YOUR S CORPORATION – A CHECK-UP

P1250694-003

In my experience, a lot of people don’t pay enough attention to their Subchapter S Corporations until tax time, when it’s sometimes too late to correct errors or oversights.

You formed the S Corp because of the benefits you would get from it, so it would be a shame to operate it in such a sloppy way that you could miss out on some of those benefits. Please take a moment to be sure you are following these guidelines, and make any necessary changes before the end of the year.

Reasons for forming an S Corp generally include:

  • Reducing payroll taxes on a portion of your income
  • Retirement contributions in excess of the limits on IRAs and 401(k) plans
  • Deduction of health insurance costs
  • Limited liability

I will discuss these items briefly below, then move on to some other relevant thoughts.

W-2s and Payroll Taxes

Generally speaking, your S Corp does not pay tax, but rather the income “passes through” to your personal tax return. This pass-through income is taxed at your regular rates, but it is not subject to the federal and state payroll taxes you would pay if you were an employee.

It is important to note that a shareholder of an S Corp is not self-employed, but is actually an employee of the company. As such, you are required to pay yourself a reasonable salary, a term that is not clearly defined, but is intended to prevent shareholders from entirely avoiding Social Security, Medicare and other payroll taxes. One way to look at it is that you should pay yourself what it would cost to hire someone to do your job.

Your salary is treated as a deduction by the company, so you aren’t taxed twice. You pay payroll taxes on your salary, but you don’t pay payroll taxes on the remainder of the S Corp’s income after deducting your salary. That’s one of the benefits of an S Corp.

Action required:  Pay yourself a salary, and issue a W-2 at the end of the year. I suggest you use a payroll service to be sure you are in full compliance with the complex rules and regulations surrounding payroll. Do this before the end of the year.

Retirement Contributions

As an S Corp owner, you have a choice of retirement plans that you can establish. One of the most popular plans is a Simplified Employee Pension, or SEP. An advantage of a SEP plan is that the company can contribute a percentage of your salary, up to a maximum contribution of $54,000. This is substantially higher than the limits for IRAs and 401(k) plans. Do be aware, though, that you also have to offer the plan to your other eligible employees, and contribute the same percentage on their behalf. This is a specialized and complex area, so you should speak with a knowledgeable professional on the subject.

It is important to note again that as an S Corp shareholder, you are not self-employed, but rather an employee of the company. The retirement plan must be created in the name of the company, not yourself, and the contributions are made by the company. Contributions are deductible from the company’s income of course.

Action required: You can establish a SEP retirement plan any time during the year, or up to the date when the company’s tax return is due (even if you file for an extension). Other types of retirement plans may have different rules, so be sure to investigate before the end of the year.

Health Insurance

As an S Corp shareholder, you can deduct health insurance costs for yourself and your family directly on your tax return. But there is a special process for doing so, and it is important that you follow it. The company must pay for your health insurance. It is acceptable to have the insurance in your own name and make the payments yourself, but you need to have the company reimburse you, and deduct the expense.

Health insurance paid by the company is considered compensation to you, and must be added to your salary on your W-2 at the end of the year. You will not pay payroll tax on this amount, but it must be included in gross earnings. You then deduct the amount directly on your personal tax return.

It seems a bit convoluted, but those are the rules.

Action required:  Be sure to have the company reimburse you for medical insurance payments before the end of the year, and be sure to instruct your payroll service to include it on your W-2. If the payroll service gives you trouble, ask to speak to a supervisor… they do this for thousands of people every year.

Limited Liability

To ensure that your S Corp offers limited liability you need to be disciplined in the way you operate it. Without going into depth, you need to establish that it is a separate entity, and not just an extension of your own personal finances. That includes keeping a separate bank account and credit cards, maintaining careful accounting records and keeping up to date with your state’s filing requirements.

Action required: Check that you are following the appropriate discipline to ensure your company is a separate entity.

Estimated Tax Payments

We are required to make payments during the year of the amount of tax we estimate owing for the whole year. This is easy for the salary you pay yourself, because you are expected to withhold and pay federal and state tax from each paycheck.

The issue here is the tax you expect to pay on the company’s earnings that pass through to your personal return. Depending on your situation, these amounts can be substantial, and to add insult to injury, there are penalties for underpayment of estimated tax.

Action required:  Speak with your tax professional at least once during the year, to be sure you are making appropriate estimated tax payments.

State and Local Tax Registration

Many cities have tax filing requirements, and it can be annoying and expensive if you haven’t met their requirements. Los Angeles, for example, assesses tax on income above a specified level, but also has a requirement to register for a business license and renew it every year.

