Category: tax planning

Agreements Matter

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

I have been summoned to a meeting.

I was helping a developer client with a sticky problem.  Once of the LLC’s was showing unequal capital accounts and I was tasked with trying to figure out why and then work with the LLC’s tax advisor on getting it straight.  Now the members wanted to discuss the impact of the plan to correct the problem their not following the operating agreement created.

The capital accounts were all out of sorts with a low of about $4K and a high of $50K.  Now, it is important to realize that the LLC was owned equally, 20% each for five members.  Distributions were all over the place.  All distributions happened on the same day but for entirely different amounts.  There were no instructions in the operating agreement to allow for disparate distributions.

The LLC’s CPA and I set up a meeting to review what had been happening and why.  The concern is that at least one capital account will go negative in 2019 and there is a plan to sell the project in 2020.  Not surprisingly, there is no claw-back or capital restoration provision in the LLC operating agreement.  So, someone was getting a bunch of money upfront with no requirement to take less than their 20% of the net proceeds upon sale.

The stuff of lawsuits.

Here is the frustrating part.  The tax advisor knew what they were doing was going to cause a problem but what could he do?  It was why he had his team set up the first layer of reallocations – to try and address the shifting of cash without the shifting of income.  Clearly it wasn’t enough.

I give him credit, he had tried to address this matter repeatedly over the previous 3 years.  He shared with me all his emails and memos to the manager and members.  To the members, it wasn’t a problem, until it was; capital accounts are edging towards negative territory.  His efforts to get the Members to see reason wasn’t working and it was now becoming a serious problem as almost 20 individuals were involved in this LLC.

The basic issues:

82% of the space is occupied by tenants controlled by the members.  Each of these tenants pays the same lease rate / square foot.   This is so even though they do not occupy the same amount of space.  Tenant 1, which is controlled by Member A occupies 25% of the total SF while tenant 5, controlled by Member E occupies less than 8%.

This isn’t as irrational as it sounds.  I agree that the goal should be to charge market rates for the space being occupied.  The 5 controlled tenants are paying $32.00 / SF.  It is a class A office building in downtown.  Each of the controlled tenants is occupying and using all the space they are paying for.  Is $32/SF reasonable?

Or perhaps that is the wrong question.  If we determined that the rent was overpaid, wasn’t it logical to offer a rent rebate back to the tenant?  After all, the tenant is the one who paid the rent, not the member.  The ownership of the LLC members was not the same as the tenant.  And remember, none of the members actually leased space; their businesses did.

What the CPA and I agreed to was that none of the tenants were overpaying rent, even though they are controlled by a member.  A business with 20 employees (tenant A to a tee) would occupy 5,500 SF of class A space.  They would pay anywhere between $20 and $40 / SF.  A business with 6 employees (tenant E) would pay between $24 and $48 / SF.

What we want is the members to accept that certain tenants (the affiliated tenants) are occupying the space and paying the rate / SF they are, due to the superior negotiating strength of the respective Member.  In short, Tenant 1 management was convinced to pay fair rent in this building for the space occupied.  Neither tenant nor member used a leasing agent.  Tenant was unable to negotiate a lower rate due to the control.  If this is true, couldn’t the argument be that the Member who put the tenant into place should get the benefit of the premium paid to the LLC for the additional rents paid and costs avoided?

Naturally being accountant’s we had to make it a little more complex but we ran it by counsel and the lawyer felt it was reasonable.  We had economic substance – a rational reason to reallocate cash flows and we had a model which supported the calculation.  Our reasoning that larger spaces could command a discount is sound and the fact that the controlled tenant didn’t (or couldn’t) request lower rents was because of the control of the Member.

The calculation actually allowed us to document almost all the distributions.  Three tenants had been overdistributed during the prior 4 years and two received less than they should have.  The largest over distribution is about $37K and the Member with the largest deficit was only $27K.  These can be corrected in the last distribution of 2018.

The downfall of this plan is that we would be creating specific allocations of the revenue.  The only way to do this fairly was to treat the payments as guaranteed payments.  That means that the Members could potentially see a tax hit for the payments.  Naturally, no one is happy about that and this is the reason for the meeting next week.  Also, no one wants to amend the prior returns as the sheer number of returns involved amounts to almost 200 separate amended returns.

