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Month: August 2017

Real Estate Investors: Let’s Talk about Like-Kind Exchange

Posted on by Debra Barcuch

Are you thinking about divesting a real estate investment and then replacing it with another property? If you sell appreciated property outright, you’ll incur a taxable gain, which lowers the amount available to spend on the replacement property. But you may be able to defer your tax bill (or even make it disappear) with a Section 1031 like-kind exchange.

Unfortunately, there are rumors that upcoming tax reform legislation could eliminate the time-honored like-kind exchange privilege. So, while tax breaks for like-kind exchanges are still in place, it could be a good idea to complete any like-kind exchanges that you’re considering sooner rather than later. Here’s what you need to know about like-kind exchanges under the current tax rules.

Beware of the Boot

To avoid any current taxable gain in a like-kind exchange, you must not receive any “boot” in the transaction. Boot means cash or other property that isn’t of a like kind to the relinquished property. When mortgaged properties are involved, boot also includes the excess of the mortgage on the relinquished property (the debt you get rid of) over the mortgage on the replacement property (the debt you assume).

If you receive any boot, you’re taxed in the year the property is sold on a gain equal to the lesser of:

1. The value of the boot, or

2. Your overall gain on the transaction based on fair market values.

So, if you receive only a small amount of boot, your exchange will still be mostly tax-free (as opposed to completely tax-free). On the other hand, if you receive a significant amount of boot, you could have a large taxable gain.

The easiest way to avoid receiving any boot is to swap a less valuable property for a more valuable property. That way, you’ll be paying boot, rather than receiving it. Paying boot doesn’t trigger a taxable gain for you.

What Constitutes Like-Kind Property?

You can arrange for tax-free real property exchanges as long as the relinquished property (the property you give up in the exchange) and the replacement property (the property you receive in the exchange) are of a like kind. Under Internal Revenue Code Section 1031 and related guidance, “like-kind property” is liberally defined. For example, you can swap improved real estate for raw land, a strip center for an apartment building or a boat marina for a golf course.

But you can’t swap real property for personal property without triggering taxable gain, because real property and personal property aren’t considered like-kind. So, you can’t swap an apartment building for a cargo ship. You also can’t swap property held for personal use, such as your home or boat. Inventory, partnership interests and investment securities are also ineligible for like-kind exchanges. As a result, the vast majority of tax-free like-kind exchanges involve real property.

In 2002, the IRS clarified that even undivided fractional ownership interests in real estate (such as tenant-in-common ownership interests) can potentially qualify for like-kind exchanges. For example, if you sell an entire commercial building, you don’t need to receive an entire commercial building as the replacement property in order to complete your tax-free exchange. Instead, you could receive an undivided fractional ownership interest in a building as the replacement property.

What Happens to the Gain in a Like-Kind Exchange?

Any untaxed gain in a like-kind exchange is rolled over into the replacement property, where it remains untaxed until you sell the replacement property in a taxable transaction.

However, under the current federal income tax rules, if you still own the replacement property when you die, the tax basis of the property is stepped up to its fair market value as of the date of death — or as of six months later if your executor makes that choice. This beneficial provision basically washes away the taxable gain on the replacement property. So your heirs can then sell the property without sharing the proceeds with Uncle Sam.

The like-kind exchange privilege and the basis step-up-on-death rule are two big reasons why fortunes have been made in real estate.

However, as noted earlier, the like-kind exchange privilege could possibly be eliminated as part of tax reform. Even if that doesn’t happen, the estate tax might be repealed, which could also ultimately reduce the tax-saving power of like-kind exchanges.

Why? An elimination of the step-up in basis at death might accompany an estate tax repeal. For example, with the 2010 federal estate tax repeal (which ended up being temporary and, essentially, optional), the step-up in basis was eliminated, and that could happen again. An elimination of the step-up in basis would mean that a taxpayer inheriting property acquired in a like-kind exchange would have the same basis in the property as the deceased, and thus could owe substantial capital gains tax when he or she ultimately sells the property.

What’s a Deferred Like-Kind Exchange?

It’s usually difficult (if not impossible) for someone who wants to make a like-kind exchange to locate another party who owns suitable replacement property and also wants to make a like-kind exchange rather than a cash sale. The saving grace is that properly executed deferred exchanges can also qualify for Section 1031 like-kind exchange treatment.

Under the deferred exchange rules, you need not make a direct and immediate swap of one property for another. Instead, the typical deferred like-kind exchange follows this four-step process:

1. You transfer the relinquished property (the property you want to swap) to a qualified exchange intermediary. The intermediary’s role is to facilitate a like-kind exchange for a fee, which is usually a percentage of the fair market value of the property exchanged.

2. The intermediary arranges for a cash sale of your relinquished property. The intermediary then holds the resulting cash sales proceeds on your behalf.

3. The intermediary uses the cash to buy suitable replacement property that you’ve identified and approved in advance.

4. The intermediary transfers the replacement property to you.

This series of transactions counts as a tax-free like-kind exchange, because you wind up with like-kind replacement property without ever taking possession of the cash that was transferred in the underlying transactions.

What Are the Timing Requirements for Deferred Like-Kind Exchanges?

For a deferred like-kind exchange to qualify for tax-free treatment, the following two requirements must be met:

1. You must unambiguously identify the replacement property before the end of a 45-day identification period. The period starts when you transfer the relinquished property. You can satisfy the identification requirement by specifying the replacement property in a written and signed document given to the intermediary. That document can list up to three properties that you would accept as suitable replacement property.

2. You must receive the replacement property before the end of the exchange period, which can last no more than 180 days. Like the identification period, the exchange period also starts when you transfer the relinquished property.

The exchange period ends on the earlier of: 1) 180 days after the transfer, or 2) the due date (including extensions) of your federal income tax return for the year that includes the transfer date. When your tax return due date would reduce the exchange period to less than 180 days, you can extend your return. An extension restores the full 180-day period.

