YOUR S CORPORATION – A CHECK-UP

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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!

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Profit Improvement – Delay of Expenditures

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Delay of Expenditures

Time is money. Delaying expenditures until absolutely necessary reduces interest, storage and other carrying costs, reduces pressure on borrowing limits and has a positive impact on return on investment. Speeding the receipt of funds has the same impact.

Financial Review

A land developer traditionally let marketing decide when certain tracts would be made available for sale to builders. The sites they selected appeared to be random throughout the communities, and they professed no particular strategy. I proposed marketing contiguous tracts to delay the outlay on roads and other infrastructure costs. As a result, we delayed the spending of tens of millions of dollars, and there wasn’t a grumble from marketing.

Looking Around

A retailer’s distribution center was designed to service a fixed number of stores, and the time was upon us to start construction on a new, larger center. The limiting factor was the number of boxes that would fit on the conveyors that passed in front of the merchandise pickers. I observed that if we simply changed the shape of the boxes, we could serve up to 50% more stores without incurring the multi-million dollar capital expenditure.

Process Review

Homebuilders often sell their model homes to investors, and lease them back until the community is sold out. The process is rather complex, involving the buyer, various attorneys, appraisers, the construction and marketing departments, accounting and treasury, among others. Meanwhile, the clock is ticking on interest and carrying costs until the transaction is completed. I led a Six Sigma team to look into speeding the inflow of cash. We flow-charted the process, identified bottlenecks and delays, and established a standard timetable to be followed on all future transactions. We reduced the cycle time by three weeks, and calculated annual savings at $400,000.

Does your CFO get involved in planning your major expenditures?

Thinking About Year-End? … You Should Be

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Year-end is almost upon us again. Now is the time to get your house in order – it will take a huge amount of stress off the closing process a couple of months from now.

Being truly ready for the auditors can save audit time and fees, reduce stress on your staff during the audit, and maybe make your financials available for lenders and investors a little earlier. Equally importantly, audit-readiness is a good indication that your accounting department is organized and up to date. How many other ways do you really have to determine that? Here are a few things you should consider:

Preparation of Financial Statements

Do the auditors historically require that you make embarrassing changes to the financials? What has been done to avoid that this year?

–          Does your accounting department prepare the financials, including notes?

–          Have you questioned any balances or accounts that seem surprising or unusual?

–          Did you do anything different this year? Are you sure it is accounted for correctly? Now is the time to sort that out, not during the audit.

–          Have any changes in accounting rules affected your business? Are there any changes not yet required that you could implement early?

Reconciliations

Reconciliations provide explanations for changes in Balance Sheet and P&L accounts, and your accounting department should be able to show them to you every month.

–          Do you know exactly what is in every balance sheet account?

–          Can you explain every change in the balance sheet?

–          Have expenses been calculated consistently every month?

–          Can you show how cost of goods sold affected inventory every month?

If you can say yes to all of these items, updating to year-end should be a piece of cake.

Updated Estimates

Where your monthly accruals and amortization calculations are based on volume or other estimates, have they been updated to be sure the year-end balances are correct? Again, a 2 month update at the end of the year is a lot easier than doing it for the entire year.

Variance Analysis

Has there been a thorough analysis documenting all significant P&L and Balance Sheet variances from last year? Are the explanations reasonable, and the underlying facts correct?

Documentation of Procedures

–          Are the fundamental internal control procedures properly documented?

–          The auditors typically make recommendations for improvements in procedures and controls if they find any deficiencies. Were last year’s recommendations fully implemented?

–          Have changes in staffing or procedures resulted in changes to the control environment? Now is the time to correct them.

Not sure if you’re going to be ready for year-end? Do you know who to call?

Hmmm… Didn’t Think of That

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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.

A Part-Time CFO

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At certain stages of growth, many companies find themselves in the awkward situation of needing the services of an experienced CFO, but feel they can’t afford to hire one.

Yes, a good CFO with the depth of knowledge and experience you need can come at a steep price. And – no offense intended – there may not even be enough to keep a good CFO challenged and interested on a full-time basis at this stage of the company’s growth. So what are the options?

The Options

Try to hire a CFO who may or may not find the job satisfying and lucrative enough to stick around for a while.

Hire a slightly stronger accountant at a slightly higher salary, and hope that he or she can rise to the challenge of a job far beyond his or her education and experience level.

Redirect your attention away from running and growing your business to focus on the CFO role yourself.

Ignore the financial needs of the company, and hope for the best.

Divide up the CFO role and ask your other executives to take care of it in their spare time.