Since I don’t know the tax situation of any of the individual members I can’t say with certainty what the net effect would be when passed through to all the various owners.  My gut instinct is almost zero; which means the concern is overblown.  But people fear what they have been conditioned to fear; in this case, each Member has a different tax advisor who has considerable influence over the client and each tax advisor has a different take on taxes.  Me personally?  I think that taxes are an ordinary cost of being in business: Make money – pay taxes.  But like any business cost, there is no need to pay more than you should.

I happen to agree with the LLC’s tax advisor.  the net cash flow from the rents after debt service should be distributed only in relationship to the Members ownership, i.e. 20% each.  If they wanted it another way, the structure should have been different – that is, perhaps the tenants should have purchased their space similar to a condominium arrangement and then they could have redistributed the net back to the owners.  But, that isn’t the structure they wanted.  They wanted to keep it simple.

While I understand the argument from the Members, it doesn’t stand scrutiny.  The rents charged were within an expected range.  Yes, Member A has a point; in comparison to smaller spaces for the other tenants, his company is overpaying.  But in relationship to the rest of the market, the lease rate was reasonable.  I can see where the Member could say he was being forced to shift income and cash flow to the other members if they didn’t reallocate; so what? This could have been easily avoided by the Member owning a smaller building and leasing it to his business as the sole tenant.  That isn’t what they wanted.

All this simplicity created enormous complications.  So, it is extremely important to think through your organization and how you want to generate revenues and distribute profits because in many cases your options are limited by the structure of your agreement.   Agreements matter and trying to smash a complex arrangement into a simple business agreement will cause nothing but headaches.

 

An Uncomfortable Moment

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

The other day I was speaking with another CPA firm’s leaders about opportunities to cross-refer – they don’t do audits or reviews and we don’t do taxes – and I was asked what one of my most uncomfortable professional issues was.  I dislike airing my dirty laundry but at the same time, I have found that being forthright about these things helps me heal as well as hopefully provide a lesson for other professionals.

In 2002 I was “interviewed” by a joint task force investigating abusive tax practices.  Even today I am upset with myself for having put myself in that position.

I was in my 7th year (2000) and was recently given responsibility for managing the tax team along with the accounting and auditing team.  Beyond knowing what was, and more importantly wasn’t, allowed, the owners felt I could apply some of our audit processes to tax.  It was fun redesigning the entire workflow to streamline the processes.  I was also part of the local chamber and about that time I was asked to give a presentation on tax planning for small businesses.

After my presentation, I was approached by two gentlemen who wanted to discuss an idea they had.  I am always game for a business conversation so I set an appointment with them.  They gave me some materials they put together and asked if I would read them to plan for the meeting.

As I read their stuff, I became concerned about what they were trying to do.  I made my notes, did lots of research and came to the conclusion that what they wanted to do wouldn’t fly.  But…

And this is where things went sideways for me.  I love a challenging problem.  So I decided to change the scenario, restructured how it should work, Identified potential pitfalls and even created the basic literature to help them with sales.  All told, I invested about 20 hours into this before we even met.  But I felt good – I took a problematic process and modified it to where it would work.

When we finally met, they appreciated the information but were disappointed that I felt their plan wouldn’t work as they had originally conceived it.  I walked them through my analysis and they seemed to have a response to every point.  This seemed odd, so I asked them about how they had come to so much knowledge about this… and they divulged that they had been to 3 other firms who each had found flaws in their plan: I was the only one to offer a full rebuttal and a new concept though.

They asked me how confident I was in my research and I told them very confident.  They then offered us $15,000 to help them formalize the documentation and issue a tax opinion on the plan.  That was a good sized engagement and I felt I had convinced them that my way was superior to theirs – even if they couldn’t offer a huge tax benefit to participants.

The next week I met with their in-house accountant and their attorney, along with the owners.  Once we got going they kept pushing to use their original plan as they felt it was bullet-proof.  I told them that if they felt it was bullet-proof then they didn’t need me.  I explained that their plan would never fly; they kept saying that it was being done by this firm on the east coast.  They got another lawyer on the phone from back east who allegedly represented the firm who was “killing it”. He agreed that it was a “gray area” but he was certain it could pass an IRS challenge.

