Author: C.O.R.E. Beliefs

Evaluating Risk in Your Business

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I received another interesting Google alert which reminds me how small business owners often take their business for granted.  This one was about how the bookkeeper managed to write almost 100 checks to himself over 3 years to the tune of almost $250,000.

Let me start by saying that the bookkeeper was wrong.  No ifs, ands, or buts about it.  But to be honest, the business owner provided the means and the opportunity.  That doesn’t excuse the behavior but the owner would have been $250,000 wealthier if he hadn’t failed in his responsibilities to set up his company to deter such poor behavior.

First, a small business owner should never, ever give the bookkeeper check signing authority.  There is no such thing as a good reason for this.  One of the most important rules to protect your cash is make sure that the person with direct oversight of the accounting system can not sign a check.

Yes, I know there are many good reasons to have a second signer and I think there probably should be at least one other.  But have it be your shop manager or construction foreman, not the bookkeeper!  Hell, have your cousin Bob be a signer so that when you are out of town he can come by the office and sign checks.

But you have to make sure that the second signer knows the rules.  The most important rule is that no check is signed unless all the paperwork is with it.  That means a purchase order (yes use those too), a vendor invoice, a receiving ticket (what? You don’t have anything to prove items were delivered?) all packages together so they can review it prior to signing.  Everything must match or they must not sign.  And the bookkeeper cannot pressure them for any reason.  As a matter of fact, they should call you immediately if they feel something is off.

I understand it is possible that someone could create lots of documents to support stealing but the reality is that it would take some advanced planning to pull it off.  Plus, once it was discovered (and it will be) it is pretty obvious they had real intention to steal from you and that it wasn’t merely a crime of opportunity (oh look a $1,000 bill lying on the ground, finders keepers).  But ultimately having someone who is not part of the accounting control system look things over might actually help you find new ways to do the work.

We are big fans of using automated workflows and online document management.  These can make the process of approvals easier, faster and far more reliable.  Properly constructed, your system wouldn’t even allow a check to be written until the work flow is complete.  You could have several different people review their parts and then you can be comfortable in knowing that whoever signs the check (or pushes the enter key for an ACH transaction) is doing so with proper authorization.

Here are a few other commonsense rules for vendor payment management:

  • Make sure that all vendors have filed a W9 and submitted their insurance documents
  • Create a receiving document to prove what was delivered and that it matched to the PO
  • Create PO’s for goods being purchased
  • Have a contract with professional service providers for every major project they do – no open-ended hourly billing
  • Have one of your employees call random vendors to verify their information to make sure they really exist and do business with you
  • Review your accounts receivable aging reports and personally follow up with customers who haven’t paid in 60 days.

These steps won’t stop a determined fraudster but they do substantially reduce opportunity.  And without opportunity, most fraud disappears.

If you are looking for an accounting firm who understands business and how to protect it, check out our website for more information and to contact us.  We look forward to the opportunity to be of service to you.

Have a great day and Happy New Year.

Transaction Approval

~ C.O.R.E. Beliefs ~ Leave a comment

Typically, anything I write that deals with HOA’s and Condo audits are written on C.O.R.E. Beliefs.  But, I already wrote a nice little article about reserve funds there and also today’s issue, while stemming from a condo audit, is applicable to every type of business entity out there.

We are currently struggling with a condo audit.  The association has been around for about 20 years and every 5 years or so the board decides to spend money on an audit.  Like all good auditors, we are performing some tests of transactions in the non-audited years to ensure that the money has been accounted for correctly.  Specifically, our concern is the reserve fund.

The first thing we noticed was board meetings did not often have quorum.  Quorum is a fancy Latin term for “who decides”.  It is the minimum number of selected representatives who have to participate in meetings in order for votes to have affect.  So, why is this a concern?

In many associations – and non-profits need to be concerned here too, quorum is typically defined as a “majority of the board members”.  In this particular case, there were 5 board members so a quorum would be 50% plus 1.  Three in this case.  At several meetings only two board members were in attendance.

The board then conducted business.  It discussed contracts for reserve fund expenditures and approved them.  Bad form.  And bad business.

The whole point of quorum is to ensure that the meetings are adequately represented.  You want to make sure that there is robust debate where called for and a full airing of the concerns when necessary to ensure that funds are spent wisely.  When debate doesn’t happen you get decisions that can be challenged.  Which is where we are today.

The problem for us is that we are auditing the records.  They approved a siding project, which was funded from reserves, and did not document how much it was approved for.  There was no indication that there were three (3) competitive bids submitted or even requested.

The initial invoice, prepared on a percentage of completion basis, indicated that the base contract was $98,000.  The total paid to the contractor was $129,000.  We can’t find any reference that the change orders were request or approved by the board.  And it happened when there were 5 different board members.  The five current members were not even involved in that particular project.