Will Like-Kind Exchanges Survive Possible Tax Reform Efforts?

Under the current tax rules, like-kind exchanges offer significant tax advantages, but they can be complicated to execute. Your tax advisor can help you navigate the rules.

Looking ahead, it’s uncertain when and if tax reform will occur and whether the tax benefits of a like-kind exchange will survive any successful tax reform efforts. So, if you own an appreciated real estate investment and you’re contemplating swapping it out, it may be advisable to enter into a like-kind exchange sooner rather than later.

Follow Detailed Recordkeeping Rules for Vehicle Expense Deductions

Posted on by Debra Barcuch

Many business owners fail to follow the strict tax rules for substantiating vehicle expenses. But if your business is audited, the IRS will most likely ask for mileage logs if you deducted vehicle expenses — and it tends to be especially critical of the amount deducted if you’re self employed or you employ relatives. While the basics seem simple, there are numerous exceptions.

Mileage Logs

Taxpayers can deduct actual vehicle expenses, including depreciation, gas, maintenance, insurance and other vehicle operating costs. Or they can use the standard mileage method, which allows a deduction based on the standard rate for each mile the vehicle is driven for business purposes. For example, the standard mileage rate is 53.5 cents a mile for 2017 (down from 54 cents per mile for 2016). If you drive 1,000 miles for business purposes in 2017, you could deduct $535 under the standard mileage method.

Regardless of the method used, the recordkeeping requirements for mileage are the same. They’re also the same whether you’re the only employee who uses a vehicle, you employ others who use company vehicles, or an employee uses his or her own vehicle and is reimbursed by the company.

Vehicle logs must provide the following information for each business trip:

  • Date,
  • Destination,
  • Business purpose,
  • Start odometer reading,
  • Stop odometer reading, and
  • Mileage.

Employees who use their own vehicles must provide these details to their employer. If an employer reimburses an employee without the required documentation, the reimbursement is taxable income. If an employee uses a company vehicle, the IRS considers any usage that’s unaccounted for as personal use and the value of unaccounted usage should be included in the employee’s income for the employer to secure a deduction.

The IRS requires “contemporaneous” recordkeeping for mileage. That means a recording at or near the time of the trip. You can record the mileage at the time of the trip and enter the business purpose at the end of the week. But waiting much longer could raise suspicion about the validity of the vehicle log and potentially jeopardize your entire vehicle deduction.

The tax agency requires varying levels of detail, depending on the circumstances. For example, you might be able to list only the customer’s name if you visit someone regularly to demonstrate new products, provide service and take orders. But cold calls to prospective customers may require a more detailed write-up in your vehicle log. A single entry may be enough for visits to several customers in the same day, but you may need to log any detours taken for personal reasons, such as personal errands or lunch with your spouse.

In some cases you may be able to avoid recordkeeping if your company maintains a formal policy forbidding employees from using company vehicles for personal reasons. However, the exception has numerous rules and restrictions. For instance, the policy must be written and meet six conditions, and the exception applies to only employees who aren’t “control” employees, such as:

  • Employees who are appointed by the board or shareholders or an elected officer whose pay is $100,000 or more,
  • Directors,
  • Employees who earn at least $205,000 annually, and
  • Employees who own a 1% or more share of equity, capital or profits in the business.

Exceptions to the Rules

We’ve used the term “vehicle,” because the recordkeeping rules apply to more than just cars. Technically, every vehicle is subject to the rules. But the IRS permits specific exceptions for the following vehicles that are unlikely to have more than a minimum amount of personal use:

  • Delivery trucks with seating only for the driver or only for the driver plus a folding jump seat,
  • Buses with a 20-person minimum seating capacity,
  • Special purpose farm vehicles, and
  • Any vehicle designed to carry cargo with a loaded gross vehicle weight over 14,000 pounds.

Not listed above are more obvious exceptions, such as cement mixers, combines and bucket trucks. In addition, the IRS permits exceptions for trucks or vans that have been specially modified so that they aren’t likely to be used more than a de minimis amount for personal purposes. An example is a van that has only a front bench for seating, has permanent shelving that fills most of the cargo area, constantly carries equipment and has been custom painted with the company’s name and logo.

Simplified Recordkeeping

Complying with the IRS mileage recordkeeping rules can be tedious, especially for workers who drive significant distances for business purposes. Here are some ways you can simplify the process:

Use technology. Mileage logs don’t have to be kept in a written diary or day planner — you can download an app to your tablet or cell phone to track mileage. These apps typically allow you to take a picture of the odometer for the beginning and ending mileage. If you allow this method, require workers to back up their electronic mileage logs regularly to prevent loss of mileage records. Alternatively, you might use GPS tracking of company vehicles to help document mileage.

Apply sampling methods. The IRS allows taxpayers to use the mileage for regular routes — for example, if you visit the same customers on a fixed weekly schedule — and extrapolate the sample mileage over the entire tax year. This can save time, but you’ll have to show that the sample is valid. And if the route changes midyear, you’ll have to show how you updated the sample.

The easiest way to simplify recordkeeping for vehicle expenses is to use the standard mileage rate, rather than tracking actual expenses. Doing so eliminates the need to save gas receipts and maintenance records. But the downside is that this method tends to understate expenses, particularly if you drive an expensive gas guzzler or pay above-average insurance premiums. If a vehicle’s business use is high but its total use is low, actual fixed costs — such as insurance and depreciation — are likely to be higher on a per-mile basis than with the standard mileage rate.

Ongoing Attention

Vehicle expenses can quickly add up for businesses — as well as for individuals who are tracking mileage for itemized medical or charitable deductions, or supplemental business activities such as managing investments in local businesses or rental properties. But as easily as they add up, so too can vehicle deductions vanish in an IRS inquiry.