If you are operating outside the state in which you registered the company, you need to check on filing requirements. California, for example, is very aggressive about finding and taxing out-of-state businesses that do business there.

Action required: Learn the filing requirements, and follow them. They will find you if you don’t.

Auto Expense and Home Office

The S Corp can own a car, and deduct any allowable business expenses, but you may find it easier to keep the car in your own name, and submit for reimbursement any business mileage, documenting the locations, distances and business purpose of each trip. You would complete form 2106 on your personal return, and deduct the reimbursement. I often find it convenient and preferable to use the IRS standard mileage rate where eligible – it’s 53.5 cents per mile in 2017.

Similarly, assuming you meet the rigorous and very specific requirements, you can deduct an expense for the business use of your home office. Again, submit expense reports for reimbursement, detailing the square footage of your office space and the total size of your home, in addition to specific allocated costs such as rent, mortgage, utilities, etc.

Action required: Submit detailed expense reports, and have the company reimburse you. Do this before the end of the year.

An S Corporation can be a very useful business format, but there are rules that need to be followed to ensure you get all the appropriate benefits. And remember that an S Corp is not necessarily the best entity for you, depending on your situation and your objectives.

As always, speak to a tax professional before acting… and after!

Advertisements

DO I NEED AN LLC?

P1250709-001

Whenever a client tells me they’ve formed, or plan to form an LLC, I ask…

Why?

Especially if they don’t have partners in their business.

The question takes a lot of people by surprise, because they just assume they need a company to start a business, or they think it’s the only way to achieve liability protection. They often haven’t considered the costs of forming and maintaining an LLC, and even more often don’t know how to operate it prudently.

An LLC (Limited Liability Company) can be a useful structure under certain circumstances, but they aren’t for everyone. Here are some thoughts:

– LLCs are kind of cool. I had an LLC myself, and it felt pretty cool, until I added up all the other factors and costs

– You don’t need an LLC to operate a business

– Limited liability may give you some protection against creditors or liability claims, but it’s not a sure thing

– A single-member LLC doesn’t even exist for federal tax purposes, so it’s exactly the same as operating as a sole proprietor

– Maybe an S Corp would serve your needs better

– There may be a state tax or filing fees for your LLC – the California minimum tax is $800

– You need to stay current with all LLC filing requirements for your state, or you may lose the benefits of the LLC

– Forming an LLC in another state may not save you tax in your home state

– Tax rates are higher on self-employment earnings – with or without an LLC – so you need to make estimated tax payments

– You can make much larger deductible retirement contributions if you are self-employed – with or without an LLC

– You can deduct your health insurance if you’re self-employed – with or without an LLC

Sole Proprietorship

There is nothing to stop you from starting a business without an LLC. When you operate a business in your own name or a DBA, it’s called a Sole Proprietorship. You can buy and sell products or services, buy equipment, rent space and incur operating expenses for your business. If you keep careful records and maintain separate bank accounts, the business can be accounted for separately from your personal activities.

For tax purposes, your business is reported on Schedule C of your personal tax return – Profit or Loss from Business. Your net income is taxed as ordinary income, and is subject to an additional Self-Employment Tax. This is basically your social security and medicare tax that you would pay if you received a paycheck from an employer. The difference is that you pay the employer share of these taxes, too. The calculation is complicated, but it comes to a little under 15%. You need to keep this in mind when making estimated tax payments during the year.

In a sole proprietorship, there is no built-in protection against creditors or liability claims.

Single Member LLC

If you are the only member of your LLC, you are taxed exactly the same as if you were a sole proprietor. A single member LLC is called a Disregarded Entity for tax purposes, which means that the IRS doesn’t even recognize its existence. Your business income is reported on Schedule C of your personal tax return, and you pay the Self-Employment Tax.

The only difference is that, depending on which state you are in, you may have to file a separate LLC tax return or information return, and/or pay an LLC tax or filing fee.

And oh, yeah… there is theoretically some protection against creditors and liability claims.

Limited Liability

Yes, limited liability means that the company is a separate entity for legal purposes, and creditors or legal claimants can only go after the company’s assets. You are only liable to lose any amounts you have invested or lent to the company, and your home and other personal assets are protected. That’s the theory, anyway.

Let’s look at it practically… Is anybody really going to lend money, lease property or give credit to your single member LLC without a personal guarantee from you? I didn’t think so. So what is the benefit of limited liability against creditors if all the LLC debts are your personal responsibility?

