Category: Income Taxes

Happy Thoughts

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

Good morning.

I write more about our newest family member on my other blog CORE Beliefs but Kubae and I are so excited to welcome Ginger into our home!  We picked her up Saturday from the Southwest Washington Humane Society.

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Here are my two wonderful young ladies.  Yes, Ginger has her own pink bed, pink walking harness, pink extending leash and collar and even a pink car seat.  She is a corgi-terrier mix, 6 months old and hates being separated from her “mommy”.

No, she does not sleep in her bed.  It is funny, when we put her little bed on top of the chest, I told Kubae that our little sweetheart was going to jump into our bed within 5 minutes.  No sooner did we turn out the lights than we heard her little paws on the foot rail and a soft plop as she hit the mattress.  She curled right up between us!  The good news is she sleeps through the night.

Moving on.

You have no doubt heard the various predictions about the tax reform bill that is currently in committee.  You have probably even formed an opinion as to the effectiveness of this effort at tax reform.  Sadly, your opinion is likely based upon your political disposition instead of really getting to understand what is being done.

When you hear that tax reform never pays for itself, be careful.  I think the evidence is there that within a short time span the tax law does not spur sufficient growth to “pay for itself”.  But I think there is a case that, over a generation, the tax cuts can be effectively stimulative.  The bigger issue is if the pain and suffering are worth the wait.

The 1986 tax act was a major rewrite of the tax code.  It did not really “pay for itself” in the first 5 or 10 years.  I believe, however, that when we look at today’s tax receipts, federal spending and redistribution, we notice that our tax receipts are substantially higher than what they were in 1985.

More importantly, it changed certain behaviors by changing the incentives.  Passive activities were no longer sought after for their generous tax breaks – unless one could find a passive investment that spun off income.  Requiring social security numbers and birthdates for dependents de-incentivized the deduction of, shall we say, dubious dependents.  Yes, I have heard that it created a far more complex tax code – I wouldn’t know for certain because in 1986 I was playing Marine – but I think overall it led to an economic improvement that has enhanced our lives and general prosperity.

As you measure the economic impact of the current tax reform measures, keep in mind that part of what we want to change is how certain behaviors are incentivized.  One code section that comes to mind is section 121.  IRC 121 is the home sale exclusion rules which state that if you own and live in your home 2 of 5 years, the gain can be excluded.  I believe it was enacted in 1999 (or thereabout).

This was a huge benefit to home owners over prior law.  The prior law required you to buy a home of equal or greater value than the home you sold.  Unless you were over 55.

With this change, you could now sell your home and rent until you found the right property.  If you moved from a high cost of living area to a much lower one, you would not have to fear being taxed because your new home was less in value, even if larger.  It provided opportunity – that is, an incentive, to consider moving every few years instead of every decade.

Yes, as with all changes like this, there were lots of attempts to structure transactions to get the benefit without technical compliance.  And there is a link between IRC 121 and the huge run-up in home values in the early 2000’s but I think, overall, that this “reform” served the economy better than under the old law.

Now, congress wants to update IRC 121 and incentivize people to live in their homes longer by requiring 5 years of 8 owning and living in the home.  It remains to be seen if this is a positive or negative incentive – especially with an economy that possibly is going to require citizens to relocate for new job opportunities.   But the point is, it might take more than 5 or 10 years to determine if a change helped or hurt the economy.  And if, after 10 years, congress sees that it is perhaps not working as intended, I would hope they would try to correct it by having a fair and open debate.  Ahh to be a dreamer.

As you read the opinions of your favorite pundits and listen to your talking tax heads, keep in mind that things change constantly.  So, have a happy thought and don’t get wrapped up in the minutia of their debate.  Updating the tax code is a good thing, although I do agree it could have been handled a little more maturely by everyone involved.

 

It’s Official

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

In today’s newsletter from Currie & McLain, they told their clients that they are officially becoming part of Integrated Tax Services (ITS) effective January 1, 2018.  It has been a pleasure to work with the team at Currie & McLain and I know that ITS will be able to offer the same excellent tax service clients came to appreciate from Currie & McLain.

Doug and I purchased the HOA and condo client base of Currie & McLain in September so that there was a firm ready to handle the audit and review services for homeowner associations and condo properties.  C.O.R.E. Services does not do taxes, we refer that out to ITS and other firms who demonstrate superior client service.  But we do offer the review services that are often required of businesses with bank loans and financial statement loan covenants.