The key to preserving your deductions is maintaining up-to-date mileage records. Too often, taxpayers assume they can put together a mileage log the night before the IRS visits. That rarely works. For example, the IRS questioned a situation in which the taxpayer used the same pen over a two-year period. In another case, the IRS noticed that the taxpayer claimed to be at the post office and an hour later was at a client 110 miles away. In cases where there are more than a few discrepancies, the IRS often denies all vehicle expense deductions, claiming the mileage log wasn’t credible. On top of losing your deduction, you also might face penalties and interest for underpaying your tax liability.

When it comes to the recordkeeping requirements for vehicles, the IRS rarely allows exceptions for its strict rules. Don’t assume you qualify for an exception, check with your tax advisor first. He or she can help you navigate the complicated vehicle recordkeeping rules with confidence.

Identifying Weak Links to a Successful Transition

Posted on by Debra Barcuch

 

If we can determine that there is, in fact, a potential buyer for the company based on a number of attractive assets and an initial calculation of business value, we can then pursue additional constraints to realizing the preferred value.

An owner may not be satisfied by the initial calculation, believing that the company can be worth far more. This may be true. We can identify weak links or bottlenecks that impede a higher value. According to the Theory of Constraints methodology, common constraints that impede a goal (in this case, a favorable multiple for your business), can include the following:

  • Physical – Equipment or other tangible items such as material shortages, lack of people or lack of space
  • Policy – Required or recommended ways of working that are outmoded or restricting
  • Paradigm – Deeply ingrained beliefs or habits that impede throughput
  • Market – Production capacity exceeds sales

When we begin the conversation with a manufacturer — or any business owner — about some of the factors holding back a successful business transition, all four of these constraints can arise over time. An owner, for example, may strongly believe that a family member will take over the business, and that family member has not given the owner any reason to believe otherwise. This is a paradigm constraint in which the owner needs to be open to the possibility of a Plan B to mitigate the risk that this family member won’t or can’t take over.

Physical constraints may include workforce shortages or outmoded equipment; these require a longer-term and strategic approach to attracting and training talent as well as applying throughput improvements to the production floor. Market constraints may require diversification of product lines to maintain throughput that matches market cycles. And policy constraints can be addressed by looking at “how things have always been done here” to how they can be done better.

Policy constraints can be the biggest constraint to business transition planning because they tie closely to ingrained cultural beliefs about how things are done. It may require an outside advisor to identify policy constraints and to walk owners through a process of improvement. An open communication process can also support policy change when new employees come on board and are able to suggest improvements in process or production.

Of course, a big paradigm constraint is the constraint of time. Owners often say they don’t have time to think about business transition planning because they are too busy running the company. Perceived lack of time leaves owners with a lack of knowledge about their business value, which creates assumptions, misguided hopefulness and inertia. Transition planning is left to waste away in quadrant three of priorities: important but not urgent.

If time is a major constraint to business planning, the Theory of Constraints introduces the “five focusing points” to eliminate this constraint.

Beware of inertia creeping back in. Business transition planning is not a “one and done” activity. It will require regular attention over several years to monitor progress on business value improvements, delegation of owner responsibilities to experienced and stable team members, and development of contingency plans. Increasing your time to work on the plan is a big initial step toward committing to increased year-to-year profits and fair value for your business.

Continue Reading: Taking the Critical Path Towards Succession

Gary Jackson, CPA, is a tax partner at Cornwell Jackson. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience at Cornwell Jackson and in providing tax planning to individuals and business leaders across North Texas.

Contact him at gary.jackson@cornwelljackson.com.

Understand Your Social Security Retirement Benefits

Posted on by Debra Barcuch

For years, people have questioned the viability of the Social Security system going forward. In July, the Social Security Board of Trustees released its annual report on the long-term financial status of the Social Security Trust Funds.

The report projects that the combined asset reserves of the Old-Age, Survivors and Disability Insurance (OASDI) Trust Funds will become depleted in 2034, unless Congress takes action to reverse the situation.

In general, people approaching retirement age often have other questions about benefits they may be eligible to receive from the Social Security Administration (SSA). Here are common concerns regarding the Social Security system.

What’s My FRA?

Your full retirement age (FRA) depends on the year in which you were born.

Year of Birth

Full Retirement Age
1937 or earlier 65
1938 65 and 2 months
1939 65 and 4 months
1940 65 and 6 months
1941 65 and 8 months
1942 65 and 10 months
1943–1954 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 and later 67

If you were born on January 1 of any year, refer to the previous year. If you were born on the first of the month, the SSA figures your benefit (and your FRA) as if your birthday were in the previous month.

Collecting Retirement Benefits

According to the 2017 report by the Social Security Board of Trustees, roughly 61 million beneficiaries were collecting money from the SSA at the end of 2016, including:

  • 44 million retired workers and dependents of retired workers,
  • 6 million survivors of deceased workers, and
  • 11 million disabled workers and dependents of disabled workers.

In 2016, the SSA’s total income ($957 billion, including interest income) exceeded its total expenditures ($922 billion). So, its asset reserves grew by $35 billion last year.

The reserves of the OASDI Trust Funds together with projected income should be sufficient to cover the SSA’s costs over the next 10 years. However, starting in 2022, the SSA’s total expenditures are expected to start outpacing its total income.

Is it time for you to start collecting retirement benefits? You may apply for benefits as early as age 62. Starting early will reduce your monthly benefits by as much as 30%, but, of course, you’ll receive benefits for more years.

If you want to receive full retirement benefits from the SSA, you must wait until you reach the so-called full retirement age (FRA). See “What’s My FRA?” at right. Your tax advisor can help you determine if you would likely be better off waiting until your FRA to start taking benefits.

Applying for Benefits

Apply for retirement benefits three months before you want your payments to start. The SSA may request certain documents in order to pay benefits, including:

  • Your original birth certificate or other proof of birth,
  • Proof of U.S. citizenship or lawful alien status if you weren’t born in the United States,
  • A copy of your U.S. military service paper(s) if you performed military service before 1968, and
  • A copy of your W-2 Form(s) and/or self-employment tax return for the prior year.

