I have a client. I will name him “Jed”. Jed is a craftsman. He is a contractor. It really does not matter what his trade is, just know that he is very good at what he does and he has done a fair amount of work for me. He has done work for a number of friends of mine because I think that he is very good at what he does. Over time, I have become his lawyer for various things that have occurred in his life that would require such help. Among the issues that I have helped him with was that he was deep in debt and was about to lose his house to foreclosure. Bankruptcy happens to be one of my major areas of practice, and I was able to help him out. However, in order for him to file bankruptcy, he needed to be current on his tax filings. Unfortunately, he was several years behind in both his personal and corporate tax returns. It turns out that one of the main reasons that this man was in such financial distress was that he had absolutely no financial controls in place. He paid cash for just about everything, including all of his business expenses. In fact, his bank records were of very little assistance as so little of his business flowed through his bank account in a normal way.
To file his back tax returns, Jed brought into my office bags of receipts, and a box of contracts that showed the various payments that had been made to him. From the contract and payment histories scribbled on them, we were able to figure out what his revenue for the various years was. The bags of receipts, were far messier to deal with. Getting those organized into a useful form and added up was a particularly painful task as I was up against stringent time deadlines because of the pending foreclosure and bankruptcy. I actually brought in some temporary help to get this done in a timely manner. Since many of his receipts were sort of organized by vendor, we set up a QuickBooks account for him and used this to begin organizing him. For example, we added up his Lowe’s receipts for the year and entered it into QuickBooks as Lowe’s and then in an account called materials. Thus we had made it so that any time that he has a purchase from Lowe’s, the relevant information is already in QuickBooks and it will default to materials unless we specifically change it for some reason. Like most business men, he had a number of vendors that he did business with repeatedly, and they are all set up in QuickBooks. In the fullness of time, we were able to reconstruct the past and figure out what he made and what he spent and actually came up with some numbers that made sense. On the bankruptcy side, I was already constructing his personal budget, and was very pleased to see that we had him generating a cash flow from the business which was in line with what he was telling me that he was spending in his personal life. In the course of reviewing with him the various entries in his expense logs, he must have said to me on at least six (6) different occasions that ‘I had no idea that I spent so much money on that’. This is a recurring theme with my bankruptcy clients. Very often, the problem is not a lack of income or a lack of revenue, as much as it is the fact that spending is not under control because the clients do not fully understand their spending. This problem becomes particularly acute for any kind of contractor. How can you properly price a job, if you do not know what it costs to do it?
I had liquidated his old company in bankruptcy and started a new one for him. This required that he open a new bank account for the new company, which was probably a good thing. Truth be told, it would not have been worth the time and effort to balance the checkbook on the old account anyway. We discussed the fact that going forward, all of the revenue of his business was to go into that bank account. By putting all of the revenue of the business in this account, and nothing else, figuring out his gross revenue at the end of the year became a very simple matter. We just have QuickBooks add it up.
We also discussed that all the purchases of the business, and nothing else, were going to go through this account. Never again was he going to walk into Lowe’s and hand them a wad of cash, at least not for the business. I advised him that I had no issue with the business setting up a Lowe’s account, or otherwise getting a credit card, so long as that account or that credit card was paid through the business account. However, the use of cash to make business purchases was to be scrupulously avoided. In this way, we would have an absolute record, and bulletproof documentation, of what the expenses of the business are. I instructed him to keep his bags of receipts, although I have recommended that he find a better system of filing them. However, they are now only necessary as backup documentation. Through the bank records we now have a system that shows a flow of revenue coming in, which shows when it came in, and shows the expenses flowing out and when and to where they flow. As long as these numbers are more or less in line with each other, it is unlikely that anyone will ask to see the actual Lowe’s receipts. A contractor spending money at Lowe’s is not unusual. If the expenditures at Lowe’s are occurring in amounts and at times that are in line with the revenue that is coming in, that does not raise any red flags. However, if an auditor should ever want to see the receipts, then that auditor will have the bags of receipts to look at just as we did. By the way, the bags of receipts that we had to go through to do the previous year’s taxes are now all organized in binders. I rather doubt that he will do that going forward, and I do not do that for my own office, but it is important to have the back up documentation available just in case.
While I have offered to give him the QuickBooks data and account structures that we have set up so that he can do his own record keeping, he has made clear that this is not something that he wants to do. As such, once a month he comes to the office with his bank statement and cancelled checks and we enter them into QuickBooks ourselves. We give him a QuickBooks generated report on what he has made and spent that month. This helps him to figure out issues in his own business that I have already discussed.
Preparing his taxes this year will not be the painful experience that it was in the past. His bookkeeping is in much better order, and figuring out his income and expenses does not require a conference room table to spread receipts out on. Better still, he is making a decent profit. His mortgage is paid. Obviously, he is still a work in progress. Getting him to be as diligent as we would like each month about coming in and sitting down and getting the bookkeeping done is still not where we would like it to be, but the improvement is significant. He knows what he is making and what he is spending money on. The money is documented and is flowing through the proper accounts in the proper ways. While a tax audit is a heart attack for every small business person, I at least feel confident that he will have no trouble getting through one and explaining to any examiner where these numbers came from. In every way, we are in a better situation than we were when my client, on the eve of foreclosure and with his business collapsing, came into my office with bags of contracts and receipts.
I will do this client’s taxes again this year, but unlike in years passed, I will not dread it. I am hopeful that we will get his taxes done in an hour or two. In addition, the taxes will be, not only accurate, but bulletproof. By bulletproof, I mean that not even the nastiest IRS auditor will be able to find fault with the return. Because there is no cash involved and the store receipts have all been saved, I can document and prove every expense that my client is claiming. Similarly, since all of the revenue of the business has gone into the business bank account, I am not concerned about any allegations of unreported revenue. I am a tax preparer, not an auditor, but if my client has done everything that I have told him to do, then he need not fear any manner of an audit. Since all of his expenditures are documented, there is not concern of him paying too much income tax. Simply put, my calculation of his profits for the year will be accurate. Most importantly, my client is having the best year that he has had since before the financial crisis. He might be having the best year ever; I would not know. Part of the reason for that is that now he can focus on what he does well, and is not bogged down by what he is quite bad at, which is keeping his business records straight. Apparently, being disorganized took up a lot of time and really caused him a lot of stress and aggravation. In addition, now that he has a firmer grasp of what he is taking in and what he is spending on each job, he is pricing his jobs better, and getting a tighter grip on his expenses. He is now able to do jobs for less money, and is walking away from jobs that he used to take and lose money on.