I am thankful for the new Federal income tax laws that allow pass-through entities to deduct state taxes as any other ordinary expense. That number can be significant and a lovely gift from Uncle Sam.
However, I was taken aback when I saw how smaller businesses started reporting this on their income statements. Am I surprised? No, but I’m disappointed because this business owner’s accountants were (and still are) allowing the tail (tax reporting) to wag the dog (meaningful management reporting).
I’m going to let you in on a secret. Even small business CFOs and controllers find the concept confusing, so they take the path of least resistance. I will then explain how pass-through state income taxes should be reported in the financials each year.
The Three Reports
Before I address the proper internal reporting for pass-through state income taxes, we need some foundational thinking about reporting in general. If you are subject to audited reports, every U.S. business has three bases of reporting:
- Meaningful (internal) management reporting should be done using the accrual method for accounting purposes.
- Tax basis (which could be cash or accrual).
- GAAP basis.
The following video content will still apply if you are not subject to GAAP reporting, but the reconciliation process will be quicker.
In summary:
- At a minimum, every small business has internal and tax reporting. Those subject to external reviews and audits will have a third reporting basis for GAAP.
- The three reports should never have the same bottom lines or net book value (NBV for equity).
- All three reports should be reconciled annually.
Departures from Tax and GAAP Reporting – A Few Examples
Instead of trying to write about examples where the three bases of reporting depart from one another, let’s do this through a quick video:
The Smart Way to Report Pass-Through State Income Taxes
In cases where I own the reporting, I report pass-through entity state taxes as a distribution. Nearly 100% of the owners I have worked for pay their Federal and state taxes through business distributions which is an equity transaction never seeing the P&L. And that should continue.
Because of the new deduction allowance, I’d make that number ‘more’ visible on the detailed balance sheet by adding an account entitled: Distributions – State Taxes. It’s still a distribution, by I’ve called it out with this new account.
GAAP will reveal the expense between EBT and Net Income. However, my internal reporting will still tie out to the GAAP reporting as both reduce equity.
I’ve seen a few local business owners lump this new expenditure in SG&A, and it looks extremely silly. In the example below, the internal accountant recorded the pass-through tax starting in 2023 for no reason other than the guidance they got from the tax partner. Is that the only reason to record the number in the general ledger as an expense as opposed to a distribution?
For business owners only, just because your accountant books an entry to a distribution doesn’t mean the outlay is not deducted. It is. Remember from the video earlier, we reconcile the numbers annually. Our bases of reporting should never equal, but they are reconcilable.
What Happens When My External Accountant Disagrees With Me?
External accountants do not own your internal trial balance. The better question is to ask, “Why are they so focused on their way of reporting?” That’s easy to answer:
- Tax accountants look at your numbers through their lens or prism. Naturally, they expect to you report numbers that make their lives easier. And we are through that special distribution account we created.
- External auditors believe the world revolves around the GAAP report. Until those external auditors become CFOs and controllers, they will never appreciate the meaningful reporting a CEO craves.
- Internal accounts know the life revolves around the business model which is finding, getting, and serving a customer. All reporting syncs to that business model through smart corporate and accounting governance which will normally depart from tax and GAAP reporting.
In short, all parties view the world differently from a reporting standpoint. But we still need to reconcile the numbers while achieving all three reporting purposes.