And what about liability claims? Sure, you have limited liability, as long as you operate the LLC in a disciplined fashion… and if you aren’t crooked. If a claimant or creditor is determined to go after your personal assets, they may try to “pierce the corporate veil.” That is, if they can demonstrate that you didn’t use separate bank accounts or separate credit cards, and generally didn’t operate the business as an entity completely separate from your personal affairs, they may get past the limited liability protection offered by the LLC. The same goes if they can demonstrate that you behaved fraudulently.

Insurance

How much liability do you expect to have? Most businesses don’t have that much to worry about – how much liability can your IT consulting business or online retail operation really generate? Liability insurance should cover most situations at a reasonable cost, and umbrella insurance would be an added layer of protection. A lot easier than operating and paying for an LLC.

Of course, there are businesses with potentially greater liability. It is common to see LLCs formed for day care facilities and rental properties. This is typically in addition to liability insurance. Just remember to be disciplined in keeping the business separate, and keep up to date on your state filings and payments.

Subchapter S Corporation (S Corp)

Depending on the size of your business, you might be better off forming an S Corp. One of the features of an S Corp is that not all of your income is subject to Self-Employment Tax, as it is in an LLC. There are a lot of issues that need to be weighed in going this route, but there are even more rules that need to be followed to the letter in order to realize the ongoing benefits. I’ve seen many S Corps formed by people who were never taught how to operate them, and left them exposed to unfavorable tax and legal consequences.

Out-of-State LLCs

Some states have high taxes and fees for LLCs. California, for example, has a minimum tax of $800. This gives some people the bright idea of forming their LLC in a state with lower costs. Don’t do it. Your home state – especially California – will catch you, and they will claim that you are conducting business in that state. You will then be required to pay tax and penalties.

Delaware is a very popular state in which to form an LLC, for a variety of reasons. Depending on your home state, you will probably want to register the LLC as a foreign LLC doing business in your state. That is certainly the case in California.

Retirement Plans

You can deduct much larger retirement contributions if you are self-employed. While a regular IRA contribution is limited to $5,500, a SEP IRA contribution can be 20% of your self-employment income, up to a total contribution of $54,000. You don’t need to have an LLC to be eligible for a SEP IRA. The same goes for deducting your health insurance.

Am I saying you probably don’t need a single member LLC? I like to joke that the average life of an LLC among my clients is a year and a half. They don’t mind paying the $800 California tax the first time, because they are full of hope and ambition, but the second time it comes up, it’s pretty hard to see what they are getting for their money… So yeah, I’m saying you probably don’t need an LLC.

Buying a House … Residence vs Rental Property

IMG_4156-002

A common question my clients ask is “Should I buy a house?” A logical extension of the question is “Should I live in the house, or would I be better off renting it out?”

Actually, the question is more often phrased “What are the tax benefits of buying a house?” This can result in a barrage of technical information that doesn’t answer the real question.

THE TAX STUFF

Let’s get the technical tax stuff out of the way:

–  The interest portion of your mortgage payment and your property taxes are tax deductible
–  If you rent out the property, you can also deduct operating expenses like repairs, utilities and management fees
–  If you rent out the property, you can also deduct depreciation. The house itself is depreciated over 27.5 years. Improvements, furnishings and appliances are depreciated at faster rates
–  If you live in the house for more than 2 years, you don’t have to pay tax on the first $250,000 of capital appreciation – the exemption is $500,000 if you’re married and file a joint return
–  If you make under $100,000 you can deduct rental losses on your tax return. But if you make between $100,000 and $150,000, the deduction phases out to zero. The good news is you can deduct the disallowed losses when you sell the house
–  If you rent the property, your gain on sale is taxed at capital gains rates, which are lower than regular rates. Depreciation you deducted is recaptured at regular rates
–  If you pay Alternative Minimum Tax, all bets are off…but if you live in the house, your mortgage interest is a deduction for AMT purposes

There’s the barrage of information. Do you know what you want to do now? I don’t think so.

WHAT YOU”RE TRYING TO ACCOMPLISH

Living in your house accomplishes three main objectives:

– You stop paying rent to somebody else
– Tax deductions for mortgage interest and property taxes make your monthly payments more affordable
– With a relatively small down payment, you get the benefit of the full amount of any gain on sale. It’s not unusual to make a gain as big as your down payment. That’s a 100% return on your investment – and $250,000 or $500,000 of the gain is tax-free

When you rent out your house, the objective is to bring in enough rental income to cover your cash payments for mortgage, property tax and operating expenses. Depreciation doesn’t affect your cash flow, but it can be used to create losses for tax purposes if you are in an income range to benefit from the deduction. I’m sure there are places where you can generate positive cash flow from a rental home, while paying no tax because of the depreciation deduction. A few years ago I worked with a Midwest homebuilder where we marketed houses for exactly that business model, but I now live in Southern California, and positive cash flow is only a dream.