For most retirees, the easiest way to apply for benefits is by using the online application.

Receiving Benefits While You’re Working

If you’re under FRA and earn more than the annual limit (subject to inflation indexing), your benefits will be reduced, as follows:

  • If you’re under FRA for the entire year, you forfeit $1 in benefits for every $2 earned above the annual limit. For 2017, the limit is $16,920.
  • In the year in which you reach FRA, you forfeit $1 in benefits for every $3 earned above a separate limit, but only for earnings before the month you reach FRA. The limit in 2017 is $44,880. But the SSA only counts earnings before the month you reach your FRA.

Beginning with the month in which you reach FRA, you can receive your benefits without regard to your earnings.

Retiring after Your FRA

You can receive increased monthly benefits by applying for Social Security after reaching FRA. The benefits may increase by as much as 32% if you wait until age 70, but of course you’ll receive benefits for fewer years. After age 70, there is no further increase. Your tax advisor can help calculate the payout for waiting to collect your retirement benefits and help you determine if you likely will be better off waiting beyond your FRA to start taking benefits.

Managing Benefits for an Incapacitated Person

If a Social Security recipient needs help managing his or her retirement benefits — perhaps an elderly parent — contact your local Social Security office. You must apply to become that person’s representative payee in order to assume responsibility for using the funds for the recipient’s benefit.

Qualifying for Social Security Survivors Benefits

A spouse and children of a deceased person may be eligible for benefits based on the deceased’s earnings record as follows:

A widow or widower can receive benefits:

  • At age 60 or older,
  • At age 50 or older if disabled, or
  • At any age if she or he takes care of a child of the deceased who is younger than age 16 or disabled.

A surviving ex-spouse might also be eligible for benefits under certain circumstances. In addition, unmarried children can receive benefits if they’re:

  • Younger than age 18 (or up to age 19 if they are attending elementary or secondary school full-time), or
  • Any age and were disabled before age 22 and remain disabled.

Under certain circumstances, benefits also can be paid to stepchildren, grandchildren, stepgrandchildren or adopted children. In addition, dependent parents age 62 or older who get at least one-half of their support from the deceased may be eligible to receive benefits.

A one-time payment of $255 may be made only to a spouse or child if he or she meets certain requirements. Survivors must apply for this payment within two years of the date of death.

Paying Income Taxes on Benefits

You’ll be taxed on Social Security benefits if your provisional income (PI) exceeds the thresholds within a two-tier system.

PI between $32,000 and $44,000 ($25,000 and $34,000 for single filers). Recipients in this range are taxed on the lesser of 1) one-half of their benefits or 2) 50% of the amount by which PI exceeds $32,000 ($25,000 for single filers).

PI above $44,000 ($34,000 for single filers). Recipients above this threshold are taxed on 85% of the amount by which PI exceeds $44,000 ($34,000 for single filers) plus the lesser of 1) the amount determined under the first tier or 2) $6,000 ($4,500 for single filers).

PI equals the sum of 1) your adjusted gross income, 2) your tax-exempt interest income, and 3) one-half of the Social Security benefits received.

Need Assistance?

The long-term insolvency of the SSA program underscores the importance of saving for retirement while you’re working. Social Security benefits should be viewed only as a supplement to your other assets.

If you have additional questions about receiving Social Security retirement benefits, contact your Cornwell Jackson advisor. He or she can help you navigate the application process and understand tax issues related to receiving retirement benefits.

Revenue Recognition for Contracts: Changes Coming Soon

Posted on by Debra Barcuch

Revenue is the top line of your company’s income statement. So, it tends to receive a lot of attention from investors, lenders and other stakeholders. Why? Changes in revenue can tell whether your company is growing or declining. Moreover, changes in the composition of revenue can provide insight into your strategic plans.

If your company enters into contracts, it may need to update the way revenue is reported under new accounting guidance that goes into effect for public companies starting in 2018. Private companies get an extra year to change their reporting practices and systems to comply with this new standard.

Here are the details on what’s changing, including expanded disclosure requirements  that will affect a wide range of businesses.

Prepare to Add Disclosures

What’s the biggest challenge companies encounter when adopting the new revenue  recognition standard? Many companies that have already made the necessary changes report spending a significant amount of resources modifying their recordkeeping practices to comply with the standard’s expanded disclosure requirements.

Under existing U.S. Generally Accepted Accounting Principles (GAAP), most companies disclose limited information about revenue. When it comes to contract revenue, a company’s footnotes typically reveal only its general accounting policies and segment reporting.

The updated revenue recognition guidance requires all companies to provide a cohesive set of disclosures about the nature, amount, timing and uncertainty of revenue and cash flows from contracts with customers.

Specifically, the new standard will require you to:

  • Break down revenue into appropriate categories, such as product lines, geographic markets, contract length and services vs. physical goods.
  • Provide opening and closing balances of receivables, contract assets and contract liabilities.
  • Identify various performance obligations (or promises) in the company’s contracts, including when the reporting organization typically satisfies its performance obligations and the amount allocated to the remaining performance obligations in a contract.
  • Explain significant judgments and changes in judgments made when recognizing contract revenue.

The updated guidance also requires additional information about assets recognized from the costs to obtain or fulfill a contract with a customer.

The Basics

Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, will result in a major shift in the way some companies report revenue. For simple point-of-sale retail transactions, little change is expected: Revenue will continue to be recognized when goods or services are delivered to the customer. The process gets more complicated for long-duration, multi-element contracts, sales that include incentives for customers with poor credit, and contracts with built-in discounts or performance bonuses.

The breadth of change under the new standard depends on your industry. Companies that currently follow industry-specific revenue recognition rules under U.S. Generally Accepted Accounting Principles (GAAP) will feel the biggest effects from these changes. Examples include software manufacturers, telecommunications companies, defense contractors, airlines, hospitality and gaming companies, and health care providers.

