Month: May 2016

Good Business Performance Starts with Good Record Keeping

Good financial record keeping is vital to the success of any business. Good records help plan for the future, prepare accurate financial statements and tax returns, and enable business owners to create sensible budgets and cash flow projections.Taxes_iStock_000001334173_Medium

Small-business owners have a multitude of issues to contend with, whether they are in startup mode or more seasoned. One area that often requires a bit more of their attention is keeping good financial and other records for their company.

How keeping good records makes for good business

Your bookkeeping records help you make smarter and well-informed business decisions, for one thing. You don’t know where you’re going if you don’t know where you’ve been. Solid financial record keeping for your business helps you plan for the future based on real data. Your company’s financial records:

  • Provide the basis and support for your tax return preparation (track income, expenses, deductions, etc.).
  • Help you prepare financial statements (income statement, balance sheets, cash flow) and other financial reports that help you monitor your company’s progress. Are you doing better or worse than anticipated or compared to prior years or budgets?
  • Track inventory and maintain better inventory controls and spending.
  • Identify income sources and pricing levels.
  • Collect revenues and know which customers owe you money.
  • Track your basis in property – needed to figure gain or loss on the sale, exchange or other disposition of property; depreciation, amortization, depletion, and casualty losses.
  • Are the foundation for formulating accurate, sensible budgets and cash flow projections.

So beyond the “why keep financial records?” are several other questions we often hear from our clients who are business owners.

Which records should I keep?

Although there is no law stipulating what you must keep, for a small business we recommend your bookkeeping records include reconciled bank statements, cash receipts by customer, payroll reports, vendor invoices, accounts payable and accounts receivable aging, and anything specifically related to your field or industry that you’ll need for your tax returns. We recommend tracking all your business-related income and expenses in an accounting software program.

Depending on your occupation, you might have expenses related to: travel, meals, entertainment, wholesale goods or supplies, and equipment purchases or leases. In addition to your financial data, The Association of Records Managers and Administrators (ARMA International) offers these basic guidelines:

  1. Business documents – Establish your right to conduct business, such as articles of incorporation, by-laws, and business and tax-collection permits.
  2. Business agreements – Demonstrate your company’s obligations to your customers/clients, suppliers, vendors (such as contracts), and your staff (such as employee benefit packages and individual selections).
  3. Executive decisions – Show how business decisions were made and commitments honored, including annual reports, dividend records, board of directors meeting minutes and actions, and company health and safety documents.
  4. Regulatory compliance – Proof you have met legal and regulatory requirements of your industry.

How long do I keep financial records?

There is no set answer but general guidelines that relate to income tax returns are outlined by the IRS. Time frames range from three to seven years, depending on certain criteria (the IRS recommends “indefinitely” for certain other scenarios). Hold on to all filed tax returns and basis records because they will help with preparation of future returns and provide excellent financial history. Employment tax records should be retained for at least four years.

A good rule of thumb is to keep documents as long as you need to prove the income or expense/deduction on a tax return. Your accountant should be able to recommend the best course of action for you.

What is the burden of proof?

Burden of proof refers to your responsibility to substantiate entries, deductions, and statements made on your tax returns. If you plan to deduct certain expenses, you must be able to prove certain elements of them.

The IRS offers more in-depth information and guidance about the how, what, and when of maintaining financial records at https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Recordkeeping.

Can’t keep it all straight? No worries.

Maintaining your company’s books and other records may feel daunting to owners of small businesses without a controller, staff accountants or a good bookkeeper. Our Business Office Group’s EZ-Bookkeeper Solutions fill that void and relieve that pressure by handling all your full-charge bookkeeping and back-office administrative needs. This staff has been trained by our own CPAs and ensure your financial records will be well organized and in order, and that statements and reports will be properly prepared and filed on time.

Give us a call to find out more at (201) 655-7411 or go to www.krscpas.com/services/business-services-bookkeeping/ for details.

Interest Tracing on Debt-Financed Distributions – What’s Deductible?

 

Dollar_Signs_iStock_000002198189_LargeMany pass-through entities, including limited liability companies, are often tempted to cash out on the appreciation of their real estate holdings through refinancing. The members then have the discretion to use these funds as they see fit, including investing in other properties and projects or for personal use. It is often assumed that interest on the new mortgage is fully deductible for income tax purposes; however, that is not necessarily the case.