Getting proper approvals is an important aspect of taking care of business.  It could be that you, the owner of your company, wants to approve every transaction at time of payment by signing a check.  Or it could be you are the executive director of a non-profit which has a policy that commitments over $5,000 must be reviewed and approved by the finance committee.  Regardless of the process, it is the fact that there is a check and balance that makes it work and when someone overrides that part, you get all sorts of troubles.

Ideally, the board minutes would have documented the issue – siding replacement – and the names and amounts of the competitive bids submitted.  There would be debate about the relative merits of the quotes and then a final approval of the winning bid.  All completed at a properly called board meeting with quorum.  Ideally, there would be another meeting where changes to the scope of the original work order were discussed and approved.  We don’t have that.

We are struggling with a way to remain in the audit and issue an opinion.  We think the owners deserve to know what is going on and a properly worded Disclaimer of Opinion could help them understand and maybe even want to participate as board members.  But, our options are rather limited and we may be forced to withdraw, which doesn’t really help anyone.

What can you do if you are either a board director or are thinking of becoming one?  Make sure that you follow your by-laws and/or state law when it comes to how meetings are carried out.  Know the number required for quorum and make sure you have sufficient notes in the minutes that someone can follow the work and see how the decision was made.  You will save yourself a lot of grief, and an expensive “non-opinion” audit report.

Have a great day and if you are looking for a proposal for audit or review services for the upcoming year, please consider C.O.R.E. Services.  You can find out more about us on our website.  We look forward to the opportunity to be of service to you.

Quantifying Entity Elections

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The new tax law, the Tax Cuts and Jobs Act of 2017, has created a new set of expectations when it comes to choosing the correct entity for your business.  But one of the things it didn’t do, as far as my analysis can tell, is eliminate the “unreasonable” compensation issue for S Corporations.

I have run several different scenarios comparing the tax and net cash flows for a somewhat typical small business.  I compared the following tax effects:

  • C Corporations paying most of the profits in the form of wages to the owners
  • C Corporation paying nothing but dividends to the owners
  • S Corporation paying wages to the owners of most of the profits
  • S Corporation paying no wages to owners
  • An Operating partnership

Hands down, the continued superior driver of net cash to the owners is driven by the S Corporation paying no wages.  Hands down.  For most small businesses making reasonable profits, the most tax advantageous manner to do this is electing to be an S Corporation and then not paying anything to the owners.

This is so even if the business does not have any other employees so that it can take advantage of the Qualified Small Business Credit of 20%.  This credit is capped at the amount paid in total wages.  Given the rather insignificant differential in tax rates of C Corporations at 21% and the individual rates of ‘Middle income” taxpayers at 22%, there is no marginal difference as far as income tax goes.  The game continues to be the avoidance of payroll taxes.

Hopefully the following scenario will help.  Lets say two friends, Will and Fred, decide to form a fishing guide business called, Will and Fred’s Amazing Adventures.  The Company does $1.0 Million in Revenues, $300,000 in payroll for guides and helpers and a net profit, before paying anything to Will and Fred, of $300,000.

  • As a C Corporation paying $250,000 in wages to Will and Fred, the total taxes paid are $99,000 and net cash to Will and Fred is $176,000 – or $88,000 each.
  • As a C Corporation paying no wages and issuing dividends instead, the Total Tax is $107,000 and net cash to Will and Fried is $200,000 – or $100,000 each
  • As an S Corporation paying $250,000 in wages to Will and Fred, the total taxes paid are $98,000 and net cash to Will and Fred is $201,000 – or $100,000 each
  • As an S Corporation paying no wages and instead paying all earnings as distributions of “profits”, the total tax is $53,000 and net cash to Will and Fred is $247,000 – or $123,000 each
  • As a general operating partnership, total taxes are $90,000 and net cash to Will and Fred is $210,000 – or $105,000 each

A really aggressive tax practitioner would work with Will and Fred to be taxed as an S Corporation and not pay wages.  Most slightly less aggressive practitioners would have them set compensation at $25,000 each.  Zero is hard to defend whereas $25,000 is hard to beat – for the IRS.  I will save that debate for another day but the point is, there is still no disincentive to not pay  wages to the owners.

It is true that there is still better net cash flow to the owner by being treated as an S Corporation than by being taxed as a C Corporation and paying the same wages but no one will say “Gosh that’s good enough for me!”.  Taxpayers will strive for the lowest tax effect and highest dollar return and that still points to S Corporation treatment and low officer wages.  And we are talking about a 20% increase in net cash and a 30% reduction in taxes – no one is going to sneeze at that opportunity.

In summary, the best advice for Will and Fred would be, in the following order:

  • Be an  S Corporation and pay themselves reasonable, but low, wages
  • Be a general partnership
  • Be an S Corporation and pay themselves almost all income as wages
  • Be a C Corporation paying themselves almost all income as wages
  • Be a C Corporation paying themselves no wages and taking all income as dividends

Yes, there are other things to consider – such as health insurance and retirement – but for strictly tax purposes this is how I would advise the owners of Amazing Adventures.