Nearly all companies will be affected by the expanded disclosure requirements, which call for more details on the composition of revenues. (See “Prepare to Add Disclosures,” at right.)

Exceptions to the new rules include insurance contracts, leases, financial instruments, guarantees and nonmonetary exchanges between entities in the same line of business to facilitate sales. These transactions remain within the scope of existing industry-specific GAAP.

5 Steps

Compared to current practice, the updated guidance requires management to make more judgment calls based on overriding principles. The new standard calls for five steps to decide how and when to recognize revenue:

  1. Identify a contract with a customer.
  2. Separate the contract’s “performance obligations” (discrete promises to transfer goods or services).
  3. Determine the transaction price.
  4. Allocate the transaction price to each performance obligation.
  5. Recognize revenue when or as the company transfers the promised good or service to the customer, depending on the type of contract.

Essentially, the updated standard requires companies to assign a transaction price to each of a contract’s separate performance obligations and consider whether it’s “probable” they won’t have to make a significant reversal of revenue in the future. They also may need to adjust transaction prices to reflect the time value of money. Different companies may interpret the “probable” threshold differently, however, threatening financial statement comparability among entities.

It’s important to note that the new standard doesn’t change the total amount of revenue your company reports. Rather it’s a matter of timing. Companies may report revenue sooner (or later) under the new standard, depending on the terms of their contracts and management’s application of the “probable” threshold.

Use of Estimates

Recognizing revenue under the new standard will require management to make subjective judgment calls on such issues as:

  • Identifying performance obligations,
  • Estimating standalone transaction prices for distinct goods and services, and
  • Evaluating variable consideration (such as rebates, discounts, bonuses and rights to return) when determining the transaction price.

As the start date approaches, it’s important to assess whether the use of estimates could expose your company to additional financial reporting risks. The Securities and Exchange Commission’s Office of the Chief Accountant is urging public companies to conduct a risk assessment to ensure that they meet their financial reporting responsibilities under the new standard. The implementation process may include adopting new internal controls to help prevent management bias and inadvertent errors that could mislead stakeholders about contract revenue.

In light of the increased risk of potential misstatements, expect more questions from your accountant regarding revenue. If your statements are audited, expect your auditor to request more documentation and perform different auditing procedures than in previous years. Also, understand that the new rule may result in temporary book-to-tax reporting differences. That’s because the tax rules regarding revenue recognition haven’t yet changed to jive with the new accounting standard.

Need Help?

If your company issues comparative financial statements under GAAP, you should have already started the process for adopting the new revenue recognition standard. Most public companies that have already made the changes report that it takes more time and effort than they initially expected.

Contact your accounting professional to determine the extent to which the guidance will affect your company and how to revise your recordkeeping procedures, accounting systems and internal controls to facilitate compliance.

Casualty and Theft Losses: Find the Silver Lining

Posted on by Debra Barcuch

We’re in the midst of hurricane season now, but the eastern and southern shores aren’t the only parts of the country at risk for catastrophic events. Mudslides, earthquakes and wildfires often plague the West Coast, tornadoes may touch down across the Great Plains and Midwest, and low-lying areas near rivers and tributaries across the country are prone to flooding.

Although nowhere in the United States is safe from Mother Nature, there is a silver tax  lining: If your personal-use property is struck by a natural disaster, damaged by another calamity or stolen, you may be able to obtain some relief by claiming a casualty or theft loss as an itemized deduction on your individual tax return. As with most tax breaks, however, there are important rules and limits you need to be aware of.

Close-Up on Business Casualty Losses

What happens if your business property — rather than your personal-use property — is stolen, vandalized or otherwise damaged by an event? The same basic casualty and theft loss rules generally apply, with a few notable exceptions.

Most important, the limits for individual casualty and theft loss deductions don’t apply. In other words, you don’t have to worry about the $100-per-event reduction or the 10%-of-AGI threshold. Business casualty and theft losses are fully deductible (subject to the other restrictions listed in the main article, such as those related to salvage value and insurance reimbursements).

As with income-producing property, if business property is destroyed, the amount of your loss is your adjusted basis in the property. Any decrease in fair market value doesn’t come into play.

The Basics

To qualify for a casualty loss deduction, the damage or destruction must result from a “sudden, unexpected or unusual” event. Typically, this includes damage or destruction caused by natural disasters, such as hurricanes, tornadoes, fires, earthquakes or volcanic eruptions. But casualty losses may also result from such events as automobile collisions or water pipes bursting during a severe cold snap.

Similarly, losses due to vandalism or theft of property can be deducted. These amounts are combined with casualties for tax purposes.

On the other hand, you aren’t allowed to recoup losses due to normal “wear and tear” or progressive deterioration. For example, damage to shrubbery and plants caused by a long summer drought doesn’t qualify for the casualty loss deduction. Neither does damage to a home from termites or other insect infestations over long periods of time.

Quantifying Your Loss

For personal-use property that’s partially or completely destroyed, your casualty loss is the lesser of:

  • Your adjusted basis in the property, or
  • The decrease in the fair market value of your property as a result of the casualty.

However, if your property is income-producing property, such as rental property, and it’s destroyed, the amount of your loss is limited to your adjusted basis in the property.

The adjusted basis of your property is usually your cost, increased or decreased by certain events, such as improvements or depreciation. For instance, if you bought a home for $500,000 and you’ve added an in-ground swimming pool, deck and finished basement for $150,000, your adjusted basis in the home is $650,000.

For property that’s been stolen, your theft loss is generally your adjusted basis in the property.

For both casualty and theft losses, the deductible loss must be reduced by any salvage value and by any insurance or other reimbursement you receive or expect to receive. For example, suppose you own a barn with an adjusted basis of $25,000. The barn is destroyed by a fire and the insurance company reimburses you $15,000. In this case, $10,000 of damage is eligible for the casualty loss deduction, subject to additional limits. (See “Deduction Limits” below.)