So what does this mean for clients?

ITS will be able to do all your tax work and I would strongly encourage you to continue your relationship.  With the integration of the preparation teams, there will actually be more qualified staff to work with clients.

For businesses who need attest work on their financial statements, C.O.R.E. would like the opportunity to work with you.  Because we only focus on audits and review engagements we dedicate our resources to completing these engagements timely and effectively.  We encourage you to have ITS prepare your business tax return while we do the procedures to be able to issue an opinion or conclusion on your financial statements.

C.O.R.E. emphasizes audits and reviews of common property associations – HOA’s, condominium associations and co-operatives.  Doug and I have many years of experience in both the technical aspect of audits and reviews as well as many years of focus on these types of associations.

If you are on a condo or HOA board and are looking for a quote for an audit or review and are interested in working with a firm that dedicates itself to performing the right procedures to ensure that your management’s accounting is accurate, feel free to reach out to C.O.R.E. Services.  If you would a referral for your taxes, either personal or business, we would be happy to give you the right referral based on your needs.

Have a great weekend.  And congratulations to Leslie, Linda and Doug for taking such excellent care of their clients.

Deferred Tax and Tax Reform

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

This is going to be entertaining.

We have a few clients that have substantial deferred tax assets – mostly from net operating losses (NOL) carried forward during their start-up period.  Tax losses for corporations are typically carried back two years and carry forward 20.  The problem is that when the adjustment was made, the assumed tax rate was above 25%.

Why is this a problem?

Lets say that a company had a $400,000 loss in 2016.  The assumed tax rate for book purposes was 25% and so is carrying forward NOL of $100,000 from that loss.  the adjustment to initially record this was

Deferred tax asset           $100,000
Income tax benefit                               $100,000

The income tax benefit is part of the income tax expense (benefit) line on the P&L statement.

2017 was a breakeven year, no income or loss for book purposes so the tax expense (benefit) recorded is $0.

But there is a problem.

Congress is enacting sweeping tax reform which indicates that the new tax rates are going to be 20% for 2018 and beyond.

GAAP requires that assets be reviewed for impairment at least annually.  Well, this deferred tax of $100,000 is an asset.  So is it impaired?

Since the law has not been signed as of today, it is not set in stone.  So one argument is that, since you are not sure of the actual change, you shouldn’t reduce the asset value.  However, is it more than remotely possible that the tax law will change?  And if so, should the impairment be recorded?

Since both houses of congress have passed a corporate tax law which reduces taxes and the president has indicated that tax reform will be signed, all indications are that corporate tax law will change.  And since, in this case, the law is expected to be in force for 2018, it appears that new tax rates are more than remotely possible.  It is probably a near certainty.

So what do we do?

I think businesses need to look at their deferred tax accounts and ask if the carrying amounts are correct for their upcoming year ends, even if the tax law is not passed prior to 12/31/17.  Just as importantly, I think if your company has a September, October, or November year end you probably need to look at those accounts and determine if the amounts accurately reflect possible changes.

In this particular case the client should probably record an entry to reduce the deferred tax asset to $80,000.  The adjustment would be in the current year as the original adjustment was correct given the known fact patterns.  So an adjustment of the prior periods tax benefit would not be correct.

You will also want to make sure you either update your tax footnote or add one to explain the changes and how your company implemented them.

The good news is that this adjustment should not have a major impact on bank loan covenants as most base their covenants on EBITDA – earnings before interest, taxes, depreciation, and amortization.  No matter what the tax adjustment, EBITDA won’t change.

However, there may be still be a gotcha to this as it appears there is possibly going to be a limit to the deductibility of interest expense.  Latest read was that it was capped at 30% of profit before interest.  If this holds up, then it is possible that, in the example above, there might actually be taxes due.

Lets say that the Company made $50,000 before interest expense.  The interest expense was $50,000 which led to the breakeven.  If they cap interest, then for tax purposes, taxable income is $35,000 (50,000 X (1-30% cap)) which leads to income taxes due of $7,000.  But for book purposes, the tax effect was zero, leading to the $7,000 being added to the deferred tax asset – at the same time you are reducing it for the reduction in rates.