Interest Tracing of Debt-Financed Distributions

When a partnership distributes some or all of the proceeds from a debt, the distribution is called a debt-financed distribution. Under the interest tracing rules, the recipients of the debt-financed distributions are required to trace the expenditures made with the distributed proceeds in order to properly allocate the interest expense.

Interest Deductibility

After each recipient of debt-financed distributions traces how the funds were used, they must then classify Interest Tracing on Debt-Financed Distributions docxthe expenditures in one of four categories:

    1. Personal expenditures – personal interest expense is generally not deductible. An example would be using the proceeds to pay off a credit card debt.
    2. Trade or business expenditures – funds are used in an expenditure that you are actively engaged in for profit. Let’s say the sole proprietor of a law firm purchases a computer server with the proceeds from a debt financed distribution. The portion of the interest expense used to purchase the computer server would be deductible on the owner’s Schedule C.
    3. Passive activity expenditures – if proceeds are used by the member to make an investment in a separate partnership or pay expenses on behalf of an entity in which he does not materially participate, the interest would be subject to the rules governing passive activities (see my previous blog on Passive Loss Limitations).
      For example: Bill receives $100,000 in debt-financed distributions from his investment in a real estate partnership. He then uses that money to invest in a new LLC that purchased rental real estate. The interest expense related to the $100,000 of proceeds will be used to compute Bill’s net income or loss from his passive activities on Schedule E.
    4. Investment activity expenditures – if the proceeds are used in investment activities, the interest is treated as investment interest expense.
      For instance, Bill used the proceeds to purchase Apple stock. The interest expense is reported on Form 4952 (Investment Interest Expense Deduction), and is potentially deductible on Schedule A as an itemized deduction.

If you are a member of a partnership or other entity with real estate holdings, and are considering cashing out and investing your debt-financed distribution in other assets, be sure to consult a tax professional to ensure your audit trail is complete.

If you’d like to discuss your potential transaction or have questions about interest tracing rules, contact me at [email protected] or (201) 655-7411.

Buy-Sell Agreements

 

Buy-sell agreements are the most important, but perhaps most overlooked agreement that a business can have. These legal documents protect business owners when one owner leaves the company for any reason.

Although many businesses have buy-sell agreements, they were likely drafted when the business was formed many years ago and have not been looked at or updated since. If your business has a buy-sell agreement, take it out, read it, and ask your accountant to calculate what would happen if the agreement were triggered today. Evaluate the results from both sides, as a buyer and as a seller.

  1. The first question is, is the price calculated pursuant to the agreement fair to all parties? If is unfair, it is time to execute a new agreement. (By the way, don’t assume that the younger party to the agreement will be the buyer, or that the older party will be the seller. Owners may leave their businesses for many reasons.)
  2. Another important issue in buy-sell agreements is the payment terms. Does the agreement require a lump sum payment or payments over an extended period of time? If a lump sum payment is required, how will that payment be funded? If funded by insurance, is the policy still in force and is the amount sufficient to make the payment? That $1 million term policy that was purchased when the business was formed may not be enough to cover the price today if the business has grown. Also, term insurance expires at certain ages, perhaps leaving no funding for the agreement.
  3. If the agreement requires that the business be valued, it should specify the standard of value to be used. There are big differences between fair market value and fair value. I once served as an expert in a dispute in which the agreement used the term “value.” The standard of value issue was eventually resolved, but not before the parties spent a lot on legal fees.

Don’t pay the price for no agreement

Not having a buy-sell agreement is a different kind of agreement—one to spend a lot of money, perhaps hundreds of thousands of dollars, on professional fees, and years to resolve the issues. Companies without an agreement end up letting a judge or a jury decide what will happen to the business that they worked so hard to build.

Although it is often an uncomfortable conversation to have with your partner, it is a much easier conversation to have now, when you are both healthy, your interests are aligned, and retirement or disability is not on the horizon. It is a far more difficult to reach an agreement after a triggering event, especially when that conversation is with a widow or children who are not at all concerned with fairness.

I have only touched on a few of the issues surrounding buy-sell agreements.

Take a look at your agreement with your CPA and attorney to be sure that it is up-to-date, or contact me at [email protected] with comments and questions.

Cash Flow Projections Can Protect Your Company’s Future

cash flow managementFor many small businesses and startups, managing their cash flow is a continual challenge. Questions that come up often are:

  • How do we manage seasonal peaks and valleys?
  • How can we keep our cash working for the business throughout the year?
  • What’s the best way to use excess cash to benefit the business?