I did a lot of soul searching on the matter.  They were certain they were right and I was certain they were too aggressive.  I felt our more conservative approach would survive a challenge, which was most likely to happen since they were targeting larger corporations with their plan.  In the end I wrote the opinion letter based upon the plan I outlined, not theirs.  I wrote them a separate letter stating why their plan would not work, quoting chapter and verse of the tax code.

They thanked me, paid our bill and I never heard from them again.  But I did hear from the task force about 2 years later in 2002.  It seemed they decided to use our tax opinion letter to support their more aggressive plan.  One of their customers used it to justify their participation, were audited, and showed the IRS auditor our opinion report who then pointed out that the plan they put in place was not the plan I wrote an opinion on.

Which led to my being interviewed.

I missed the warning signs.  I understood opinion shopping but hadn’t really faced it before.  I was quite proud of that research and how well we documented the situation.  It was complex and challenging.  But I failed to heed my own warning signs.  I saw the problem and thought they could see the elegance and superiority of my plan.  In the end they saw their greed and willingness to use people to get the results they wanted.

It was an uncomfortable experience and I don’t recommend it to any professional.  It did, however, give me great life, and business lessons that I still use to this day.

  • Go with your gut.  As a professional advisor, you have to trust your instincts.  Not every client is a perfect client and if you feel they are not a good fit, go with it.  There are other client opportunities out there.
  • Be wary when clients shop other advisors.  I think a client interviewing several potential firms is a smart move, especially for business clients.  I encourage it.  But it is entirely different when they seem to have paid several firms for advice they don’t seem interested in heeding.
  • If a client plans on using your work to stay out of trouble, make sure it is effectively documented.  We had an engagement letter and I kept copies of all our drafts and research.  We also kept all their correspondence which showed their thoughts and plans.
  • Finally – slow down.  I love a good juicy complex problem.  I enjoy research, writing and presenting.  But I jumped into it before I knew the client.  I inadvertently talked myself into this engagement by buying into the solution I presented.  Had I gotten to know them a little better, we would have likely turned down the work.  Yes, a good sized engagement is always hard to turn down, but having to sit for an interview with law enforcement is almost always going to be uncompensated.

Be selective.  I have come to understand me and my passion for problem solving.  But I have also learned that not everyone’s problem is worth the energy.  I like underdogs, I love winning.  I have learned to love learning (losing) by choosing the work I want to do for clients I am passionate about working with.  Having fewer, more engaging clients who value your input and expertise is much better than tons of clients who treat you as a commodity.  Quality over quantity every time will help you become healthy, wealthy, and wise.

 

Will You Need a Tax Preparer Next Year?

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

One of the big “selling points” (to use the term very loosely) of the new tax act was that it would make tax filing simpler for the vast majority of people.  Oh, but if that were true.

Put it this way, if you are currently paying over $500 for tax preparation you will likely still need to see a professional to ensure that you are in compliance with tax law.  Your taxes are not simpler to calculate and you are likely faced with a monstrous number of choices that some professional guidance is warranted.

As discussed previously, if you are in business for yourself and live in a high tax state, It is unlikely that you can easily file your own taxes.  I mean, except for those engineers and frustrated accountants out there who think that the real magic is in dropping numbers into boxes and creating an Excel spreadsheet to do the calculations.  That is the easy part.

You are facing a daunting array of choices and options – from filing as a C Corporation to the amount of wages you should pay.  Do you take bonus depreciation or regular?  Each decision has current and future ramifications that can benefit or hurt you.

Will you need a tax preparer?  Most likely.  Oh, not if you are a W-2 employee for a company and have a modest lifestyle.  Let’s face it, $12,000 of itemized deductions is hard to get over as a single person.  Property taxes, state taxes and mortgage interest will likely be only about $10,000 at best.  Your taxable income will be higher but your bracket will likely be lower – which is the tax reduction you were promised.

If you are a sales professional who used to have a fairly outsized unreimbursed employee expense deduction you will likely no longer need an accountant to prepare your taxes.  You may want to talk with one though to help you renegotiate your compensation package because the loss of those deductions is going to sting.  Unless you can make it work as an independent distributor of the companies products – in which case, yes, you may want to work with a tax preparer.

