible which is a whole other article.
Once you’ve fixed your P&L…
Now that you’ve got as much as you can out of your Current Account and into your P&L, then it’s time to fix the cashflow for your business.
This is easier said than done, but ultimately needs to be addressed. Why would you be a bank to your business, if a mainstream bank isn’t willing to be a bank to your business?