Your income mostly comes from the gain you make when you sell the house. This gain is taxable, but it’s taxed at a lower rate than your regular income.

The downside of renting out your house is that you still have to live somewhere. Any profit you make will be reduced by the rent you pay. If you already own your home, of course, that’s not an issue.

RESIDENCE OR RENTAL – WHICH IS BETTER?

Here’s an example that compares the results of living in your home and renting it out.

I made a number of assumptions as the starting point. I’m sure you can poke holes in some of them, but bear with me.

– You are currently paying rent of $2,500 a month
– You have $150,000 for a down payment
– You buy a house for $600,000 and sell it 5 years later for $700,000
– You take a $450,000 mortgage at 4.0% interest, and pay 2.0% a year for property taxes
– You can rent the house to tenants for $3,600 a month
– Operating costs are $3,600 a year for your residence, and $5,000 for the rental
– Your selling costs are 6% when you sell the house
– Your regular tax rate is 30%

Option 1 – Don’t Buy the House

If you don’t buy the house, you continue to pay $2,500 a month in rent. After 5 years, you have spent $150,000. End of story.

Option 2 – Live in the House

Your mortgage payment is $2,170 a month, and your taxes are another $1,000. You’re now paying for repairs and maintenance, but the tax benefit of the interest and tax deduction means you’re only paying about $200 a month more than when you were renting.

You make $100,000 in profit when you sell the house (less $42,000 in closing costs) but you don’t pay tax on the gain. You also get your down payment back, plus you paid off $43,000 on your mortgage.

Over all, your total cost after 5 years is $63,000. This compares with $150,000 you would have spent on rent. Congratulations – by buying the house you saved $87,000.

Option 3 – Rent the House

You rent the house out for $3,600 a month, which is pretty much exactly the amount you pay out for mortgage payments, property taxes and operating costs. You get a tax deduction of $16,000 a year for depreciation, but if you make more than $150,000 it just adds to your deferred loss.

You make the same $100,000 profit when you sell the house. This is taxable at capital gains rates, but the $42,000 closing costs are deductible. As above, you get back your down payment and the $43,000 you paid down on your mortgage.

Your after-tax income from the rental property is $82,000. Nice, really nice. You’ve made a pretax return on investment of 11% a year. Compare that with the return on other investments.

BUT… not so fast.

You still have to live somewhere while you’re renting out the house. Right? Assuming you continue to pay $2,500 a month in rent, that turns your rental profit into a net cash cost of $68,000. The good news is that you’re still miles ahead of where you would have been if you hadn’t bought the house at all, and only about $5,000 behind using the house as your residence.

Do you think you could increase the rent on the house over 5 years? That would make the results of renting vs living in the house about the same, wouldn’t it?

CONCLUSION

Sorry, I’m not giving you a conclusion. This was just one example, and your situation is almost certainly going to be different. My assumptions are just assumptions, and you would have to do a careful analysis of the facts before you move forward.

There are a lot of subjective issues as well. Do you want the headache of being a landlord? And what about unforeseen problems like bad or unreliable tenants? But what about the upside gain if rents keep climbing the way they are in Los Angeles these days?

I would be happy to discuss your specific situation, and run my model with assumptions that apply to you.

Reduce Your 2015 Tax Bill

IMG_1221-001

My clients often ask me if I can help them reduce their tax bill. The answer is yes… but for most tax saving opportunities, you have to take action before the end of the year.

Here are some things you can do before December 31 that may have a big impact on your tax bill when April 15th comes around.

Itemized Deductions vs Standard Deduction

There is a long list of expenses that are deductible for tax purposes. They include medical expenses, charitable donations, mortgage interest, state and local income taxes, employment expenses, etc. Some of these expenses are subject to limitations, of course.

Most taxpayers are entitled to the Standard Deduction, though, so unless your deductible items add up to more than the Standard Deduction there is no need to keep track of them. A single person, for example, gets an automatic deduction of $6,300, and a married couple filing jointly gets $12,600.

Sometimes, you may find yourself with deductions that are close to exceeding the Standard Deduction, and accelerating payment of some of the deductible expenses could result in claiming additional itemized deductions. This strategy could result in making it difficult or impossible to itemize next year, but you will come out ahead if you can itemize every second year.

Keep this strategy in mind when you read the rest of my comments.