Good cash flow projections will help any business stay on course towards a brighter future. If you have you ever heard the expression, “Failing to plan is planning fail” then you know how important cash flow projections are to the financial health of your business.

What is a cash flow projection?

A projected cash flow statement lays out a prediction of your company’s available funds over a period of time. It represents cash receipts minus cash payments (income and expenses) over a particular time period (e.g., month, quarter, year). It is a fundamental and vital business tool.

Cash flow projections affect and inform all areas of your business, from human resources to various operational concerns. A good cash flow projection should be realistic and based on your annual operating budget, prevailing market conditions, industry trends, and prior sales cycle data. This will all affect decisions about your inventory (retailers, manufacturers, distributors), staffing levels and payroll, business loans, and your accounts payable process.

If your business is in startup mode, a cash flow statement involves compiling a comprehensive list of budgeted expenses and a conservative estimate of revenues as well as the timing of payments and receipts. Professional and licensing fees, incorporation costs, security deposits and other expenditures associated with starting a business must be included.

Looking at these metrics will help you identify your company’s anticipated cash flow from income and expenses by month (which in turn informs your budgeting process). By updating these cash flow projections on a regular basis, using the actual financial records (receipts, checking account figures, etc.) you will be better prepared to keep that cash flow in the positive column. Managing your cash flow by having smart projections will also affect your company’s credit, as a lender will want to see those projections as part of the business loan process.

How cash flow projections help small – and all – businesses

Decisions that are guided by your company’s cash flow projection may include:

Accounts receivable – You can’t pay your company’s bills if you aren’t being paid by your customers. Cash flow projections will guide decisions about the payment terms to institute from your customers. For instance, does it make good fiscal sense to accept credit cards? What about offering discounts for early payment?

Sales forecasts – How accurate are the sales forecasts and how can we meet them?

Budgets – Budgets are vital road maps to keep companies on track against their actual income and expenses. A cash flow projection by month or by quarter will inform the budgeting process and then help business owners and managers course-correct as needed.

Inventory management – What’s on hand and how do you pay for it? How quickly does your inventory convert to cash? Do your vendors insist on large minimum orders or can you go on a smaller on-demand ordering system?

Business line of credit – You might need a line of credit from your bank to sail through seasonal cash flow crunches; a solid projection will help you get the credit you need to remain viable throughout the year. Another factor here is how debt service impacts your monthly cash flow.

Business loans – If you plan on making capital improvements or will be expanding and need business capital, showing the lender a smart cash projection chart will show you are keeping strong financial records and have long-range plans in place that align with your financials.

Excess cash – If your company is profitable and you find your cash flow is positive, take a look at projections to determine how to use that extra cash. Should you reinvest in the company (and avoid that business loan)? Pay down business debt? Expand into new markets? Award employee bonuses?

In short, projecting your sales and the accompanying cash those sales bring to your company will help you develop smarter budgets and guide more informed business decisions. Cash management will help you prepare for surpluses and deficits.

Getting started on developing your company’s cash flow projection

It all starts with accurate, timely accounting records. Most accounting software will provide cash flow and budget reporting. Or, ask us about our bookkeeping services for small businesses to get your financial records set up properly and maintained regularly.

Want to know more? Download our free Managing Your Small Business’ Cash Flow Guide to find out how to make the most of the money flowing into and out of your business. It’s filled with helpful tips and industry secrets to keep your revenue working as hard as you do.

 

 

Passive Activity Loss and the Income Tax Puzzle for Real Estate Professionals

Does being a real estate professional have income tax advantages?

real estate professionalsIt all comes down to passive and non-passive activities related to property.

As  discussed in a previous post, the IRS recognizes two types of passive activities as they relate to investment real estate, one of those being “trade or business in which the taxpayer does not materially participate.” The other passive activity being rentals, including both equipment and rental real estate.

Generally, rental real estate activities are passive regardless of one’s participation but there is an exception for real estate professionals.

For most taxpayers, income and loss from real estate is considered passive, with passive activity losses generally limited to passive activity income. However, real estate professionals must treat rental real estate activities in which they materially participate as non-passive activities. Therefore, a real estate professional can deduct rental real estate losses from other non-passive income.

How the real estate professional designation affects income taxes

For income tax purposes, the real estate professional designation means you spend a certain amount of time in real estate activities. According to the IRS, real estate professionals are individuals who meet both of these conditions:

1) More than 50 percent of their personal services during the tax year are performed in real property trades or businesses in which they materially participate and  2) they spend more than 750 hours of service during the year in real property trades or businesses in which they materially participate.

real estate professionalsAny real property development, redevelopment, construction, reconstruction , acquisition, conversion, rental, operations, management, leasing or brokerage trade or business qualifies as real property trade or business.