If your property is covered by insurance, you must file a timely insurance claim for loss reimbursement. Otherwise, you can’t deduct the casualty or theft loss.

Deduction Limits

Unfortunately, you can’t deduct your entire casualty or theft loss — and you might not be able to deduct any of it, depending on the size of the loss and your income. The deduction is limited by the following two rules:

  1. The amount of your aggregate casualty and theft losses must be reduced by $100 for each separate casualty or theft loss event.
  2. You can deduct your aggregate casualty and theft losses only to the extent they exceed 10% of your adjusted gross income (AGI).

To better understand how these two rules work together, suppose your AGI for 2017 is $100,000. In July, a hailstorm causes $12,000 in uninsured damage to your home. Then your car is involved in an accident in October, and your out-of-pocket cost to have it fixed is $3,000.

Based on these facts, you may claim a deduction based on the two separate events: the hailstorm and the car accident. After insurance reimbursements, the deductible amount of your loss for damage to the home is $11,900 ($12,000 – $100), while the loss for the car is $2,900 ($3,000 – $100). Thus, the total amount of your casualty losses is $14,800 ($11,900 + $2,900). But, because 10% of your AGI is $10,000, your deduction is limited to $4,800 ($14,800 – $10,000).

If, however, your only casualty loss for the year was from the car accident, you won’t be able to deduct anything because your $2,900 loss is under the 10% of AGI threshold.

Timing of Deductions

Normally, you can deduct a casualty loss on your tax return only for the tax year in which the casualty occurred. This is true even if you don’t repair or replace the damaged property until a later tax year. For example, if your basement floods in late 2017, the resulting loss is deductible on the 2017 return you’ll file in 2018, regardless of when you repair or replace anything that was damaged or destroyed.

However, a special tax election may apply for damage occurring in an area designated by the President as a “federal disaster area,” allowing you to choose to claim the available casualty loss on the tax return for the tax year preceding the year of the event. For example, if you incur a loss in a federal disaster area before the end of 2017, you can choose to amend your 2016 return to obtain faster tax relief. You don’t have to wait until you file your 2017 return.

The timing rules for deducting theft losses are a little different. Generally, you can deduct the loss for the tax year you become aware that the property was stolen; it doesn’t matter when the theft actually occurred. However, you can’t claim a deduction while there’s still a reasonable probability that insurance will reimburse you for the loss.

So if you submit an insurance claim for a theft you discovered in 2017 but don’t find out until 2018 whether the claim will be paid, you can’t deduct a theft loss on your 2017 return. If in 2018 the insurer denies your claim (or reimburses you for less than your adjusted basis in the property), then you can deduct the unreimbursed loss on your 2018 return, provided you meet the other rules for the deduction.

Supporting Your Deduction

If you qualify for casualty and theft loss deductions, be sure to keep accurate records and evidence to support your claims. If the IRS challenges your loss deduction, you may need to supply auditors with such information as appraisals to assess fair market value, correspondence with insurance claims representatives and receipts to support the original purchase price, improvements and repair costs. Your tax advisors can help you collect the appropriate documentation to withstand IRS scrutiny.

Assessing the Demand for your Business

Posted on by Debra Barcuch

One of the big assumptions, or constraints, that holds back a business transition plan is that the owner assumes there is a future demand for the company. Before you determine how much a buyer is willing to pay for your business, you have to confirm there actually is a potential buyer.

Having no future buyer is an “undesirable effect” that can be addressed and eliminated by applying the Theory of Constraints “thinking process.” If you are concerned that there may not be a potential buyer, this is your current reality. The next step in the thinking process is to identify what can be changed to attract a potential buyer. This may include things like clean accounts receivables and strong credit terms, upgraded equipment, a highly trained and stable workforce, cash in reserves, profits and a transferable customer base. Other considerations may include:

  • Long-term demand for the products
  • Intellectual property
  • Well documented processes and systems
  • High cost to enter the industry
  • Easy access to debt financing and capital
  • Favorable tax structure

The Theory of Constraints emphasizes that increasing throughputs is more important than cutting expenses — something that seems contrary to traditional accounting. However, throughput has no limits whereas you can only reduce expenses to zero (rarely). In addition, net profit is derived by throughput minus operating expenses. In a manufacturing environment, efficient production and improving net profits are attractive to potential buyers. By contrast, inefficient production and low expenses are less attractive.

To determine the true demand for your business in the early stages of business planning, a calculation of business value can be performed to provide a baseline from which to pursue a more formal business transition plan. It will remove the constraints of owner procrastination and assumptions by putting real numbers to your future net worth.

Continue Reading: Identifying Weak Links to a Successful Transition

Gary Jackson, CPA, is a tax partner at Cornwell Jackson. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience at Cornwell Jackson and in providing tax planning to individuals and business leaders across North Texas.

Contact him at gary.jackson@cornwelljackson.com.

How Theory of Constraints Applies to Your Business Transition Plan

Posted on by Debra Barcuch

Business Transition

Manufacturing firms spend a lot of time focusing on streamlined operations and leveraging technology to reduce constraints in the supply chain. What if the theories of supply chain management were applied to business transition planning? In similar ways, you must assess demand, identify and find solutions around constraints, communicate effectively and take the critical path. This article aligns supply chain theory with business transition planning to give owners and leaders common language — and maybe some motivation to get started.

At a recent three-day conference called MEP Supply Chain Optimization for Leaders, the theories presented included an overview on the Theory of Constraints. The elements of this theory, well-known to many manufacturers, took on a potential brand new application for me.

As I listened, I realized that the Theory of Constraints was the very model that could eliminate common bottlenecks for business transition planning. The Theory of Constraints (TOC), conceived by Dr. Eliyahu Goldratt, is a methodology for identifying the most important limiting factor (i.e. constraint) that stands in the way of achieving a goal. In a complex manufacturing system where multiple linked activities rely on one another for efficiency and production flow, the weakest link can take down the whole system.