OR…

Hire a part-time CFO at a fraction of the cost of a full-time CFO.

What Will a CFO Do for You?

In collaboration with you and your management team, an experienced CFO will quickly assess the company’s finance, accounting and control needs, and lay them out in order of priority. Areas that he or she will be considering include:

Project the future needs of the company based on achievable growth plans – resources, facilities, and the associated costs.

Identify and quantify financing needs to achieve the business plan – both short term and long term.

Develop relationships with financing sources – debt and equity – that are important to the company’s ability to operate and grow today, as well as to support long term growth and development.

Evaluate and make recommendations regarding the strength of the existing accounting staff.

Evaluate and make recommendations on accounting and information systems.

Oversee the preparation of financial statements, ensuring that the best professionals are chosen to provide auditing, tax and other outside services.

Lead the preparation of operating budgets to keep the company on track to achieve its short term goals.

Introduce the management disciplines and internal control structure necessary for the next level of growth.

Advise on the most appropriate methods and rates of growth – including acquisitions.

Conduct due diligence on acquisitions, and satisfy due diligence requirements of investors and lenders.

Lead programs and efforts to contain and reduce costs while still fostering growth.

Strategize on potential exit strategies – sale of the business for example – and help attract investors and buyers.

What to Look For

The more experience a CFO brings to the table, the more widely that experience is likely to vary among the candidates you speak with. All the more reason to have an idea of the qualities that are most important to you and your business. Here are a few thoughts:

Do you feel comfortable talking to the CFO? We all work better with people we like and trust.

Does the CFO seem to find your business interesting? Of course you find it interesting, but you can’t just assume that others do too.

Is a CPA important? Yes, it probably is. It demonstrates a minimum intellectual standard and level of accounting knowledge, and like the top business schools, the top accounting firms tend (with clear exceptions) to attract the best talent.

Does the CFO have a wide variety of experience in which he or she had to show resourcefulness and flexibility, as well as the willingness to learn on the job? How has he or she performed in situations similar to those likely to arise in your company? References come in handy here.

Has the CFO worked with companies similar in size to yours? I can tell you that working for a Fortune 100 company is very different from the environment of an owner-operated entrepreneurial venture. If you are planning to grow rapidly, does the CFO have rapid growth experience?

How about industry experience? Unless you are in a wildly specialized business like banking or insurance, industry experience is probably not critical. CFOs and CPAs are famous for their transferrable skills, and should be expected to learn your business quickly. On the other hand, some businesses like real estate have a steep learning curve, and some prior experience can make a big difference.

Why would a CFO want a part-time position? If this is a temporary move while he or she is looking for a full-time job, it doesn’t have much long-term potential. On the other hand, there are plenty of financial executives who like the flexibility of a part-time situation, and who enjoy working with a variety of interesting clients, each with its own challenges and rewards.

As the company grows in size and complexity, would the CFO potentially be interested in turning a part-time arrangement into a full-time position?

Do you know who to call to discuss hiring a part-time CFO?

Profit Improvement – Allocation of Resources

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Allocation of Resources

Where a company chooses to invest its resources has an important effect on its profitability and ROI. This can be managed at the time of the initial investment, but ongoing investment needs to be reviewed with a critical eye.

Profit maximization – A land developer and builder was very disciplined in its due diligence on land acquisitions. Land development is a surprisingly complex process involving massive investment, and is subject to a seemingly endless list of restrictions and costly requirements from all levels of government. So choosing between land investment opportunities is a painstaking process, but often subject to emotional responses. We built a linear programming model to maximize the profitability of our land use plans based on our budgets and timing, as well as the attendant marketing and government constraints. This removed much of the emotion from the land acquisition process.

Unprofitable operations – A homebuilder was focused on entry-level housing, and suffered from tight margins and the need for economies of scale and tight discipline in that sector of the business. At the same time, its land entitlement and development business was generating high margins and even higher returns on investment. With 80% of the company’s overhead, but only a small percentage of profits coming from homebuilding, we weighed the investment required to operate a full-scale builder in a higher price category against the potential return, and decided to walk away from the business entirely. Overhead was drastically reduced, and capital was redirected to the more profitable business of land development.

More profit with lower investment – A retailer was famous for the department stores it had operated for many years. Over time, though, these stores had lost ground to competitors, and capital investment had been cut back in proportion to declining profits. The company also operated a number of successful specialty store formats. A time of reckoning came, and the company realized it could make management changes and invest heavily in its department stores, possibly reaching the level of success, for example, of Target Stores. After an intense review, though, they recognized that specialty stores had a higher potential return, a relatively lower investment, lower risk and correspondingly low barriers to entry in niche specialty markets. Relying on its depth of experience, the company closed its famous department stores, and reallocated its funds and energies toward rapid growth in specialty retailing. It became one of the top-performing companies on the New York Stock Exchange.