Defer Income / Accelerate Deductions

There are opportunities to defer income items that would be taxable this year, and move them into next year. You may also be able to pay certain deductible expenses this year that you might have waited to pay next year. This strategy only makes sense, of course, if you are not expecting to be in a higher tax bracket next year.

If you are self-employed, you can delay billing your customers or clients, so you don’t receive payment until after December 31. Similarly, you can speed up payment of some of your expenses, to get a deduction this year.

Talk to your employer about receiving any year-end bonus after December 31, so you don’t pay tax on it until next year.

Pay your January 15 state tax estimated payment before December 31. Make your mortgage payment at the end of December, instead of January 1. If your medical bills for the year are likely to be more than 10% of your income (7.5% if you’re over 65) then pay as many outstanding medical and dental bills as you can before year-end. Same thing for alimony payments and other deductible items due in January.

Property taxes are typically paid twice a year. In Los Angeles, they are due on November 1st and February 1st. Consider paying both installments this year.

An important note… For many taxpayers, particularly those with higher incomes, there is a limit to the benefit you can get from certain deductible expenses, and the Alternative Minimum Tax (AMT) comes into play. The expenses most likely to be affected are state and local income taxes (especially in California and other high-tax states) and office and employment expenses. If you are subject to the AMT, accelerating payment of these expenses will not do you any good. You should speak with your tax advisor about other possible strategies.

Take Losses Before Year-End

If you have losses on taxable investments, think about selling them this year. They will offset any capital gains you may have, but even if your losses are more than your gains, you can use up to $3,000 to reduce other income, and you can carry any excess losses forward to future years.

Retirement Plans

Make the maximum contributions to your retirement plans.

You can deduct $18,000 (more if you’re over 50) to your 401(k) plan – but make sure you contribute enough to get the full amount of your employer’s matching program.

You may be able to deduct up to $5,500 (more if you’re over 50) to a traditional IRA. If you don’t make a contribution before the end of the year, you have until April 15th.

If you’re self-employed, you can contribute to a SEP IRA or a similar plan. You can deduct approximately 20% of your self-employment income, up to $53,000. The good news is that you can make your contribution all the way up to the filing deadline, including extensions, which gives you time to calculate your income.

Don’t take money out of your IRA or 401(k) plan if you are under 59 ½ years old. There is a 10% penalty on top of the regular tax, and some states have an additional penalty.

You can take a distribution from your IRA without a penalty if you are a first-time home buyer, if you make qualified tuition payments, and several other special situations. Remember that if you have a 401(k), and plan to make tuition payments, roll the 401(k) over into a traditional IRA first.

Consider rolling over your traditional IRA into a ROTH IRA. You will pay tax on the full amount when you roll it over, but if you expect to be in a low tax bracket this year, for any reason, this might be a good time to do it. Also, there is no required minimum distribution from a ROTH IRA after age 70 ½.

Start taking minimum required distributions from your traditional IRA if you turn 70 ½. There is a 50% tax if you don’t.

Charitable Donations

Charitable donations are a nice deduction, assuming you do not claim the Standard Deduction.

If you have shares of stock that have appreciated in value, consider donating the stock to charity. If you have owned the stock for more than one year, you can deduct the entire appreciated value of the stock, and avoid capital gains tax or NIIT.

Gifts

You can make tax-free gifts of up to $14,000 ($28,000 for a married couple) per recipient. (Remember that gifts are not taxed to the recipient, but to the giver)

Qualified payments for tuition or medical expenses are not considered a gift, as long as they are paid directly to the educational institution or the medical provider.

Avoid the “Kiddie Tax”

If your dependent children (under 19, or under 24 if they are full time students) have investment income over $2,100, it will be included in your income, and taxed at your full rate, including NIIT. So think before you give them stocks to sell to pay for college.

Depreciation Opportunities

As the law stands right now, you may deduct up to $25,000 of qualifying assets purchased in 2015, under Section 179. This amount was $500,000 in 2014, and may be increased by Congress for 2015 before the end of the year. In 2014 there was also a bonus depreciation provision that allowed you to expense 50% of qualified asset purchases. This may or may not also be reinstated for 2015. Think about these provisions when purchasing equipment for your business.

Subchapter S Corporations and LLCs

If you have a Subchapter S Corporation, don’t forget that you are required to pay yourself a reasonable salary. A major benefit of having an S Corp is that not all of your profits need to be subject to employment taxes, but you do need to pay yourself a salary, and issue yourself a W-2 as an employee. Issuing yourself a 1099 is not a substitute. Setting up W-2 payments after year-end is annoying, and there are stiff penalties for late payment of employment taxes, so take care of it before the end of the year.