It is important to note that services performed as an employee in real property trades or businesses do not count unless the employee is at least a 5% owner of the employer.

Once it is determined a taxpayer qualifies as a real estate professional (by meeting both of those criteria), non-passive treatment is available only for rental real estate activities in which the taxpayer materially participated. To meet the material participation standard, a taxpayer can elect to treat all interests in rental real estate activities as a single activity. If the election is made, material participation is determined for the combined activity as a group. Since these decisions have implications for one’s income tax liability and potential deductions, it is important to review these guidelines with your accountant and/or trusted tax adviser, and to gain a full understanding of the differences between passive/non-passive income and expenses.

Example

David owns a real estate brokerage firm. He works full time as a broker and also owns three rental properties. David  materially participates in his rental properties and does not employ any management company. HIs material participation comprises finding tenants for his rentals, overseeing repairs, and approving all leases.

Let’s assume that David’s income is $200,000 from the brokerage firm and rental losses associated with the properties he owns are $30,000. David would be able to deduct the $30,000 in full from his gross income because he is a real estate professional and materially participates in the rental properties. If he was not a real estate professional, the $30,000 of losses would be suspended until he had passive income from the properties.

Are you puzzled about whether or not you qualify for these deductions?

Need some help understanding how these passive or non-passive activities might relate to your income tax puzzle, as a real estate professional? I’m here to help; contact me at [email protected] for a consultation. You may also want to check out New Tax Law Explained! For Real Estate Investors.

What is Risk? How Does it Affect Business Value?

 

risk and business value
What are the risks in your business, and what can you do to reduce them?

According to Dictionary.com, risk is defined as “the chance of injury or loss; a hazard or a dangerous chance.” In the business valuation context, risk refers to the possibility of financial loss or drop in asset value.

In layman’s terms, the risk in buying a business is that you will overpay for it. The more risk that is associated with an investment, the higher the return that is demanded by the investor. The higher expected returns are achieved when the market places a lower value on a business that is perceived as having higher risk.

In estimating the value of a business, the analysis is based on expected cash flows and the risk that such cash flows will not be received as expected. An astute buyer seeks to minimize risk, through careful evaluation and understanding of the business he or she is considering buying or investing in. As I have said in previous blogs, the evaluation of a closely held business is no different than the evaluation done in purchasing 100 shares of a public company:

  • Will the company continue to pay dividends?
  • How much will those dividends be?
  • What will the shares be worth when you are ready to sell them?

Certain risks, such as the economy in which the business operates, are uncontrollable. Some risks, such as future competition, may be anticipated but others, such as technological obsolescence may come as a complete surprise. Many years ago, a client purchased a chain of successful photographic film developing labs and continued to operate them successfully until the advent of digital photography. The client certainly did his homework, but did not see the change that was coming. Neither did Kodak and look what happened to them!

Controllable risks to consider

If you are buying or selling a business, what are some of the controllable risks that you should look out for?  Here are a few of the more common ones:

  • Poor accounting records – A company’s accounting records should tell the full financial story of the business. With all the low-cost accounting software that is available, there is no reason that every business should not have great accounting records. A company’s books should speak for themselves; the more stories, explanations, and exceptions, the greater the perceived risk.
  • Customer concentration – Is the continued success of the business dependent upon a single customer or a few customers? If the loss of any of these customers would negatively impact the business, that is a significant risk.
  • Supplier concentration – Is the business dependent on any suppliers that cannot be quickly and easily replaced? This could be a problem if anything happens to one of those suppliers.
  • Key employees – Is the business dependent on the services of one or more employees? Are there enforceable employment contracts and non-compete agreements in place with them? If the business does not have these agreements (signed by all parties and on file), what would happen if those employees went to work for your competitor?
  • Foreign competition – Can the product or service offered by the business be purchased at a lower cost from a foreign provider? Everything from tax preparation to manufacturing to technology consulting can be outsourced overseas these days. If this hasn’t affected your business yet, chances are it soon will. What are you doing to remain competitive?

Taking these factors into account, what are the risks in your business, and what can you do to reduce them?

Everything you do to reduce business risk will be a step toward increasing your company’s value. If you’d like a fresh look at the risks inherent in your business, or to discuss the business valuation of your company, contact me at 201.655.7411 or  [email protected].