Until manufacturers focus on eliminating the main constraint and pursuing a critical path toward improvement, the system remains inefficient and profits are limited. In the same way, bottlenecks in business transition planning limit success.

After years of working with intelligent and successful manufacturers, I can safely say that owners are the primary bottleneck to a successful business transition and the profits that they deserve. They are all familiar with supply chain management theory and applying it to their own operations. However, planning for the inevitable change in ownership is not a favorite pursuit. While it’s beyond rational, it’s reality.

Business transition planning is a challenge in any industry. The important thing is to get started. For manufacturers, it may help to view this process with the common experience of the supply chain. Consistent planning plus communication plus oversight should equal improved production flow and profits. Without supply chain management, you already know the risks. In the same way, here are some real risks for manufacturers that delay business transition planning.

  • Allowing someone else to decide the future of your company for you
  • Working longer than you planned
  • High legal and accounting costs for a rushed sales transaction
  • Loss of business — and personal — net worth*

*Estimates on delay of business transition planning (between ages 45 and 60 vs. age 68 or later) can cost owners increasing multiples in diminished net worth.

Often, the main bottleneck created by owners is procrastination. They usually have an idea of their transition plan, but have not taken steps to pursue it and don’t know how realistic their expectations are on paper. Expectations for business value, a realistic successor or buyer, and continuation of operations are not guaranteed without a plan.

What if your first phase of business transition planning was handled within 210 days? This is the same time frame for applying the Theory of Constraints to your supply chain. If it’s good enough for your supply chain, imagine the value to your business and future net worth if you:

  1. Assessed demand for your business
  2. Identified weak links or choke points to a successful transition
  3. Took the “critical path” that is most challenging to pursue your plan

By looking at these three areas of your business transition planning process, within a manageable 210-day time frame, you will make tremendous progress toward a successful and profitable transition. Our Succession Planning Starter Kit can provide more information on potential barriers and action steps for manufacturers over those 210 days.

Continue Reading: Assessing the Demand for your Business

Gary Jackson, CPA, is a tax partner at Cornwell Jackson. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience at Cornwell Jackson and in providing tax planning to individuals and business leaders across North Texas.

Contact him at gary.jackson@cornwelljackson.com.

Reduce Your Risk of Committing Employment Discrimination

Posted on by Debra Barcuch

Whether a claim is unfounded or not isn’t apparent until it’s investigated, of course. But if statistics from the Equal Employment Opportunity Commission (EEOC) provide any insight, it’s worth noting that retaliation claims — the most common form of complaint — rose by 6% last year.

These claims involve allegations that employers took adverse action against employees who filed discrimination complaints. When an employer is found to have retaliated against a worker who files a complaint, that employer is culpable, even if the original discrimination charge proves to be invalid.

Only about one-third of retaliation charges addressed last year were determined to have had a “reasonable cause,” a fact which hasn’t changed much since the year 2000. Fighting such claims is time-consuming and disruptive, but generally necessary to avoid being stigmatized as a “bad” employer, not to mention to avoid incurring expensive penalties.

Going to the Mat

A recent federal case illustrates how far an employer might have to go to defeat an unfounded discrimination claim. A U.S. citizen of Arabic descent was given a low performance rating, and complained to the HR department that a supervisor had made a racially offensive remark. The employee was placed on a performance improvement plan, and claimed that the plan was in retaliation for his complaint about that remark.

He was transferred to another department, and two months later received another poor performance review. In keeping with company policy, the employee’s performance was later evaluated by a committee, which ultimately upheld the new supervisor’s negative review. The employee was terminated shortly thereafter.

The EEOC concurred with the employee’s retaliation claim, but the employer appealed the case to a U.S. District Court for the Southern District of Texas, which rebuffed the EEOC. The EEOC then sought help from the 5th Circuit Court of Appeals, which upheld the District Court’s ruling, seven years after the employee made his first retaliation complaint.

Lessons Learned

Needless to say, few employers have the legal budget or the appetite to stick to their guns fighting such a case all the way up to a federal appellate court. But the actions that the employer took ultimately brought vindication, and now offer important lessons to others. Here’s a quick summary of what happened in this case, which reveals why the employer may have prevailed.

  • The negative review didn’t happen until about 10 months after the employee had joined the company, suggesting that he was given plenty of time to prove himself.
  • The employer took the worker’s original discrimination complaint seriously, and transferred him to another department. The purpose of the transfer wasn’t to concede any wrongdoing on the original supervisor’s actions, but to give the worker an opportunity for a fresh start.
  • After the second supervisor gave the employee a negative review, a committee was formed to assess that review.

By taking all these measures, it was abundantly clear that the employer proceeded with intention and hadn’t acted rashly. But knowing when to “go to the mat” to defend your company against an unfounded claim isn’t always so clear.

Tips from the EEOC

Here’s what the EEOC says when it comes to developing a strategy for your company, which may help you nip employment discrimination claims in the bud.

General policies should:

  • Train human resources managers and all employees on Equal Employment Opportunity (EEO) laws.
  • Implement a strong policy based on EEO laws that’s embraced from the top levels of the organization.
  • Train managers, supervisors and employees on the policy’s contents, then enforce it and hold them accountable.
  • Promote an inclusive culture in the workplace by fostering an environment of professionalism and respect for personal differences.
  • Encourage open communication and early dispute resolution, which may minimize the chance of misunderstandings escalating into legally actionable EEO problems. An alternative dispute-resolution (ADR) program can help resolve EEO problems without the acrimony associated with an adversarial process.
  • Establish neutral and objective criteria to avoid subjective employment decisions based on personal stereotypes or hidden biases.