Have a great day.  If you have any questions, feel free to write and ask and if you are interested in discussing how we might be able to help with tax planning and business strategy, feel free to contact us and learn more about how we can work with you.

 

 

The Corporate side of the Tax Act

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IT is not every day I elect to write this blog before my CORE beliefs missive.  But there are some provisions of the new tax act that have an impact to clients that I think has not received enough attention.  The tax changes for corporations can be found in Subtitle C – Business Related Provisions.

Tax Rates

Most Corporations will be subject to tax at 21% of taxable income.  It is a flat tax so every dollar of taxable income is taxed at the 21% rate.  For those Corporations where income was managed to a lower bracket, like 15%, this is no longer effective.  So, some Corporations will pay higher (although in the scheme of things, really small dollar truth be told) but overall Corporations will pay less.

Professional Service Companies

We have several clients who were structured as C Corporations which are also treated as Professional Service Corporations (PSC’s).  These have always been subject to a flat rate of 35%.  From what I read this has now been reduced to 25%.

Effective Date

Sadly, while this tax law will likely take effect 1/1/2018, it is for taxable years BEGINNING after 1/1/2018 so if you have a fiscal year that doesn’t end by 12/31/2017 you will not be able to see any advantages of this until the next fiscal year.  So, June 30 clients you are not going to see the benefits of this tax law until the next fiscal year beginning 7/1/2018.  There is a special provision for certain asset purchases, however, which takes effect as of 9/27/2017.

Qualified Real Property

An interesting change is adding specific real property to the defining of property subject to the new $1,000,000 section 179 limit.

(f) Qualified real property.—For purposes of this section, the term ‘qualified real property’ means—

“(1) any qualified improvement property described in section 168(e)(6), and

“(2) any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service:

“(A) Roofs.

“(B) Heating, ventilation, and air-conditioning property.

“(C) Fire protection and alarm systems.

“(D) Security systems.”.

The key term is nonresidential – so rental homes and apartments won’t qualify but if you own a commercial building in an LLC and lease it to your Company it will.

Use of Cash Method of Accounting

Raises the income limit to $25,000,000 so many very large “small” businesses will not have to do the mandatory switch-over to accrual.   By the way, this limit also is for Unicap rules under 263(a) and the use of the percentage of completion method for construction.

Special Write-off of Fixed Assets subject to MACRS

All purchases between 9/27/2017 and 1/1/2023 are subject to 100% expensing.  Notice that includes purchases in 2017 that occurred after 9/27.

Limitations on Interest Deductions

This doesn’t seem as straightforward as it sounds.  Interest deductions on borrowed money will be limited to the interest income recorded PLUS 30% of adjusted taxable income (taxable income before accounting for interest) PLUS flooring interest.  Although there appears to be an exception:

(3) EXEMPTION FOR CERTAIN SMALL BUSINESSES.—In the case of any taxpayer (other than a tax shelter prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3)) which meets the gross receipts test of section 448(c) for any taxable year, paragraph (1) shall not apply to such taxpayer for such taxable year. In the case of any taxpayer which is not a corporation or a partnership, the gross receipts test of section 448(c) shall be applied in the same manner as if such taxpayer were a corporation or partnership.

So, if you are under the $25,000,000 ceiling discussed earlier, this doesn’t apply.  So, small real estate developers, it doesn’t seem like you have to worry that the interest you pay will not be deductible.

Loss Carryback and Carryforward

There is no longer a carryback of losses.  They are carried forward indefinitely.

Like-Kind Exchanges

1031 no longer applies to all property. It is now only applicable to real property.  It is a big deal but not as big as it seems since 1031 was almost exclusively used for real estate.  But I have had clients with large investments in equipment that we ran through the 1031 exchange because of the deferred nature of the activity, plus the equipment was sold to one party and purchased from another.

Fringe Benefit Deductions

This is potentially a bigger issue than reported.  If you provide food as a working condition fringe, you no longer get to deduct the expense; this includes the operation of the cafeteria and kitchen.  Same for transportation and commuting benefits you paid for employees.  This includes parking.

Domestic Production Activities Credit

No surprise here that this is being eliminated since tax rates are going down.

Carried Interest Rule

This rule was modified to require that the investment be held 3 years before any payments received are treated as capital gain.  This is a minor change since most investments of this nature are held over a year anyway before the arrearage of the performance fee is paid.  This will change how some investor/developer deals are structured – maybe.

Using Gift Cards and Cash for Employee Awards

Beginning 1/1/2018 you will no longer be able to keep “safety bonuses, etc.” out of wages.  If you give your employees anything with value it must be included in their W-2 and subject to appropriate taxes.

I still need to get through the various business tax credits but I think this gives you an idea of the major changes in store for businesses – especially those treated as a C Corporation.  I should finish this sometime around Christmas.

Have a great weekend.