You will adapt to the new tax law just like tax preparers will adapt.  I doubt that 2019 will see a dramatic reduction in the number of returns filed by paid tax preparers; perhaps by 2021.  Of course, that assumes we are not whipsawed by a change in congress which decides to change the tax code again.

In the meantime, use your resources to engage the best professionals available.  If you are interested in starting a business then I suggest talking with a professional who can help you plan and grow your business profitably.  Too much of an emphasis on taxes minimizes your potential.  Trust me, there are lots of ways to use profits to improve your business but you have to make the money first.  The easiest tax planning is based on zero.  It is the absolute worst for planning your life though.

Time for the plug.  If you are looking for some solid planning feel free to contact me.  I enjoy working with small business owners who have dreams of making a ton of money and who want great advice for getting their business to the next level.  I am here to be of service to you.  Feel free to contact me anytime.

Have an awesome Tuesday.

The New Bonus Depreciation Deduction

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

Continuing on with my examination of the new tax act, I am going to examine the purported meat of the “jobs” portion of this act.  Beginning 9/27/17 (that’s right, assets purchased as of a very odd date at the 3nd of the third quarter) you can deduct 100% of the purchase price for certain qualifying assets.

But, this is one of those temporary tax deals.

Placed in Service before % Deductible
1/1/2023 100
1/1/2024 80
1/1/2025 60
1/1/2026 40
1/1/2027 20

It get better, I think.  the new code appears to also allow for the purchase of used property.  The code section they added says, ”

c) APPLICATION TO USED PROPERTY.—
(1) IN GENERAL.—Section 168(k)(2)(A)(ii) is amended to read
as follows:
‘‘(ii) the original use of which begins with the
taxpayer or the acquisition of which by the taxpayer
meets the requirements of clause (ii) of subparagraph
(E), and’’.
(2) ACQUISITION REQUIREMENTS.—Section 168(k)(2)(E)(ii) is
amended to read as follows:
‘‘(ii) ACQUISITION REQUIREMENTS.—An acquisition
of property meets the requirements of this clause if—
‘‘(I) such property was not used by the taxpayer
at any time prior to such acquisition, and
‘‘(II) the acquisition of such property meets
the requirements of paragraphs (2)(A), (2)(B),
(2)(C), and (3) of section 179(d).’’

To interpret legaleze, the “original use” means new property.  Under the old code, what you had to buy in order to qualify was new, under the premise that new stuff creates jobs.

The new tax law adds a new clause, “such property was not USED by the taxpayer at any time prior to such acquisition…”  Again, to interpret, whatever you buy will qualify as long as you didn’t already use it before buying it.  Think converting a leased car.  You were using it and then decide to “buy” the car.  This would not qualify as you already used it.  It doesn’t stop you, however, from buying someone else’s leased vehicle and then claiming the bonus depreciation.

Ok, I am with you, used equipment doesn’t generate jobs.  But it does allow a business the option now of spending 30-40% less by buying pre-owned and still getting the 100% write off.

What is interesting is the new tax law provides taxpayers the option to elect out of the bonus depreciation.  I will admit that under the old rules, where we had graduated corporate tax rates, I often suggested that C Corporations elect out because the item was taxed at less than 25% and we were pretty certain that the next years tax rate was going to be 35%.  But now, it is a flat 21% so there are no brackets to maximize.

The election is no doubt for Schedule C businesses and possibly pass-through entities since they are still subject to the graduated tax brackets.  I have to analyze a few scenarios to see if the election is worthwhile though.

And try to find the hidden gem that is no doubt lurking in one of the “by extension” paragraphs.  These call to the other code sections to ensure their references are updated and possibly one of these has another limit I haven’t caught yet.  Stranger things have happened.

Naturally, please don’t take this as tax planning advice and whatever you do, don’t rush out and buy stuff without talking with your tax professional.  If you like, I am happy to discuss your situation and help you decide if taking the 100% bonus depreciation is worthwhile if you are not currently working with a professional.  Feel free to contact me if you have any questions about this or any other aspect of the new tax law.

Have a great day.