How to analyze your business' taxes
Now that we have such a high-level intuitive understanding of the way the IRS identifies fraud, tax evasion, and potential issues (read here) we can begin to analyze our actual financials. I will speak to both the small business owner reviewing their own financials, whether you maintain them yourself or use an accountant wont matter, and additionally I will speak to the accountant that might be reading this curious as to how they can better use their newfound tax process knowledge to better assist their customers.
Tax Analysis Process
Document Review
This review is simple in nature, we will be reviewing the same information that is provided to the IRS as part of your tax return. The main report for this is your “Profit and Loss Statement”. The “Balance Sheet” is an additional report which is usually collected by the IRS. Collect or request these 2 reports (if you use an accountant you may need to ask them to generate them for you) and we will use them to analyze your business financials.
Begin with your Profit and Loss statement. You can do a quick eye test if you see anything glaringly as taking up an absurd sum of your revenue (ex. An expense category that is 60% of your revenue. $500,000 revenue, $300,000 Advertising expense), but I prefer to be thorough and treat this as a “mock tax filing”. In the following images, you will find the specific deduction categories the IRS has in the forms for both 1120-S and 1065. As a note, we will cover in-depth the different filing statuses and corporate structures, for now I will assume most businesses are filing form 1120-S, but I included 1065 for illustrative purposes to show the similarities.
Form 1120-S (2024)
Form 1120-S Other Deductions Worksheet (TurboTax 2022)
Form 1065 (2024)
You will notice Form 1120-S has the “Line 20 - Other deductions”. The second image is from a sample worksheet to show how these other deductions were calculated. This worksheet contains the most common “other deductions” across industries for small businesses filing form 1120-S.
Using the categories listed in the images (1 and 2) begin assigning your Profit and Loss items to each category. We recommend using an excel spreadsheet for easy mapping, and later calculations, sorting, and general management of this data. Assigning these values to a category can be difficult as there is not always a truly correct answer for some more ambiguous or specific expense categories. For example, Anytime Fitness is a franchise, it has franchise fees that are charged to its franchisees. I chose to file these under the “Other (itemize):” option on the Other deductions worksheet. I felt this best captured that expense, but again, arguments could be made to place it under another category. I say all this to show it's important to be intentional, but also debatable what is exactly correct. The point of this exercise is to familiarize with how our actual expenses, specifically categorized on our Profit and Loss statement, map to and affect our taxes.
Now that you have all your expenses mapped from your Profit and Loss statement to your 1120-S and the “other deductions worksheet” categories we can perform an intuitive analysis.
*Here at Gym Financial Officer we have a proprietary algorithm that we use to determine the perceived risk a company has based on these categories. For obvious reasons, we will not share that here, thus you will need to perform this intuitive analysis. If you still have concerns, please connect with us and we can give you a thorough analysis.
To perform the intuitive analysis, assuming you took the advice and mapped these in an excel spreadsheet, first sort by amount. For the highest expense categories, does it make sense to be first? The top 3? Top 5? Don't look at the values yet, just the categories, if we are sorted with the highest expenses at the top, do you intuitively see these as your most expensive categories? What about the lowest (non-zero) categories, bottom 1, 3, 5, do they make sense as the least common?
If any of these have caused concern as being too high or too low, make a column for “Needs review” and add a value in there, perhaps a “1”. If you have any thoughts, add a column for “Notes” and add them now, otherwise we will address this in a moment.
Now add 2 new columns in the spreadsheet. Name the first column “Percent of revenue” and the other column “Percent of expenses”.
For the “Percent of revenue” column, from your Profit and Loss statement, take the gross revenue and divide it by the expense category for each row. As an example “$500,000 revenue would be in the cell (=Cell / $500,000). Express it as a percentage.
For the “Percent of expenses” column, sum the total for all expenses, then use that value to divide by each row. Example, ( = Cell / Expenses Sum). Express it as a percentage.
Now review for anything over 20% of “Percent of revenue” or “Percent of expenses”. Specifically for Gyms, with physical locations, I would assume your highest costs are Rent, Wages, Utilities, and then Bank Charges (credit card fees, processing fees). Any category that is over 20% and is immediately questionable to you, mark the column “Needs review” with a “1”.
Again, this is where our proprietary algorithms do all the work to help us identify potential issues, strength of those signals, and overall risks.
The last step in our intuitive analysis will involve filtering to only the rows we marked as “Needs review”. For each category, you will need to run a report for your transactions (or request one from your accountant). You can now do the same thing for these transactions. Sort them by largest amount, see if there is a pattern of mis-categorization, double transactions, etc.
Questionnaire
With the technical review prepared we can now move onto some questions. These will guide us when we prepare the final review or output of our tax analysis. Pay attention to the questions and the context given for how the answer affects taxes or financial strategies. This questionnaire is the one we run through with all new or potential customers.
Structural and Business Information
Q: What type of business entity are you? (ex. Sole proprietorship, partnership, LLC, S-Corp, C-Corp)
Q: What is the tax status for your business? (pass-through, multi member, S-Corp, C-Corp)
Q: Do you have an EIN and a bank account for that EIN?
Q: What is your individual tax filing status? (Single, married filing jointly, head of household)
Financials and Accounting
Q: Do you manage your bookkeeping? Do you use accounting software? If yes, which software?
Q: Who files your taxes?
Q: How often do you reconcile your transactions?
Q: How many bank accounts, credit cards, loans are associated with the business?
Q: What is your annual revenue?
Compliance and Data
Q: Where do you store your data?
Q: If you have employees, how do you handle HR compliance with documentation?
Personal
Q: What is your short-term or long-term goal with the business? (ex. 3-yr exit, growth acquisition, absentee)
Q: What role do you play in the business? What percentage of revenue comes from your direct efforts?
Q: Do you own your own or rent your current residence?
Q: Do you currently have retirement plans through the business?
Q: How are the profits of the business used? Monthly income, reinvested, distribution-invested elsewhere?
