My Big Tax Mistake of 2016

11 May 2017

In early March I received some shocking news from our accountant: My company’s tax payment for 2016 totaled nearly all of our current cash flow. Suddenly, hundreds of thousands of dollars we needed for manufacturing costs were being funneled into checks to the federal and state governments.

It sucked. Big time.

So last week I met with my accountant to see what we could do to avoid another surprise next year. I thought I’d share what I learned with you so you don’t make the same mistake I did.

***

Stonemaier LLC uses the accrual method of accounting to calculate our taxes. This means that for tax purposes, all expenses and revenue count in the year that we ship the product to customers.

You may recall that Stonemaier raised $1.8 million on Scythe’s Kickstarter in November 2015. We also spent a significant amount of money in 2015 to begin production of Scythe (we pay 50% of manufacturing costs up front and 50% upon delivery). But that revenue and expenses didn’t count towards our tax calculation in 2015 because we didn’t ship Scythe to backers until mid-2016.

Flash forward to the end of 2016. We had a good year, with various products being manufactured and shipped within the same year. In December, we began production on 30,000 copies of Scythe (the 6th print run). This was a significant investment, and while our cash flow took a hit from it, it was still pretty robust.

That’s when I heard the news from my accountant.

***

I can trace the issue back to a decision I made in early 2016. It was then that my accountant asked me how I wanted to estimate my quarterly earnings for tax estimates. There are two ways to do this: (1) use the previous year’s tax return or (b) use projections for the current year. I chose the former, opting to pay lower quarterly estimates so we’d have more liquid cash.

So really, I shouldn’t have been as surprised to owe so much when our total 2016 taxes were calculated. (I do our monthly bookkeeping based on cash flow, not the accrual method.)

However, I learned something from this mistake: You don’t have to calculate all 4 of your quarterly tax estimates at the beginning of the year. Rather, you (or, more likely, your accountant) can do this each quarter. So if you have high expenses or low sales in the first quarter, you don’t have to give up what little cash you have remaining to pay your quarterly estimate.

This method will be particularly helpful at the end of the year. If at that time we had a clearer picture of our 2016 outlook, we could have potentially made some purchases in December to decrease our net earnings. Of course, as my accountant said several times, “You usually don’t want to spend $1.00 to save $0.40.”

***

Overall, there isn’t much we could have done to reduce our 2016 tax burden. What I could have done, though, was better anticipate the upcoming tax payment and plan accordingly with other investments. For example, while I still would have proceeded with the big print run of Scythe, I may have asked distributors to pay at least part of their commitment up front instead of waiting until they received the product.

Did you learn anything from your 2016 taxes from which other creators may benefit?

Also read: Kickstarter Lesson #4: Accounting and Finances

25 Comments on “My Big Tax Mistake of 2016

  1. The single most useful piece of business advice I have ever been given is that, each month, you should put 30% of income in a deposit account. That way you will have enough money to pay taxes no matter what.

    (This is from a UK/EU perpsective, where you pay 20% VAT each quarter; in regions with lower sales tax, the precise amount will probably be different).

    1. I really like that! I do something similar with my personal funds–I set aside money for retirement, a future car, travel, etc. Doing so helps me separate liquid cash from cash I’ll need at some point. I should do the same for Stonemaier.

    2. Totally agree, this was something I started doing when I started my own business. My business partners did not, and they had some horrible tax issues to deal with, while I just sent my saved money off to the IRS to cover my tax liability. Hard to do sometimes, but much cheaper than not having the money when the bill comes due.

  2. Suppose you have a middle man to convey KS funds. In my example I’ll use rough numbers.

    1. You spend $5000 up front for your campaign (anything, from art, videos, to FB ads)
    2. Campaign is a success way better than anticipated. Let’s say, $100,000/$10,000 (10x)
    3. After some card problems and KS gets its cut, about 90K available to middle-man.
    4. Middle-man arranges payments for you the current year, for a fee: Could be 5K sent to artists, 25K to factory for manufacturing, 5K for attending Cons, 2K for merchandise, 8K to shipping method. Around 45K.
    5. If next project is already on its way, the initial capital could be drawn from middle-man too. Suppose next year’s 5K.

    So, after an unexpectedly successful campaign of 100K, everything is paid and you get 100-45-5-(middle-man’s fee) dollars. Assuming everything is done in the same financial year, your total gain (which is the one taxed) is below half.

