Ecommerce growth can create an unusual cash flow problem for an e-commerce business. A company can be profitable, growing rapidly and still feel like it never has enough cash.
Inventory is often the reason.
Consider an e-commerce business with $1 million in annual sales and $200,000 of taxable income. If the owner’s federal and state income taxes attributable to the business are roughly $50,000, that tax bill becomes significant when compared with the company’s working-capital needs.
A seller at that revenue level might have $80,000 to $100,000 invested in inventory at cost. If the company is trying to grow from $1 million to $2 million in annual sales, its inventory requirement could increase to $150,000 or $175,000.
Now the timing of that $50,000 tax payment matters.
For a well-capitalized company, it may not matter much whether a tax payment leaves the bank account today or several months from now. For an undercapitalized seller trying to grow, it can make a substantial difference.
Taxable Income and Available Cash Are Not the Same Thing
One of the first things a growing e-commerce seller needs to understand is that taxable income does not tell you how much cash the business has available.
Assume our $1 million seller starts the year with $90,000 of inventory. During the year, sales grow and management builds inventory in anticipation of further growth. By year-end, inventory at cost has increased to $165,000.
The business has put another $75,000 of cash into inventory.
That does not necessarily create an immediate $75,000 tax deduction simply because the company spent the money. Under normal inventory accounting, inventory that remains unsold remains an asset on the balance sheet, with its cost generally recognized through cost of goods sold as the related products are sold.
This is one reason owners sometimes have trouble reconciling the profit on their financial statements or tax return with the cash in their bank account.
The S corporation might report $200,000 of taxable income even though the owner doesn’t see anything close to $200,000 of additional cash. Part of what the business earned has been reinvested in inventory.
In plain English: some of the profit is sitting on the shelf.
The faster an inventory-based business grows, the more important this distinction can become.
S Corporation Income Can Create Tax Without Creating Cash
For this discussion, we’ll assume the e-commerce company operates as an S corporation.
An S corporation generally does not pay federal income tax at the entity level. Instead, its taxable income and other tax items pass through to its shareholders, who report their respective shares on their individual income tax returns.
The important point for cash planning is that the owner can owe individual income tax on S corporation profit even if the company does not distribute all of that profit.
Return to our example. The company generates $200,000 of taxable S corporation income, and we’ll assume the resulting federal and state tax attributable to the business is approximately $50,000.
At the same time, the company is trying to increase inventory from roughly $90,000 to $165,000.
The same business is therefore trying to fund a $50,000 tax obligation and another $75,000 investment in inventory.
For an undercapitalized seller, those two numbers cannot be considered independently.
Estimated Taxes Are a Pay-As-You-Go System
Federal income tax is generally a pay-as-you-go system. For an S corporation shareholder, estimated payments are often necessary because the income passing through from the corporation is not subject to traditional income-tax withholding.
Internal Revenue Code Section 6654 governs the underpayment of estimated tax by individuals.
Generally, an individual can avoid an estimated-tax underpayment penalty by paying the lesser of:
- 90% of the tax shown on the current-year return, or
- 100% of the tax shown on the prior-year return.
For higher-income taxpayers, the prior-year percentage generally increases from 100% to 110% when prior-year adjusted gross income exceeds the applicable $150,000 threshold.
These rules are commonly referred to as the estimated-tax safe harbor.
For calendar-year individuals, federal estimated-tax installments are generally due April 15, June 15, September 15 and January 15 of the following year.
Those rules give us the technical framework. They don’t necessarily tell us the best way to manage the company’s cash.
Safe Harbor Is a Penalty Rule, Not a Cash-Management Strategy
The safe harbor is important because it gives taxpayers a way to determine how much they generally need to pay during the year to avoid an estimated-tax underpayment penalty.
But it is still a safe harbor.
It isn’t a substitute for looking at what is actually happening in the business.
Suppose last year’s tax liability produces a large required payment under the prior-year safe harbor. Paying that amount may be the easiest way to eliminate concerns about an estimated-tax penalty.
But current-year results may tell a different story. Margins may have fallen. Sales may be running below expectations. The company may have made a large investment in growth. An updated tax projection may show a current-year liability substantially different from the number contemplated when the original estimates were prepared.
The opposite can happen too. A seller can have a much better year than expected, in which case the tax projection—and potentially the estimated payments—needs to go up.
We don’t want last year’s tax return making this year’s cash-management decisions by itself.
Safe harbor should be part of the analysis. It should not replace the analysis.
The IRS Doesn’t Know How Much Inventory You Need to Double Your Sales
Let’s go back to our $1 million seller.
At its current size, assume the company carries approximately $90,000 of inventory. Management believes it can grow toward $2 million of annual revenue, but supporting those sales may require approximately $165,000 of inventory.
That’s another $75,000 of capital tied up in product.