Drawing on strengths – Another homebuilder operated in a single market, selling low margin homes during a downturn in the housing market. Recognizing its strength in efficient, low cost construction, it started looking for new opportunities. We focused on selling houses at full margin for rental by investment partnerships, expanding regionally into new markets through joint ventures, construction for hire of military housing and multifamily construction.

Does your CFO lead your management team in constant evaluation of your resource allocation process?

Overhead… Who Cares?

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You probably couldn’t stop your accountants from allocating overhead to your operating profit centers, even if you tried. I’m not a business historian, but somewhere along the line, accountants everywhere became convinced that allocating overhead to operating unit P&Ls results in a better understanding of profitability. That may or may not be true, but let’s not use an accounting concept for making business decisions.

What is Overhead?

Overhead has a different meaning in every company, and its calculation varies widely. Generally speaking, though, it is considered to be the cost of running a head office, including centralized costs such as executive salaries, office rent, computer systems, etc. When the accountants allocate overhead, it is often in the form of a percentage of gross revenue. If a company has a division that contributes 10% profit, and another that contributes 8%, a 4% overhead allocation would reduce these results to 6% and 4%.

In this example, it would appear that the first division is 50% more profitable than the second, and management might be tempted to allocate resources accordingly. But its contribution margin is only 25% higher, so the result could be misleading.

If you can’t tell if your operations generate enough profit to cover overhead, you might consider looking for a different occupation. For the record, I’m sure many intelligent people disagree with me.

Don’t include Overhead in your business decisions

In my experience, many accountants don’t really appreciate that accounting conventions have no place in business decision-making, and operating executives often don’t feel confident enough to challenge the accountants on their own turf. Some things to remember:

Overhead is just an accounting concept
Overhead does not affect cash flow
Overhead allocations do not affect total company profitability
Overhead is calculated differently in every company

I have seen some dysfunctional results arise from trying to shoe-horn an accounting concept into business decisions.

A Retailer

A retailer had several stores that were not only losing money, but had a negative cash flow. That is, their operating loss was greater than their depreciation and amortization. The stores clearly needed to be closed to stop the damage.

The CEO, however, had done his math. If he closed the failing stores, the overhead allocated to those stores would have to be redistributed to the remaining stores, reducing their accounting profit after overhead. The CEO could not be persuaded that closing the losing stores would improve the company’s total profitability.

The failing stores continued to lose cash flow, and the overhead was allocated to all stores… until the CEO was replaced.

A Homebuilder

A homebuilder had a target IRR for new community construction projects. IRR is a measure of cash flow that calculates the return realized on a cash investment. The CFO, an accountant by training, insisted that all cash flow projections include a 3% charge for overhead, despite the fact that overhead has nothing to do with the incremental cash flow generated by a new construction project. He argued that when the project was under way, overhead would be allocated for accounting purposes, so the pro formas should reflect that. The pro formas then became just a forecast of the accounting records, and IRR, the real reason for making the investment, was calculated incorrectly.

At least the pro formas were conservative as a result of this allocation, but the company probably missed out on some good opportunities whose IRR projections fell below the hurdle rate. As it happened, the company’s actual overhead was not even 3% at all.

Another Retailer

Some retailers charge the cost of their distribution centers directly to expense, in the manner of unallocated overhead, while others include it in the cost of their merchandise, charging it directly to operations.

In a year when earnings were tight, I was encouraged as division CFO to find ways to increase reported profit, so I capitalized the distribution center costs. This resulted in a large transfer of costs from expense to inventory, substantially increasing reported earnings. The parent company paid senior management large bonuses that year, regardless of the fact that nearly all our profit came from an accounting change.

Although we reported more profit, the actual economic impact on the company was a negative cash flow in the amount of the bonuses that were paid. Was the accounting technically correct? Yes. Was it the most appropriate accounting under the circumstances? Maybe not. Would I do it again? … Well, I did like that bonus.

A Land Developer

When a land developer sold finished and partially finished lots to homebuilders, they did a land residual calculation to arrive at the asking price. That is, they estimated all the builder’s costs and revenues, and priced the lots so the builder could achieve a specified percentage profit margin. But one of the costs included in the analysis was 3% – again 3% – for overhead. If they didn’t include the overhead, they could have started with a higher asking price, and maybe sold the lots for a higher price.

Does your CFO take a practical view of Overhead?