Post-tax income: an illustration

Last month, I said it was important to make business decisions based on your strategy rather than tax avoidance. For today’s post, I want to put some legs under that statement.

To illustrate, let’s say we have three small business owners—Alice, Bob, and Carol—who each earn $200,000 during the year and have ordinary operating margins of 30% (income after costs of goods sold, operating expenses, and necessary reinvestment). Now, in December, they each sit down and realize they show a profit of $60,000. How should they react to this information?

Remember that an owner should be concerned with profitability and post-tax wealth, not the amount of taxes they pay. So let’s look at their different reactions.

Alice feels her stomach drop at the thought of paying so much in taxes and decides to spend $20,000 on something—anything. Her after-tax income is $30,746. Because the primary goal is to avoid paying taxes, she isn’t very judicious about what she spends the extra money on. Some of the purchases are helpful to the business, so revenue grows at 4% each year.

Bob does nothing and pays taxes on the amount. In the first year, he has after-tax income of $46,000. Because there was no additional investment in the business, revenue grows slowly, at only 2% each year.

Carol wants to grow her business aggressively and is willing to tighten her belt to do so. According to her business plan, she spends the extra $20,000 on equipment that will improve efficiency and drive revenue growth. Her initial after-tax income is also $30,746, but her business grows at 7% per year and she improves the ordinary operating margin by 0.25% per year.

For the sake of this illustration, assume each business owner follows the same strategy each year and all numbers are real (post-inflation). Also, each business owner has the exact same personal expenses, matching the minimum post-tax income among the three for that year.

Over the course of ten years, Alice will pay $121,603 in taxes and will have a cumulative post-tax income of $398,763. At the end of 10 years, her net operating income is $85,399 before any tax-avoidance expenditures. Because she had the minimum post-tax income each year, she has no savings outside of her business.

Bob pays $157,645 in taxes (nearly 30% more!), but will have a cumulative post-tax income of $499,338 (25% more!). His net operating income is only $71,706, but every year he invested the amount of extra post-tax income very conservatively and earned 2% after inflation (compounded annually), so he also has $112,328 in outside savings.

Carol pays $163,989 in taxes and will have cumulative post-tax income of $499,912. Her operating income before additional investments is $110,308 and she has also accumulated outside savings of $106,340.

Of course, these numbers are simply illustrative. Businesses grow and shrink at varying rates, and returns are rarely so stable even over ten years.

That said, while it’s hard to say who the winner is in this scenario, there’s certainly a clear loser: Alice may have paid the least in taxes, but she is left with only a moderately more profitable business and no outside savings. Bob has the least profitable business but has already set aside a significant amount of money and has diversified his risk away from a single business. Carol may be in the best position overall, as she has a thriving business and has set aside nearly as much as Bob (and in future years will easily surpass him).

The moral of the story is that whether to spend money or not should not be driven by tax considerations alone. The tax code gives business owners lots of opportunities to save on taxes, but that doesn’t mean you should take advantage of every one of them. If you’re not investing strategically to improve your business, as I said last time, you may be dropping dollars to pick up dimes.

To close, I want to note two caveats to this analysis:

First, this analysis ignores a major opportunity for saving on taxes without making bad investments by using various income-deferral accounts, such as an IRA, SIMPLE, SEP, or Solo 401(k). This was on purpose, as I wanted to illustrate the importance of efficient investment. Once you have accepted the importance of focusing on post-tax wealth rather than the taxes paid, there is certainly a place for discussing the tradeoffs of various other mechanisms for saving on taxes while achieving that goal.

Second, some people may argue that they don’t need to consider this because they reduce their taxable business income through various strategies that transmogrify personal expenses into business ones. I won’t spend long on this except to say that these strategies run the gamut from totally legitimate to blatantly fraudulent, and one should be very careful before adopting anything that appears to be too good to be true. Any strategy that purports to show how you can write off money that you otherwise would have spent even as an employee is likely treading into some grey areas.

Even should a very aggressive tax position be assumed, that still doesn’t justify spending money in an injudicious manner. A large number of the influencers writing off Range Rovers on TikTok will find themselves just as broke as they started because they are not stewarding their resources well—but that’s a post for another time.

The information provided on this blog is for general educational purposes only and should not be taken as tax, legal, or financial advice. Tax situations vary, and you should consult a qualified tax professional for guidance specific to your circumstances.