For planning purposes these are based on simple mathematics. Your estimated tax (usually in the profit and loss) is the product of multiplying pre-tax profits by your anticipated tax rate. This simple, powerful estimator is excellent in most cases. You could make it a lot more complex with lookup functions for graduated tax rates, or formulas to change tax treatment in different countries, or for loss situations. Still, this is about planning, not accounting, and simple is good. The estimated tax rate is easy to understand and easy to apply. You get a lot more planning power from a simple and obvious estimated input than from a complex, hard-to-follow formula.
However, if you have a string of steady losses, it requires special attention. In that case, you need to be aware of tax treatments. You have a potential problem if you leave everything in default mode: you’ll end up with a projection that treats taxes as if the government pays you back when you lose money.
Exception to the rule
The illustration below shows an example of a company that projects losses through the first two years of the plan resulting in negative taxes. The problem is that the government doesn’t pay companies to lose money. A negative tax rate could end up showing in the tables.
The solution to this potential problem is the tax rate assumption as shown in the illustration below, and your own follow up.
Specifically, to handle taxes for a business plan that has a long string of losses: Set the tax rate to zero for the period of losses.
If your plan projects making a profit later on, then you’ll have a loss carried forward tax advantage that will reduce the tax rate when there are profits. This should be a simple educated guess. Take whatever your tax rate would have been, and make it lower.
More detailed solution
If you insist on detailed mathematical calculations—and only because you insist—here’s more detail:
- Take the sum of the losses.
- Multiply the sum by your estimated tax rate (25%) when you make profits, and call that the loss carried forward.
(Example: $100K * .25 = $25K).
- Subtract that amount ($25K) from the tax estimate of the first profitable year.
(Example: if the tax estimate was $50K at 25% rate, $50K – $25K = $25K).
- Change your estimated tax rate in the profitable year so the estimated tax is now equal to the reduced amount.
(Example: if estimated tax was $50K at 25%, and your target tax is $25K, then make your tax rate 12.5% for that first profitable year).
- Explain the adjustment in text accompanying your General Assumptions or Profit and Loss table. The explanation can be this simple:
“Taxes are set at zero during the loss periods. The loss carried forward impact reduces the estimated tax rate during the profitable periods.”
Treat your negative tax situations carefully. If your financial tables inadvertently treat a negative tax liability as cash coming in to your business, or as cash not spent the real impact on your business will come as a rude surprise.