Do you have an LLC? Are you getting any real benefit from it? If you are in a state that has a minimum LLC tax, you may be paying for something you don’t really need. California’s minimum tax is $800. You’re also paying for a relatively expensive tax return. If limited liability is a big concern, consider buying insurance that offers appropriate protection. Closing the LLC before year-end won’t reduce your 2015 tax bill, but it will cut future costs.

I would be pleased to discuss your tax planning issues.

The Quick Fix? … Or the Whole Enchilada?

P1150501-002

Managers need information; that’s one of the laws of nature. The uses of information are endless, and managers constantly come up with new needs for reports, analyses and procedures. But information comes at a cost. The cost may be easy to calculate, as in the case of development hours required, or it may be an opportunity cost trade-off with the company’s other priorities.

Weighing Priorities

Whenever you have a need for information, here are the questions you’ll be asked:

1. How badly do you need it?
2. How soon do you need it?
3. If we can’t give you everything you need, what can you live with?
4. What are the projected cost savings or revenue increases?
5. What is the cost of getting the information?

Large organizations have developed sophisticated processes to allocate information resources among competing priorities, often involving some sort of ROI analysis. People do tend to exaggerate, though, so the objectivity and precision of the process comes under suspicion. Smaller companies, in my experience, tend to admit that they use more subjective methods to evaluate priorities.

The result is pretty much the same, though. Unless you have a critical need, such as compliance with a new accounting policy, a new line of business or an actual system breakdown…

You’re going to have to wait. Maybe forever.

The Quick Fix

The alternative to waiting for an exciting new series of reports and procedures, reconciled, actionable and fully integrated with all existing systems is the Quick Fix. This may be a compromise resulting from the answer to Question 3 above, or you may have to take matters into your own hands.

The Quick Fix is usually inexpensive, fast and gives you most of what you need. It can be a viable alternative to waiting for an entire new application to emerge from the murky dungeons of the development process. Or it can get you started on a new initiative without waiting for months, even years, to get the Whole Enchilada.

The Quick Fix isn’t always the right answer, though. Here are some situations I’ve observed over the years.

A Retailer

As CFO of a retailer, we received systems support from the specialty stores division of the internationally known parent company. The problem was that the specialty stores division was a shoe company, and we were a fashion apparel company. Many important issues needed to be resolved to customize the systems so our merchandisers could conduct business. So it was no surprise that when the accountants had a serious problem calculating Gross Profit and Inventory, we were sent to the back of the line, and told to wait.

For a small fee, we hired a programmer to develop a custom report that not only gave us reliable Gross Profit and Inventory results, but also provided the merchandisers with a clear picture of their operating results. It only took an hour or two a month to update the program, so the Quick Fix became a satisfactory permanent solution.

Some years later, a senior executive of the parent company saw our report, and ordered it installed in all the other operating companies. The systems development people jumped on it, and rolled it out to the entire company with great fanfare. But we just shrugged our shoulders… there was no need for the Whole Enchilada.

Real Estate Services

A real estate services company had passed the level of revenues that required them to change their tax accounting from the cash method to the accrual method. They recently asked me to help them make the transition.

The company had grown rapidly, but was still using Quick Books as its accounting system. It was certainly time for an upgrade, and the accounting conversion made it a perfect time to make the change. The only problem was that it would take months of time, and a substantial cash investment to research, purchase and install a new accounting package, and to integrate it with the business operations system. Meanwhile, the tax filing deadline was coming up fast.

My first suggestion was the Quick Fix. I suggested they continue using the methods the accounting staff were used to, and just make journal entries at the end of each month to adjust to accrual accounting. The CEO, however, wanted a deeper change, including a daily reconciliation to the output of their highly sophisticated operating system.

The situation clearly called for the Whole Enchilada, but timing was such that we needed a transitional Quick Fix to meet reporting requirements, and to fill in the gaps while we studied a fully integrated system overhaul.

I reviewed the business operating system, and found it to be sufficiently reliable to use its output as the source of accounting entries. The problem was that there were no accounting cutoffs or similar checks and balances for reconciliation, so I worked with the programmers to develop daily reports that verified the integrity of the data.

As a result of the project, management realized they needed to increase the sophistication of their financial department, and hired an experienced controller. I’m looking forward to hearing how they ultimately proceed.

