Month: November 2017

Preface: Simple Agreement for Future Equity (SAFE) provides entrepreneurs with an option towards simplified financing on business ventures. While federal taxation can be a puzzle on a SAFE, the hybrid financing method has a place for certain ventures. This blog is to provide funding ideas for ventures to entrepreneurs who want to enjoy a first mile.

SAFE Entrepreneurship

Credit: Donald J. Sauder, CPA 

In recent years, a hybrid financing structure for start-up businesses has been introduced to the marketplace termed “Simple Agreement for Future Equity” (SAFE). Convertible debt has been used for decades to finance entrepreneurship. The SAFE is created to improve upon convertible debt with common characteristics:

1. Conversion provisions for an early exit from the investment
2. SAFE’s are not classified as a debt instrument, since they do not have a maturity date, so there is a chance the SAFE never converts to equity or repayment occurs; simplifies rules of startup financing.
3. Since it is not a loan, there is no accrued interest
4. Simplified documentation of the uniform agreement (if agreed to) saves start-ups and investors legal fees and reduces negotiations of the terms of the investment.

Their are typically only two main negotiation terms for a SAFE , 1) valuation capitalization 2) Discount Rate.

The negatives of a SAFE are that they require incorporation of the investment; and investors assume all the risk since there is no priority decision to convert the debt; then founders typically receive less equity too, i.e. hinged to the negotiation of SAFE terms.

While SAFE tax treatment can be a puzzle of objective determinations and subject to tax court rulings, typically SAFE financing is more an equity investment than debt for federal taxation and highly sensitive to facts and circumstances; individual ruling differ. SAFEs are an ultimate gray area of tax codes.

Why a SAFE is advised

Most large business ideas are fueled with cash. A SAFE provides that cash with less risk to a business founder. SAFE has several advantages. First, a SAFE has no accruing interest rates on the investment, e.g. no cash outflow deadlines to investors while building the business. Secondly, with a SAFE most of the risk is passed to the investors.

Because a SAFE, if conversion occurs to equity, is on pre-negotiated terms in connection to future priced equity rounds, the post-money and pre-money basis are crucial. While a SAFE can be simple, if you’ve a venture capitalist who knows the street, modified terms require a good attorney to walk the path towards equity on the modified terms, before a pending conversion occurs. Spend the time and money to get it right.

SAFE financing has a real place in the business financing marketplace. Before you embark on a SAFE financing your advised to talk with a security attorney, then decide how much equity and control your willing to sell; and lastly, keep it simple.

Like all business financing, you need willing investors, but a well-planned, strategic SAFE can fund your business idea’s; and get them on the runway with a low risk financing.

This blog is for educational purposes only, and not be construed as tax, business, or legal advice. Talk with you accredited advisor before considering any SAFE decisions.

Preface: If you’ve never respected analytics on tax decision before, you’d be advised to begin today. 2008 is long-forgotten for the majority.  Analytical financial management in your tax planning for all entrepreneurs is well-advised for a business, as this blog exemplifies, for successful continuous financial performance.

Tax Planning with Analytics

Credit: Donald J. Sauder, CPA

Tax planning as an ultimate objective should be a balanced approach of analytical and financial management towards tax expense minimization. If you’ve been an entrepreneur for years, or are new to business, you may already have workable ideas to minimize federal and state taxes and keep more for yourself.

In this blog, we’d like to consider a financial management concept that too many entrepreneurs omit, or have never considered when managing their tax planning – debt management. As your business develops this concept is vital. Sole proprietorships are likely not the subject of this blog, but more so businesses with 5 to 35+ employees.

Maybe your advised to borrow on your line of credit, or call your friendly banker for a term loan on that new truck, machine or other high tech equipment to reduce this years taxes. Here’s a conversational excerpt.

“Hey Joe, if I purchase that new gadget for $75,000 what will it save me in taxes” entrepreneur Ulrich inquiries? “Well, you’re in a 30% tax bracket and therefore you will save $22,500 in taxes”, accountant Joe responds. “Given that the business tied up all working capital increases during the year in expansion of employee overhead and a few new vehicles” Joes says, “we’ll need to finance most of the $75,000 to keep our liquidity levels in the green”. “No problem” Ulrich responds, “I’m sure banker Jerry will give us the credit”. “I’ve can put that $22,500 to better use than the IRS”.

What questions arise from the above conversation? First, the question was simply about tax savings. There was a mention of working capital balances, but there was no consideration of analytics, i.e. say debt to equity levels, or cash flow EBIT. This is an important fact. The implementation of the above tax strategy to a highly-leveraged business only increases balance sheet risk, in that the additional equipment requires additional sales, and additional overhead of employee costs, workers comp, etc., for implementation of the new or additional gadget. This increases cash flow leverage to finance the said term loan, typically for five or seven years. A resulting circular equation of debt financed tax planning.