    Now think about it in millions.

    PS all numbers are arbitrary. Middle-man can charge what he wants, assuming he’ll have to pay for his tax too.

    1. The issue I see is that if this middleman is really a separate entity he/she will have the same tax issue of a huge tax bill. They will need to report all the income net the expenses you mentioned. Unless they are doing this for lots of entities and can net them out all together it won’t work. Plus you have the trust/contractual relationship to work out. I don’t trust anyone that much. I think Jamie just needs to call his account more often :)

  3. I live in Sweden, one of the most #&€&%#% high-tax areas in the world. I have opted to pay taxes on a monthly basis, so they trail two months (sales and purchases in January due March 12 to our IRS), or one month for withheld income taxes (payable by employer).

    Chopping up the tax payments into quarters or even months if it’s possible in the US, is definitely recommended to avoid some nasty surprises.

  4. This is a great piece of advice, Jamey. I’m sure accrual vs cash accounting is not something every Kickstarter project creator thinks of, but it can have a big impact on cash flow when taxes are due if not monitored closely, as you’ve pointed out. I use the accrual method too, mainly because I wanted to simplify my income statement by incurring revenue and the associated operating costs in the same year (even if they were split between year 1 and year 2), assuming the point at which I receive revenue to the point the product is delivered doesn’t span more than two fiscal years.

    Though I hadn’t thought about how the accrual method could impact cash flow, and it certainly is a more risky accounting method for the very reason you mentioned. Cash Flow statements can be used to help manage these situations, but recalling back to when I was taking accounting in college, they are a hassle and require constant monitoring and attention.

    I really like Ludoquist’s suggestion, in setting aside a percentage each month, so at least you’re not completely hit without being prepared when taxes are due.

  5. Jamie, have a read of Profit First by Mike Michalowicz. Really interesting read and I’m sure it will help you a lot.
    Let me know what you think of it.

    Good luck,
    Matt

  6. I’m not an accountant, but do you only pay taxes on profit? Would you have known you were going to pay the tax might you had ordered larger quantities or additional games for reprints?

    1. Sean: I think the basic answer is yes, I only pay taxes on profit. Ordering more games wouldn’t have impacted profit using the accrual method, though (at least not in December), as those games wouldn’t have shipped to customers until 2017, thus deferring that expense to 2017.

    1. Rob: Good question. One thing I didn’t mention is that I do our monthly bookkeeping, but I do it based on cash flow (I find it difficult to use the accrual method on a month-to-month basis). So I always have a firm grip on cash and upcoming expenses. It’s just the tax total that really threw me off, and I’ll use the method I addressed in the post (quarterly analysis instead of annual) to fix that.

  7. My accountant is wanting to me switch to being taxed as an S-Corp rather than an LLC. Because, as an LLC., I must pay 100% of the 15.3% self employment tax (Social Security and Medicare) on my profits (I use cash bases so it’s profits for the year). But if I’m an S-Corp, my account says I only pay this on the amount I pay myself (and I’d pay myself like an employee with a W2) and not on all the profits of the company. With this in mind, I am not sure why any company would NOT decide to be taxed as an S-Corp. I would have saved $6K to $7K in taxes this year had I been an S-Corp. But maybe I am missing something?

    1. John: That’s an interesting distinction. I asked my accountant about the same thing, and while I don’t remember the exact answer, my impression was that the only difference was who was paying the self-employment tax (you or the company), not an actual decrease in the tax. But I may have misheard or misunderstood. Your answer sounds better!

  8. I know half of the self-employment tax can be deducted. I also know an LLC can be taxed as an S-Corporation. I remember meeting with an accountant when I set up “Arthurs Board, LLC “ (My gaming company) two years ago and asking about an S Corp. He advised against an S Corp due to the following: 1. less flexibility 2. increased complexity and restrictions 3. closer IRS scrutiny. Jamie, you mentioned doing the monthly bookkeeping. Is there a particular software or bookkeeping program you’d recommend?

    – Denny

    1. Denny: Thanks for sharing this information. As for bookkeeping, I’m embarrassed to say that I just use Excel. I’ve tried switching over to Quickbooks, but it just seems like a lot more work, especially given the number of small transactions we make.