A Homebuilder

A homebuilder had developed an elaborate and sophisticated construction management system, and its reporting mechanism was tied to an accounting package. Oddly enough, they also continued to maintain the original general ledger system that dated back to the 1970s. The problem was that the two systems generated very different information, and the senior managers each had favorite reports that didn’t agree with those used by other managers. Massive amounts of time were wasted in meetings, and one vice president spent most of his time reconciling the divergent reports. Needless to say, accounting was a nightmare.

The CEO had been instrumental in developing both systems, and was unwilling to see the need for change. The Quick Fix was practiced on a daily basis, but by the time the results were available, it was often too late to act on the information. An irreverent senior executive used an automotive metaphor, suggesting that when you opened the hood, the engine was run by squirrels on a treadmill.

The situation was crying out for the Whole Enchilada, and the Quick Fix just wasn’t working. Yes, the company went bankrupt.

A Land Developer

When I arrived for my first day as CFO of a land developer, I asked the controller for the most recent financial statements. “What do you mean?” she asked. That was the first sign of trouble. I soon learned that we had land on the books that we didn’t own, just as we owned land that wasn’t on the books. It was the same thing with loans and other assets and liabilities. In an organization with over 60 different companies, each with its own separate equity and debt financing, this was intolerable.

There was no Quick Fix to be found, so we shortly purchased a well-known industry-specific accounting package, and herded the numbers into their proper places.

The Whole Enchilada was the only option.

How does your company weigh the costs and benefits of implementing the Quick Fix or the Whole Enchilada?

Your Business – From a Buyer’s Point of View

IMG_8865-001

When you sell your business, you want to do everything possible to get the right price. That often means forgetting about how you have run the business, and looking at it from the buyer’s point of view.

What the Buyer is Buying

Generally speaking, a buyer will be willing to pay a price that is a multiple of the company’s annual cash flow. The multiple varies widely depending on the industry, the economy and many other factors. The price the buyer pays, though, will be a multiple of his expected cash flow – not yours.

The harsh fact is that the buyer doesn’t care how you ran the business. Certainly, he will keep what he sees as the best practices and procedures, and will probably keep most of your people, but his ideas on executive compensation, business development, human resources, inventory control, and a host of other subjects will probably differ from yours.

I actually saw a deal fall apart because the seller insisted on dictating how the business would be operated AFTER he was gone.

The trick is to know what the buyer believes he is buying.

Normalizing Results

It’s a useful exercise to adjust historical earnings for unique, unusual or non-recurring items, so future cash flow projections reflect the results the buyer is likely to achieve. This is called “normalizing” cash flow. Depending on how you’ve been operating the business, this process may identify certain assets or liabilities that should be valued separately.

Here are some examples:

Owner’s Compensation

A homebuilder’s owner paid himself a salary that was much higher than the CEO of any similar company would normally receive. It was his decision as to whether he wanted to receive the funds as salary or as a draw against earnings, but it did cause widespread resentment within the company, especially during lean times.

The important point here, though, is that by adding back the excess owner’s compensation into the cash flow projections, the company’s value increased by a multiple of say, 6 or 7 times that amount.

Below-Market Rents

A retailer had been in business for many years, and was such a desirable tenant that it could drive a very hard bargain with landlords. It was common to find 20 year leases at below-market rates, with 10-year extensions. A careful reading of the lease on the ideally-located head office revealed that it ran in perpetuity.

The low rents increased the company’s cash flow, and would have been taken into account if the company had been valued strictly on a multiple of that cash flow. Valuing leases uses much the same arithmetic as arriving at a multiple of earnings, but the terms of these leases were so unusual that we saw the need to evaluate them as a separate asset.

Ultimately, we prepared cash flow projections using much higher market-rate rents. This reduced the amount a buyer would pay for the company based on its projected cash flows, but it was more than made up by the higher value assigned to the leases as a separate asset.

Unusual Expenses

The owner of another company had a unique set of personal beliefs, and insisted that all of his employees and vendors share or participate in them – at considerable cost. Everyone was required to attend expensive week-long seminars by a California-based consultant who taught them how to deal with their personal fears. Another consultant was flown in from San Francisco for a week to realign the chakras of the executive staff. The owner catered lunches several times a week, so the entire staff would attend his meditation sessions. The company sponsored a project in which meditation experts gathered in Sedona to effect world peace.

It was highly unlikely that a buyer would continue these human resource policies, so we added back their cost to normalized cash flow, and substantially increased the asking price of the company.

Historic Land Values

A land developer and homebuilder had been in business for many years, and owned properties it had purchased up to 30 years previously. The profit margins on the houses it sold were significantly higher than they would have been if the land were acquired more recently.

There had been talk within the company of separating the land component of the business from the homebuilding component, in order to clearly see where the profit and returns on investment really came from, but the initiative never got off the ground.