When it comes to recruiting, hiring and promoting employees, keep these principles in mind. It’s important to:

  • Implement EEO practices designed to widen and diversify the pool of candidates considered for employment openings, including positions in upper-level management.
  • Monitor for EEO compliance by conducting self-analyses to determine whether current employment practices disadvantage people of different races or treat them differently.
  • Analyze the duties, functions and competencies relevant to jobs. Then create objective, job-related qualification standards related to those duties, functions, and competencies and consistently apply them when choosing among candidates.
  • Ensure that selection criteria, such as education requirements, don’t disproportionately exclude certain racial groups. The exception might be if the criteria are valid predictors of successful job performance and meet the employer’s business needs.
  • Make promotion criteria available for employees to read, and also make sure job openings are communicated to all eligible employees.
  • Instruct outside agencies that you may use for recruitment not to search for candidates based on race or color. Both the employer that made the request and the employment agency that honored it would be liable.

Adopt a Policy

And finally, to minimize the chances of facing any harassment charges, adopt a strong anti-harassment policy, periodically train each employee on its contents, and vigorously follow and enforce it. The policy should include:

  • A clear explanation of prohibited conduct, with examples;
  • A detailed complaint process that provides multiple, accessible avenues of complaint, and a prompt, thorough, impartial investigation;
  • Assurance that the employer will protect the confidentiality of harassment complaints to the extent possible, and protect employees from retaliation;
  • A reasonable expectation that the employer will take immediate and appropriate corrective action if it’s determined that harassment has occurred.

The above may appear to be a daunting “to do” list, particularly if you haven’t yet given much thought to avoiding discrimination in your workplace. But every long journey begins with a single step, and the sooner you take that step, the lower the probability that you’ll wind up with a figurative knock on the door from the EEOC.

Is Your Company’s Vacation and Holiday Policy Working as Planned?

Posted on by Debra Barcuch

Presumably you have a holiday and vacation policy already in place. But what if it’s not working well for your company or your employees?

For example, if it’s vague, you may have to make decisions on the spot when an employee asks for days off at a time that is inconvenient for you and possibly for other members of your team. That can result in hard feelings if you have to say no, or extra work for you and others if you feel compelled to approve the request.

In constructing a policy, while it’s useful to consider what a perfect world would look like from your perspective, it’s also essential to begin with considering what other employers in your labor market are doing. That way you can be sure you’re reasonably competitive without giving away the store (see “Is Your Holiday Policy Competitive” below).

Vacation Request Procedures

A solid vacation policy will spell out the requirements for submitting time-off requests. For example, you might choose to give employees greater freedom to choose days off the further in advance they make the request. The more lead time you have to plan around vacation schedules, the less of a burden an employee’s absence imposes on you and your team.

Workers who make last-minute requests should know that they may be turned down. To avoid misunderstandings, define what your company means by last minute. Depending on the complexity of your scheduling, it could mean two days in advance, or two weeks or even more.

It’s also important to set a policy that establishes priority, when more than one employee asks for vacation leave for the same period of time. If three key people from a six-member department all want to take the last two weeks of August, who gets priority?

Basic prioritization systems include seniority, and first-come-first-served, or some combination of those two.

A third option is a rotational scheme. This involves having a team agree to make their vacation scheduling requests at the same time. Employees are randomly assigned a number indicating place in the request sequence, such as a number between one and six for a department of six.

The six employees then get to make their vacation requests according to the number they choose. But the employee who drew the number one moves to the end of the line (to number six) in the next round, number two moves up to number one, and so on.

Optimal Timing

If your company experiences annual slow periods, you may choose to encourage employees to take vacations during slow periods. That encouragement could take the form of a requirement that half of employees’ vacation time be used during such slow periods. However, for employees with children, school vacation schedules will be a major consideration, and you’d want to be as accommodating as possible for those workers, without leaving yourself open to an accusation of favoritism.

Some companies elect to go into a “hibernation” mode during a traditionally slow period, and essentially shut the place down, requiring employees to use most of their vacation days at that time. This is a common practice in several European countries. Employees plan around it, and nobody is left holding the bag, having to pick up the slack caused by other employees’ vacation schedules.

Cooperative Approach

Finally, if your workforce is cooperative and flexible (or you’re working to make it so), consider trying a collective process for setting vacation schedules. In other words, let a team work things out among themselves, taking into consideration each other’s needs and priorities, as well as the effectiveness and productivity of the team as a whole. Your role is to stay out of the discussions as much as possible, empowering team members to come up with their own solutions.

Potential benefits of this approach:

  • Fostering teamwork,
  • Experiencing minimum disruption to team workflow, and
  • Avoiding having to play the role of heavy.

Remember, establishing a vacation and holiday policy involves a balancing act between the operational needs of the business and employees’ desires. The process may be more of an art than a science. It’s up to you to find that proper balance.

Is Your Holiday Policy Competitive?

According to the Society for Human Resource Management (SHRM) 2017 survey, most employers pay a premium to employees when they are asked to work on holidays. Among those that do, 40% pay double-time wages to non-exempt workers, and 21% pay time-and-a-half.

Relatively few allow employees to take a floating holiday — that is, the opportunity to pick an alternative day off to a standard holiday, such as taking July 5 off instead of July 4. Similarly, only about 18% allow full-time employees to swap holidays, for example, take Chinese New Year’s day off in lieu of January first.

In case you’re wondering how your company’s holiday policy stacks up to other companies, here are the results of a 2017 SHRM survey, entitled Holiday Recognition Prevalence.

 

Percentage of surveyed employers recognizing
these holidays
Thanksgiving 97%
Friday after Thanksgiving 75%
Christmas Day 95%
Christmas Eve 62%
Week between Christmas and New Year’s Day 15%
Labor Day 95%
Memorial Day 93%
July 4 93%
New Year’s Day (Sunday in 2018) 98%
Monday after New Year’s Day (2018) 72%
Easter Sunday 51%
Good Friday 27%
Martin Luther King Jr. Day 39%
Presidents’ Day 34%
Veterans’ Day 19%
Columbus Day 11%
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