  9. Great article Jamey! I’ve been a CPA for 11 years and have had to break this unfortunate news to clients over and over again. The best thing you can do is work with your accountant throughout the year. I’d suggest doing so at least quarterly if you are going to vary your estimated payments. Your CPA may not be able to save you taxes, but they may at least be able to set the expectation early to give you time to prepare.

    In regards to the S-corp versus LLC discussion, an LLC a multi-use entity type. It can be taxed as a single-member LLC, a partnership, or an S-corporation. There may be different state rules regarding formation, business meeting requirements, etc. In most states I deal with, the state does not care if you are an LLC that is taxed federally as an S-corporation. They just care that you are an LLC. However, you should contact your accountant or attorney regarding these for your state. Contrary to what Kingdoms Lawn Games, I have never experienced an S-corp receiving additional scrutiny by any taxing agency. It is probably the most used taxable entity structure type I encounter in my practice.

    John Coveyou is correct. If you are taxed as a single-member LLC or actively involved in the partnership you will pay self-employment tax on your net income. An S-coporation’s earnings are not subject to self-employment tax when they pass-through to its shareholders. Because of the potential avoidance of self-employment tax this creates, the IRS has enacted some “reasonable compensation” rules. These rules basically say that a shareholder must pay themselves a reasonable compensation for the work they do for the corporation. Another way of looking at it is – if I decided I’ve had enough, what would I have to pay someone to do everything I do now to keep the company running.

    At a minimum a shareholder needs to be paid to shareholders via a W-2 to satisfy this reasonable compensation requirement. At this point, the amount on your W-2 is subject to payroll taxes, so you’re really in the same boat as paying self-employment taxes (except now you have payroll returns to file, ugh!). However, the shareholder may also be able to receive “tax-free distributions”. These are distributions of profits which are not subject to SE or payroll tax.

    Quick caveat, the IRS has been challenging S-corps with now reasonable compensation. Another area of contention as of late are S-corps that rely on the services of a single person (ie. Realtors, Doctors, etc.). In these cases, the IRS has said that all of the profits are made by the fruits of the shareholders labor – there is no product being made and no other employees. So reasonable compensation is 100% of the distributions.

    As always, the above should not be relied on as tax advice. Please consult your accountant and/or attorney before relying on any of it.

    Sorry to take this on an entirely different nerdy direction :-)

    PS – Jamey, you need to get on Quickbooks! Excel is infinitely more complicated for both you and your accountant.

    1. Thank you for your detailed comment, Dan! This is a wealth of great information.

      I tried to switch to Quickbooks recently, but it would exponentially increase my workload because of the double-entry system. Perhaps at some point I’ll hire a bookkeeper to do it for me. :)

  10. Great article. I hear your pain on an abmormally high tax bill. Sold my condo last year for far more than I expected, so much so I set aside 65k as a capital gain estimate come tax time, and prepaid deductiable expenses like next year’s property tax, January’s mortgage payment, etc, to lessen the tax burden.

    On the bright side, your company did earn a tidy sum, and you now know how to mitigage the tax burden going forward

  11. This is a bit off topic as it’s about personal bookkeeping/finances.
    I don’t know anything about tax stuff or running a business or accounting but I had to share something I’ve found super super useful for my personal finances.

    I started using a great program called YNAB (You need a budget) and wow has it ever changed my finances! It really makes me want to save money the way it’s set up.

    Basically you have categories and divide your money up into them. ie immediate expenses like groceries and rent or some things you need to save towards like yearly expenses.

    It’s helped me not be surprised and have no money for insurance for instance because I know I need to put x amount in that YNAB category each month. (it’s all still in my bank account, you don’t have to move money it’s just divvied up in the budget software.)

    Also It’s helped curb my post payday spending which is when it’s hard to resist an impulse purchase when I’m feeling flush with money hehe.

    So yeah just wanted to share this because it’s changed my relationship with my money and increased my saving it which can only be good thing :) and I hope other people can find it useful too.

    1. Sarah: Thank you so much for sharing this! I’ve heard that Mint can do a similar thing. With my personal expenses, I do something kind of similar–at the beginning of every month I look back at how I spent money the previous month. It’s kind of a retroactive budget–if I see that I spent more on food than in the previous month, I chide myself and try to do better the next month. :)

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