And you thought accounting was boring.

Like I said, entertaining.

Have a great day.

Consequences

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

Happy Wednesday.

Prior to my going to work in the private sector as first a business development and marketing director for a startup and then a controller, I worked with lots of small business owners.  Almost all were structured as S Corporations.  And they almost always got in trouble for unreasonable compensation issues.

Unreasonable compensation is an outlier issue.  What I mean is that, compensation is considered reasonable if it is likely someone would take that pay package in the real world.  With C Corporations, the unreasonableness comes when the owners receive W2 income that is not tied to their job performance and where it drives the Company’s profits to zero.  With S Corporations, the unreasonableness comes when owners don’t take wages and instead act as though the business earned all the profit.

An Example:

XYZ Corp. earns $1.0 Million before payroll to Owen, the 100% shareholder.  Owen wants to take all the money out of XYZ, and at the lowest possible tax cost.  This is a fair requirement and depending on C or S status, drives a particular approach and potential audit issue.

As a C Corporation, XYZ would not want to say that Owen didn’t earn a wage and issue a dividend.  First, XYZ would pay about $350,000 of tax on the $1.0 Million in profits (35%).  Then, Owen would receive the $650,000 and pay about $100,000 in personal tax on the distributions (roughly 15%, I rounded up for simplicity sake).  So, Owen would net only $550,000 out of $1.0 Million.

If XYZ paid Owen $900,000 in wages, the tax consequences are more involved but lower.  First would be the payroll taxes, which is equal to l.2% of the first $150,000 of wages for both Owen and XYZ, plus 1.45% each for medicare on all of the wage, roughly $25,000.  Total payroll taxes are $45,000.

Owen hates the idea of writing a check to the IRS in April so he has 35% withheld.  The total withholding is $315,000.

And XYZ earned a profit of about $50,000 (since the company’s payroll taxes and the wages paid are deductions) and owes about $7,500.

Total taxes when paid out in the form of wages and driving XYZ’s profits to near zero?  $370,000 and Owens net cash received is about $570,000 (rounded of course).  And if he took a dividend of the remaining $40,000 net cash in XYZ, he would net almost $600,000, or a total overall tax rate of 40%.

The IRS would prefer that XYZ have much higher profit and taxable dividends to Owen as the combined tax effect is higher.

But what if Owen elected XYZ to be an S Corporation?

Here the consequences are reversed.  If, as an S Corporation, Owen took the $900,000 in wages, the tax effect would be the same.  But, he personally would pay the tax on the $50,000 at his marginal tax rate – 35%.  The total tax bill would be closer to 45% which is not as good as being a C Corporation and paying wages.  But, what if he didn’t take a wage?

XYZ would pass the net income to Owen, $1.0 Million.  Owen would be taxed at 35%, or pay $350,000.  There would be no payroll taxes and there are no corporate taxes so that 35% is all there is.  Net cash to Owen is $650,000.

This is a far superior approach as it drives the lowest overall tax bill.  It is also fraught with serious consequences as it is likely even more “unreasonable” than the C Corporation paying everything out in wages.

Which brings me to a quick story.  A new client came to see us – a dentist.  Not surprisingly he was being audited for unreasonable compensation.  You see, the good doctor decided to pay himself $12,000 a year and claimed that his practice generated profits of almost $500,000.

His case wasn’t helped by the fact that 2 years earlier he was a sole proprietor and earned $300,000.  The year after that he was a C Corporation and paid himself $400,000.

He wanted to know what to do.  I gave him two choices.  Pay the firm $10,000 to fight with the IRS and most likely lose and have 100% of the profits taxed as wages or pay us $2,500 to negotiate a more realistic figure of about $200,000 for wages.

He wisely chose the later option.  We were actually able to make the case that a “reasonable profit” from the business was about $300,000 – taking into consideration the focus on non-dentist services offered and a return on his capital investment.  We also convinced the IRS to waive penalties and interest on the underpayment.

If (and possibly a big IF) the tax law changes for pass-through entities, this type of challenge will become even more prevalent.  So, if you own a pass-through entity, make sure your professional is looking out for your best interest, not just how much tax can be saved.  And if you would like to discuss your tax position with someone, feel free to send me a message.  Remember, pigs get fat and hogs get slaughtered.

Have a great day.