Perspectives on Profits in an IT Service Company
6/13/08 at 10:26 AM by Frank Coker The idea of profits in an IT service company can be very confusing. Most small business owners get the idea that they should avoid profits in order to minimize taxes. But they often miss the part where you need to be a profitable business if you ever want to get a bank loan, attract investment capital, bring on new partners or build a business that can acquire other companies or perhaps be sold. If you get this right (and many companies don’t), it can have a huge impact on your business and on the cash that you ultimately pull out of your business.
Unfortunately most accounting firms and financial controllers fall into the “simplicity” trap and do not consider broader business goals. This often results in the IT service company owner receiving short-sighted advice but great solutions for minimizing taxes.
Point 1: Tax reporting and financial management reporting do not need to be the same. In fact most medium and larger companies have several versions of financial statements for different audiences: tax reporting, shareholder reports, public financial statements and operations management statements.
To the inexperienced business owner this may seem redundant. The fact is, a one-size-fits-all approach to financial reporting can be limiting and potentially damaging. Financial reports need to present information in ways that are meaningful to the various audiences. Any knowledgeable IRS agent would tell you that this is exactly how it should be done.
For most small businesses it’s hard enough to produce one set of financial reports and rarely do they produce reports for anything other than tax reporting. As a result, discussions of business profitability are often not explored by these companies. They think their goal is to show no profits. If you show profits you have to pay taxes twice: once on the profits of the company and again when profits are distributed to the owners as compensation, dividends or operating distributions. So eliminate profits and pay taxes one time – right?.
If you are an S-Corp this is less of an issue because all profits are considered to be personal compensation to the owner(s) and there is no separate corporate tax. If you are an LLC there are several ways that you can distribute profits and avoid double taxation and a C-Corp also has multiple but fewer options. But in all cases tax reporting is about minimizing profits, and that is separate and distinct from other financial reporting which should maximize profitability. The numbers on all reports still tie together, but communicate completely different messages.
Point 2: Managing business owner compensation is a key starting point for getting the profit story right. Owner compensation should be divided into two distinct components: base pay and performance pay. From an IRS reporting perspective this all gets lumped together and usually leaves the company with zero or minimal reportable profits. From a financial management perspective, owner base pay is treated as a recurring expense and owner performance pay is part of company profits. Owner base pay needs to be paid consistently every month even if that means that the company generates a loss. Performance pay only occurs when all other financial obligations have been taken care of and there is actually a profit. In the financial Profit and Loss Report, owner base pay is an expense and is included in the calculation of profits or net income. Owner performance pay is listed after profit or net income. Now you have a clear picture of profits (before performance distributions to owners) and this is key to maximizing the equity value of the company.
Point 3: Using cash-based accounting for tax reporting rather than accrual can result in a more realistic tax liability, but is generally not the best for reporting to other audiences. Some companies use cash-based accounting for revenue and accrual-based accounting for expenses for tax reporting in order to get the greatest advantage. You need to understand the overall financial (cash flow) patterns of your business to make this decision, but once you make a choice you need to stay with it and be consistent. Mixed cash and accrual based accounting may be too complicated for most businesses, but it is usually easy enough for an accountant to take accrual-based reports and generate cash-based numbers for tax reporting purposes. Then the accrual-based data can be used for reporting for lenders, shareholders, etc. Most accountants can easily support mixed-mode accounting but will often suggest that you simplify and optimize for taxes. This simplification will compromise the way you are viewed by other audiences.
Adding a little financial reporting sophistication can make a big difference to owners. It can influence the way a third party defines the value of your company, it can determine how much you pay in interest for a loan and it can give you a big advantage when you compute share values for new partners or shareholders.
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CoreConnex provides the Corelytics(tm) Financial Dashboard and specializes in professional services automation (PSA) software for VARs, MSPs, channel distribution partners, IT service providers and other professional service companies. We encourage you to share experiences and perspectives as players in this professional community. This blog is moderated. Comments that are unprofessional or derogatory will not be posted.