The low historic land values were reflected in profits, but not in the actual operating cash flows, so a valuation based on a multiple of cash flow didn’t make sense. We prepared normalized cash flow projections for the homebuilding business based on market prices for the land, and did a separate valuation of the land reserves, based on those same market prices.

Non-Recurring Costs

Most companies have expenses they needed to incur a single time, or for a limited period. Examples I have seen include legal fees and settlement costs for lawsuits, discretionary bonuses for unusual personal or company performance and employee termination costs. I worked with a company that had incurred huge expenses trying to start a new line of business that was never realized. Another committed to a year-long sponsorship of a local sports team in a marketing effort that was judged a failure.

None of these costs can be expected to be repeated by a buyer of the company, and so should be added back to the normalized historic earnings, and to the cash flow projections used to place a value on the company.

Does your CFO understand the value of normalizing your cash flows from a buyer’s point of view?

Hmmm… Didn’t Think of That

IMG_0543-001

There are executives who rely on their ability to move quickly. They are often the ones who loudly declare that if we sit around analyzing things to death, we’ll never get anything done. Sometimes, they’re also the ones who are willing to bet the farm before the analysis has been thoroughly completed.

I love working with these high-velocity types, but they often need someone like me watching their back. Someone with a strong business sense and analytical capability who doesn’t slow down the process.

Here are some examples of how things can go wrong:

Catalogue Stores

A well-known retailer operated discount department stores nation-wide. To reach a wider customer base, they also operated a successful chain of catalogue stores in communities too small to support a full-service store. A customer would place his order at a catalogue store, and the item would be delivered within a week.

Meanwhile, changes in technology and inventory management techniques had resulted in a substantial reduction of inventory carried in the full-service stores. These were large stores, so quite a lot of physical space was freed up.

A senior executive came up with the idea to put catalogue stores in the available space in the full-service stores. His analysis showed that not only would the new catalogue stores add substantial revenue and profit to the existing outlets, but they could easily be placed in the least desirable selling areas, often in store basements.

There was much fanfare as the project was launched. The executive in charge even ran afoul of his boss and colleagues when newspaper articles praised his brilliance beyond their comfort level. Then the catalogue stores were abruptly shut down as a disastrous failure. Why would a customer walk through the store, passing by the merchandise he wants to buy, only to order it in a dark basement for delivery a week later? Hmmm… didn’t think of that.

Paper Shortage

A young warehouse worker at a large office supplies distributor showed such ability and intelligence that he was rapidly promoted to be the company’s purchasing agent. This was a long time ago, in the mid-1970s, when the oil crisis resulted in chronic shortages of a surprising range of products.

One day, the purchasing agent called to place a routine order of reams of 8 ½ x 11 inch printer paper. “6 months’ delivery” he was told, and he realized he would be unable to fulfill his customer orders for much of that time.

He was a smart kid, so it didn’t take long to figure out that when the shipment did arrive, he could be looking at another 6 months for the next delivery. Of course he didn’t ask for advice. He started placing orders every couple of weeks, based on historical usage, fully expecting to be back on his regular schedule at the end of the 6 months. Yes, he was a smart kid.

The only problem is that it was a big company, and after a while, the orders accumulated into a quantity large enough to justify an entire separate mill-run by the manufacturer. There were delivery trucks at the door for days on end, and you had to walk sideways through the warehouse to get past the stacks of paper. Hmmm… didn’t think of that.

Demographics

A retailer launched a new business based largely on demographics. It was the early 1980s, and the Baby Boomers were just starting to have children of their own. It was the beginning of a huge increase in births that the industry was calling the Echo Boom. What better time to start a chain of stores specializing in children’s apparel?

After establishing a solid base in California, the plan was to follow the demographic projections that showed high percentage population growth in the southern states. The company made an aggressive move into Texas, and suffered from an economic downturn and some bad real estate decisions, resulting in the prompt closure of about half of the new stores. Still, the roll-out through the south remained the CEO’s plan.

This is the only example in this article in which I was able to play a part, so of course, I’m the hero of this story. I pointed out that the southern states were in fact projected to grow at high percentage rates, but the population density was insufficient to achieve the economies resulting from tight clustering of stores. After all, 10% of nothing is still nothing. Hmmm… didn’t think of that.

The management team listened to my presentation, and we headed instead to the northeast, where large populations were already in place. Our strategy shifted to taking business away from the department stores.

Does your CFO sit in on strategy meetings and tactical problem-solving sessions? He might just bring an important new perspective.