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About 19 million individuals and businesses filed for an extension on their tax returns last year, many due to unexpected circumstances such as IRS backlog delays. No matter the reason, filing for an extension only gives you more time to file, not to pay, which can put you at risk of overpayment, or hefty late payment fees if you underpay based on your estimation.
In addition to these risks, filing for a tax extension can also affect a business’s ability to get financing. If you’re planning to apply for a business loan this year, understand the impact an extension could have so you can keep your finances on track.
HOW TAX RETURNS FACTOR INTO BUSINESS LOAN APPLICATIONS
While every institution is different, most traditional lenders and banks look at profit and debt service coverage ratio, or DSCR, as key factors in determining a business’s ability to repay a loan. Profit is revenue minus expenses, while DSCR speaks to a business’s ability to take on new debt while covering current debt obligations.
Because tax returns are the most common place where businesses report revenue and profit, they are crucial documents when a lender is determining whether or not to approve a business loan application.
THE IMPACT OF AN EXTENSION
Many lenders simply will not move forward without a business’s most recent tax returns, but even if a lender is willing to underwrite based on older tax returns and financial statements, it may skew the financial picture you’re painting.
“Banks usually take the average of the most recently filed two years of returns, so if you had a strong year in your business, you’ll want to ensure that income is counted,” said Anjali Jariwala, a certified financial planner and founder of FIT Advisors, a financial planning firm, in an email.
A lender may review internally prepared or interim financial statements like balance sheets or profit and loss statements to get an idea of the state of the business, but “they are not going to be able to include that income until the tax return is filed,” said Jariwala.
Additionally, lenders may view an extension as an issue of credibility, according to Samuel Fuentes, a bank executive with over seven years of experience in business lending. “If there is no urgency to file taxes, then some banks view this as the company trying to work the numbers to pay less taxes, or perhaps as irresponsibility with money management,” Fuentes said in an email.
PERSONAL TAXES MATTER TOO
If you are a sole proprietor, LLC or S corporation, any delays in filing personal returns will directly affect the timely filing of a business tax return and vice versa. That’s because these formations are pass-through entities, which means business income flows through to personal tax returns, and is taxed on the personal side.
Even for businesses that don’t report pass-through income, extensions may still impact lending because of something called global debt service coverage ratio, a combination of the business DSCR and the personal DSCR of all owners or potential guarantors. Because many lenders require all majority business owners to guarantee or personally back a business loan, they need to look at personal financial information as well.
“Unlike business accounting, there is no income statement or balance sheet that can be produced for personal taxes to fill in the gap for underwriting purposes,” Fuentes said. “If their personal taxes are on extension, then the loan most likely cannot move forward.”
WHAT BUSINESS OWNERS CAN DO
Ultimately, what’s right for you will depend on your business and your goals for the year. One important benefit of filing an extension is that it gives owners more time to correctly report income and expenses that may be deductible, according to Kara Halfaker, a business consultant, certified public accountant and owner at No Fear Finance, an accounting firm with a focus on financial education.
“If a business owner has complex tax transactions or multiple businesses, it may take longer to gather documentation,” Halfaker said in an email. “It’s rarely a good idea to rush your taxes in order to get a loan through.”
If the threat of a large payment to the IRS has you dragging your feet, Fuentes recommends filing as soon as possible, especially if you have definitive plans to borrow within the next year.
“A bank would rather see you owe taxes and be making payments, than avoiding the taxes,” Fuentes said. “That builds ‘ character ’ if you show your company pays what they owe.”
The most consistent piece of expert advice is to make sure you’re on top of your bookkeeping, with both your internal processes and by hiring the right professionals. According to Jariwala, the biggest problem she sees is lack of proper bookkeeping that results in the business owner having to go back and fix years of mistakes, sometimes requiring amended tax returns. To mitigate this, Fuentes advises meeting with your accountant at least once a quarter.
Preparation is key, according to Halfaker. “The No. 1 thing business owners can do to be prepared before they need a loan is having their accounting system in place,” she said. “Business owners ideally should have a plan for a loan timeline and make sure they are doing their part to gather tax documents in advance to make preparation easier.”
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This article was provided to The Associated Press by the personal finance website NerdWallet. Olivia Chen is a writer at NerdWallet. Email: ochen@nerdwallet.com
RELATED LINKS:
NerdWallet: Small business tax deadlines for LLCs and sole proprietors https://bit.ly/nerdwallet-business-tax-deadlines
NerdWallet: How to apply for and get a business loan in 5 steps https://bit.ly/nerdwallet-how-to-apply-small-business-loan
NerdWallet: Master the 5 C’s of credit https://bit.ly/nerdwallet-master-the-5-cs-of-credit
NerdWallet: Bookkeeping basics for small businesses https://bit.ly/nerdwallet-small-business-bookkeeping