The Downside of Profits

You must be as tired of reading the Big Decision series as I am of writing it. I took a luxurious three-day time-out over Presidents Day weekend, when Curio City went almost three full days without a single sale. I think that’s the most time off I’ve allowed myself since I started this thing. So this week I’m sharing that little respite with you.

Stripped of all the bullshit, my business plan looks like this:

1. Buy cool stuff cheap from wholesalers, manufacturers, and importers
2. Resell it to individuals at a gross margin of at least 50%
3. Keep costs as low as possible
4. Profit!

So far points 1-3 have taken all of my attention. A couple of weeks ago, I got the corporate tax returns showing my first-ever profit of about $1,200. Hooray! Right?

Not so fast. Watch how the US tax code makes profits challenging.

Corporate profits get divided proportionately among all stockholders, who have to report this “K-1” income on our personal tax returns. That’s how the federal government gets its pound of flesh from S Corporation profits. The shareholders – that’s me – aren’t liable for the self-employment tax that you’d pay on 1099 income. So K-1 income enjoys a tax rate comparable to that on wages, but without reductions for Social Security and Medicare.

Once I pay the income tax on it, I own that money, regardless of whether Kraken Enterprises pays it out to me or retains it. My natural instinct upon seeing that tax return was to pay myself a nice $1,200 bonus – if I have to pay taxes on it I ought to get the money, right? And that’s about what it would cost to replace my five-year-old gaming computer.

But there’s a complication.

I can only take out earnings in a year that the company records earnings. If I were to pay out the 2007 profit this year, and then show a loss (or a smaller profit) for 2008, I would owe additional taxes on the amount distributed in excess of earnings. Practically speaking, I need to take the profits out before I know exactly how much they are. Fortunately, the bottom line in Quickbooks is a pretty close approximation. I can safely pay myself that much right at the end of the year.

I could still take the $1,200 today if I were confident that Kraken will earn at least that much this year. If I stick with either Steady As She Goes or Curio Metropolis Online, I should record a healthy profit in 2008. But if I open a store instead, Kraken Enterprises will show a huge loss this year, followed by progressively smaller losses over the next five years while the bank loan is repaid. I can’t take my 2007 earnings if I don’t expect another profit until 2013. Besides, Kraken desperately needs the operating cash. Remember my big open-to-buy deficit? Without $1,200 in retained earnings to plump up my operating cash, my bank account would be showing actual red ink right now, instead of hovering near zero.

But there’s another complication.

Kraken Enterprises owes me $28,500 in shareholder loans – the startup cash that I put into the business. I can repay those loans without owing any taxes on the payments, since that’s still my money and it isn’t income. So it should be a no-brainer to make loan payments to myself before taking out annual earnings, right? Well, yes and no. You see, I deducted the corporation’s 2005 and 2006 losses as bad investments on my personal tax return. The value of those loans is therefore reduced by the $9,700 in Curio City losses that I wrote off – meaning that I don’t expect to get that money back -- leaving only $18,800 that the corporation still owes me. As you can see, Kraken’s losses are my losses.

Ah, but there’s another complication.

This year I have to pay taxes on $1,200 worth of 2007 earnings that I didn’t actually receive. That therefore offsets my previous deductions and restores the value of my loans by $1,200. Since it’s my money, letting Kraken retain it amounts to making a new loan. So now the corporation is holding my original $28,500 in loans, minus the $9,700 that I wrote off, plus the $1,200 that I paid taxes on but let the company keep.

The smart strategy is to personally pay the small income taxes on each year’s profits and leave (most of) that money in the company, gradually erasing Kraken’s early losses and rebuilding the value of my loans back up to the original $28,500. To lessen the burden on myself, I should take just enough of the annual earnings to cover the taxes that I have to pay on them. That allows me to withdraw tax-free loan repayments until I recover my entire $28,500. Unlike K-1 payouts, loan payments are not limited by annual earned income.

(I don’t understand how I actually make any profit on that original investment – I would have done much better to just put $28,500 in a 5% savings account for all those years -- but I’ll ask my CPA about it when the time comes. For now, owning a profitable company is payoff enough).

Once my investment is completely repaid, there’ll no longer be any personal advantage in letting Kraken retain earnings. By then, Kraken should be generating enough money that the annual K-1 payment will rival my salary – with no payroll taxes owed. The IRS understands this incentive to steer money into earnings rather than payroll, and requires you to pay yourself a reasonable salary. Naturally, they define “reasonable”.

Don’t even ask me how state taxes fit into all of this. I’m quite sure Massachusetts will take a substantial cut eventually. For 2007, I just owe them the same base $456 corporate excise that I’ve owed for the past two years. I don’t think they take anything further until my company’s actual book value is positive, after the loans have been repaid. But I’m really just guessing about that.

Incidentally, if Kraken had not plowed $2,100 of operating cash into web improvements in 2007, the year’s profit would’ve actually been $3,300. If I don’t spend on further upgrades, 2008’s profit could top $5,000.

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Aging Hipsters

The web developer who might replace Eric also runs a website for baby boomers called Aging Hipsters. http://aginghipsters.com/ Its owner wants to roll out a retail page that will link to affiliates who sell merchandise of interest to boomers. She makes a few commission bucks without owning any inventory or fulfilling any orders. But she needs help picking products. Sensing that I might know a thing or two about that, she enlisted me. So I’m spending a substantial number of hours browsing other websites for items of interest to baby boomers.

What’s in it for me? Well, I’m finding a few potential products for Curio City. It takes my mind off my Big Dilemma. But mostly, I can include some of my own products without paying commissions on any sales that it might generate. At the very least, I’ll get some quality links that will raise my page ranks for those products.

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How’s Business?

Weak. My OTB has barely budged. The $456 excise tax payment that I mentioned above drained the treasury last week. I managed to pay off my charge bills for February, but unless things come roaring back quickly, I might actually have to carry some debt in March. This is just clumsy budgeting. A nice sales surge could clear it up quickly. If Panther Vision doesn’t crap out on me, I’ll receive my 4-LED caps early next week.

Next week: Back to our regularly scheduled anguish.