Small Business Saturday is a fantastic trend in American consumerism. The goal, of course, is to give the ridiculous amounts of money that we spend on Black Friday to small businesses instead—or in addition.

But what might you be overlooking about how your choices affect those small businesses? Is there a way you could help them more than just giving them your business during the holidays?

One area you’re probably not considering is the tax impact of your holiday shopping. In the modern world, gift cards are a popular choice for those hard-to-shop-for loved ones. When you buy a gift card, what effect does it actually have on the small business’s taxes? Being incredibly detailed, the Tax Code has Sections, Regulations, Revenue Procedures, and other useful guidance to help us treat the sale and redemption of gift cards properly.

According to Regulation § 451-5(c), if a gift card is purchased, an accrual accounting business (that is, a business that recognizes income only when goods and services are sold as opposed to anytime cash is received) can defer that income for up to two years. This means that, unless and until the card is redeemed by the gift card recipient, a company doesn’t have to include it as income until December 31^st of the second year after purchase.

Suppose you bought a $100 gift card from REI on Black Friday (November 27, 2015). If the gift card is not spent before the end of 2017, even though REI won’t have sales on their income statement (a gift card isn’t considered a sale, since no goods are being sold), in its 2017 tax return, REI will have the $100 included in its taxable income and will have to pay tax on it. Alternatively, if the gift card is redeemed before the end of 2017, taxes will be applied to the sale of the merchandise as usual.

Bigger companies, like REI, are accrual income taxpayers. Small businesses, on the other hand, are most commonly cash income taxpayers, which means they have taxable income when they receive cash. For them, deferring gift card sales is not an option.

If you buy a gift card from a small business—Toyz LLC, a local toy store—for $100, they have $100 of income immediately. If the store is a tax-paying business, it will have to pay $35 of that $100 by March 15^th of the next year. Now suppose the gift card is used to buy a toy that cost the small business $80. Let’s consider the impact this has on the business’s tax burden and cash flow.

Inventory can’t be written off until sold for most taxpayers that sell merchandise, so Toyz won’t be able to use the $80 cost of the toy as a deduction in the first year. Thus, instead of paying $7 of tax ($100 list price – $80 cost to business = $20 taxable income x 35% tax rate = $7 tax), Toyz will be paying a full 35% of the $100 gift card, or $35 in tax. Thus, Toyz won’t earn back the $28 tax difference ($35 – $7) until the end of the next year (assuming the gift card is redeemed), when they will be able to apply the deduction of $80 for the toy.

Purchasing a gift card from a small business instead of directly purchasing the merchandise has a real effect on the business’s cash flow:

Date	What Happened	Cash Change	Cash Balance	Taxable Income Change
06/30/2015	Toy is purchased by business	(80)	(80)	0
11/28/2015	Gift card purchased by customer	100	20	100
03/15/2016	2015 taxes paid	(35)	(15)	0
06/30/2016	Cost of toy written off because toy is actually sold	0	(15)	(80)
03/15/2017	2016 taxes paid	28 (reduction in tax from cost of toy)	13	0

Using the gift card here actually causes the relative cash of Toyz to go negative. If you bought the gift instead of the gift card, not only would it be more personal to the gift recipient, but it would be much more favorable to the toy store’s cash flow:

Date	What Happened	Cash Change	Cash Balance	Taxable Income Change
06/30/2015	Toy is purchased by business	(80)	(80)	0
11/28/2015	Toy bought by customer	100	20	100
11/28/2015	Cost of toy written off because toy is actually sold	0	20	(80)
03/15/2016	2015 taxes paid	(7)	13	0
03/15/2017	2016 taxes paid	0	13	0

 

Buying the toy directly allows the business to write off the toy sale right away, keeping the cash flow of Toyz net positive. So if you really want to help on Small Business Saturday, buy the merchandise directly and save the business the burden of needing more cash for taxes they wouldn’t otherwise need to pay.

Active Tax Management

Let’s take this a step further—since gift cards are an increasing trend, how can a small business use smart planning to avoid the negative cash flow?

Suppose the numbers above were more like $100,000 and $80,000 instead of $100 and $80—really puts things in perspective, doesn’t it? That’s why understanding how to plan around gift card sales is important. In this case, the small toy store would contact Sundberg Tax & Consulting, its new high-quality accounting firm.

By doing some fancy tax work, we could make it so the small toy store was like a bigger company, making it an accrual income taxpayer. That would allow it to defer the $100,000 until the gift cards were used, saving it the kind of dreadful negative $15,000 cash balance that could really hurt a small business.

Switching from their previous accountant to the forward-thinking CPA firm Sundberg Tax & Consulting results in this business’s 2015 taxes being $35,000 less. How’s that for a holiday gift?

 

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