What Does Cash Flow Dam Mean?
A cash flow dam is a tax saving strategy used by sole proprietors, in which they convert their personal income into business debt that is tax deductible. In a way, this strategy helps to convert bad debt into good debt, so that there is no tax liability incurred. It is also a variation of the popular Smith Manoeuvre method.
Divestopedia Explains Cash Flow Dam
A cash flow dam strategy is implemented with a specific process. It begins when the sole proprietor creates a line of credit to pay for business expenses. When the expenses are paid by credit, the money allocated for the operating expenses becomes a surplus. This additional cash is then used to pay down any nondeductible loans such as a mortgage. As a result, this payment constitutes as a repayment of a business loan and it becomes tax deductible. This tax benefit is offset by the personal income of the proprietor so that no tax is due at the end of every financial year.
For example, owner A has a small business that needs about $2,000 a month for its operating expenses. If the owner has a mortgage, then she can take a home equity line of credit. This credit will take care of the $2,000 per month operating expenses of the business. The surplus $2,000 in the business that was originally budgeted for the operating expenses will now be paid towards the non-tax-deductible mortgage. Though monthly interest costs are generated, it can be capitalized by using the business line of credit to pay for it during the entire period.
At the end of the accounting year, the owner will not have a mortgage, but will have a large business loan. As a result, the owner does not lose any money as one debt is used to repay the other. In this process, the bad debt is converted into good debt and is not taxed.
This strategy is available only for sole proprietorships, partnerships and other unincorporated entities. It is not available for corporations.
Finally, despite its advantages, a cash flow dam can also be a little tricky if the owner is negligent.