Compare that with the approximately $50,000 tax obligation associated with the company’s $200,000 of taxable income.
If the company has plenty of excess cash, there isn’t much of a problem.
But many growing e-commerce companies don’t.
For an undercapitalized seller, a $50,000 payment made months before it otherwise needs to leave the business is a substantial amount of working capital. In this example, it represents two-thirds of the additional inventory investment we expect the company to need as it grows.
This does not mean the owner should take money that is needed for taxes and recklessly spend it on inventory. The tax liability still exists.
It does mean we should understand exactly when the money needs to leave.
The IRS doesn’t know that you need another $75,000 of inventory to double your sales. Your tax plan should.
Accurate Inventory Makes Better Tax Planning Possible
There is another issue that makes tax projections difficult for e-commerce companies: the projection is only as reliable as the financial information behind it.
Inventory directly affects cost of goods sold and gross profit. If inventory is materially wrong, gross profit can be materially wrong. Once that happens, the taxable-income projection can be wrong as well.
You can perform a technically perfect estimated-tax calculation and still arrive at a bad answer if the financial statements going into the calculation are wrong.
This is why we spend so much time getting inventory right with our e-commerce clients.
For businesses with significant inventory, a physical inventory count gives us an important benchmark. Between physical counts, we can estimate inventory using sales activity and an established gross-margin relationship, while adjusting when we know the economics of the business have changed.
The goal isn’t to force the company’s gross margin to stay at a predetermined percentage. It is to use the information we have to arrive at a reasonable estimate until the next physical count gives us another hard number.
This becomes especially important during periods of growth. A company can consume a substantial amount of cash building inventory without generating a corresponding current tax deduction.
If we don’t understand that movement, we don’t really understand the company’s cash flow—and we shouldn’t be making tax-planning decisions from those numbers.
Tax Planning Should Be Revisited During the Year
One mistake we see is treating estimated taxes as something that gets calculated when the return is prepared and then left alone for the rest of the year.
An e-commerce company can change too quickly for that.
At Schultz & Associates, we generally revisit the tax position around the April, June and September estimated-tax periods. We update the projection based on what has actually happened in the business rather than continuing to rely on assumptions made months earlier.
That analysis can include year-to-date profitability, expected sales, gross margin, inventory, owner compensation, other household income, withholding, previous estimated payments and other items affecting the shareholder’s individual return.
We then compare the current-year projection with the applicable safe-harbor requirements and decide what needs to be paid.
Sometimes the estimate needs to increase.
Sometimes it stays where it is.
And sometimes the numbers support leaving cash in the business longer rather than making an unnecessarily large payment at that point in the year.
The important part is that we’re making a new decision with current information.
Sometimes Keeping the Cash Has a Cost
There is another side to this analysis.
If a taxpayer does not satisfy an applicable safe harbor, an underpayment of estimated tax can result in a penalty. We need to understand that potential cost before deciding to retain cash.
But the existence of a potential penalty does not mean we stop doing the analysis.
Suppose retaining additional cash for several months allows the company to purchase inventory before an important selling season. Maybe it avoids a more expensive short-term loan. Maybe it prevents an inventory shortage that would otherwise limit sales.
We should know what the potential tax cost is and compare it with what the capital can accomplish inside the business.
That isn’t an excuse to ignore the estimated-tax rules. It is a reason to understand them.
Growth Can Make a Successful Seller More Undercapitalized
Rapid growth can put more pressure on cash, not less.
More sales require more inventory. More inventory requires more capital. Higher profits create larger tax liabilities. And because an S corporation’s taxable income passes through to its shareholders, the owners can owe those taxes while much of the company’s cash is being reinvested in inventory.
A seller can therefore have increasing revenue, increasing profits and a tighter cash position at the same time.
That’s why we don’t think tax planning for a growing e-commerce company should be separated from its accounting and cash planning.
We need to know whether the financial statements are right. We need to understand what is happening with inventory. We need a reasonable projection of taxable income. Then we can apply the estimated-tax rules and determine when cash actually needs to leave the business.
The Goal Is Not to Avoid the Tax
If the company earns taxable income, the shareholder will ultimately have to deal with the resulting tax liability.
The objective isn’t to make that liability disappear.
The objective is to know how much is owed, when it needs to be paid and what happens to the business’s cash in the meantime.
For an undercapitalized e-commerce seller, the difference can represent tens of thousands of dollars of working capital during the year.
Our $1 million seller trying to become a $2 million seller may need every reasonable dollar available to build inventory. Sending money to the government earlier than necessary can make that growth harder. Waiting too long without a plan can create penalties and a tax bill the owner isn’t prepared to pay.
Neither is good tax planning.
Pay the tax when it needs to be paid. Understand the safe harbor. Keep the projection current. And know what your cash is doing until it actually needs to leave the business.