One mistake I’ve seen too often, is that entrepreneurs become very animated about tax costs, and leverage the balance sheet to reduce the tax expenses in the current year or cumulative years, when they should apply logical analytics for successful financial management balanced with tax costs. This myopic approach to tax expense reduction is risk fraught, because it only defers the tax expense. Here’s how the tax deferral works.

How will Ulrich pay the $75,000 loan? He will need to earn $75,000 of net income in future years, at a multiple of 1.3 for the tax effect plus interest expenses. This multiplier is likely 1.4+ depending on financing terms. Plainly said Ulrich will to earn $97,500, before interest expense to pay for the gadget in future years. All principal payments to the bank are likely from future year taxable net income. Therefore, if cash flows tighten, on a leveraged balance sheet, this myopic tax planning approach of prior year cumulative tax deferral could lead to an entrepreneur being overleveraged in the future, i.e. too much debt, on assets, e.g. equipment, that have cash flow production risks. In addition, the planned increased income generated from the gadget will result in increased future years tax expenses too, as stated before.

There is no guarantee of customer purchasing power for your business tomorrow. Three years of marginal debt financed tax planning can lead to an overleverage business, i.e. 25% of equity to assets. If the marketplace turns, the business balance sheet will not sustain operations financing, and very quickly the banker will be calling about the monthly term loan payments, and you will be calling your accountant who hopefully didn’t advise the loan.

Therefore, when tax planning, you’re now advised to look analytically at your balance sheet alongside your tax savings. The balance sheet strength, i.e. equity, can only increase with net tax income or capital contributions. Contributing capital for sustained operations on a continuous basis is not the picture of successful business. Now, debt financed tax planning may sometime be a prudent option for businesses, but advised only after considering the analytical metrics of your business.

If you’ve never respected analytics on tax decision before, you’d be advised to begin today. The 2008 economic malaise is long-forgotten for the majority. Be proactive and manage your business tax planning with a comprehensive analytical approach, and count the cost/benefit of paying taxes to build equity for an optimized business with strong financial pillars. Analytical financial management in your tax planning is well-advised for a successful business and for all entrepreneur’s.

Preface: Statements of cash flow are a keystone statement to accountants. Statements of cash flow always tell the truth. Are operating cash flows positive and robust? What are the cash sources and uses? This blog helps readers understand the value of cash flow analysis. 

Control Cash Flight with Statements of Cash Flow

Credit: Jake M. Dietz, CPA

“For riches certainly make themselves wings; they fly away as an eagle toward heaven,” according to Proverbs. Entrepreneurs sometimes painfully experience the flight of cash from the business. Sometimes cash flies away and nothing can keep it. Maybe the economy or a disaster destroys it. Other times, however, a wise entrepreneur can take steps to avoid the problem of no cash.   The statement of cash flows is a tool that business owners can use to study historical cash changes as they prepare for the future. If an entrepreneur understands past cash flows then they may be able to predict and prepare for future changes in cash.

The statement of cash flows shows what happened to your cash over time. A statement of cash flows can be generated from certain accounting software, although it may need some classification to be useful. If a bookkeeper or accountant prepares your financial statements, consider asking them for a statement of cash flows. Perhaps your profit and loss is showing a profit, but your cash is down.

Where did the cash go? This question can vex business owners, but a properly prepared statement of cash flows can help answer that question. If accounts receivable has gone up, then the statement of cash flows will reveal that you have more uncollected accounts receivable. Those accounts receivable are showing up on the profit and loss statement as sales, but the cash is nowhere to be seen.

If your company is ramping up inventory for a busy time, then the correct way to account for those expenditures is as inventory, which keeps it off the profit and loss statement until sold. You may notice a cash crunch, even if the inventory is not affecting profitability because it was not deducted yet.

Why bother studying the statement of cash flows? Why not just look at the bank account and see if there is money there? Understanding what happened in the past can be satisfying, but more importantly it can help business owners and managers prepare for the future. If cash is tight now, it might be tight again in the future. If the causes of a shortage are understood, then a company may be able to minimize the shortage in the future.

If the cash crunch is from not collecting accounts receivable fast enough, then considering taking measures to change that. Below are some possible action items.

• Ask customers for a deposit
• If customers already give a deposit, consider asking for a larger deposit percentage
• Consider sending the initial invoice sooner, or emailing/faxing it so it gets to the customer sooner
• Consider calling customers that are behind on their payments and sending them statements

If the cause of the cash crunch is from increased inventory, consider taking some of these steps to address it.

1. Reduce amounts of inventory, perhaps by implementing lean procedures
2. Ask the vendor if they would store the inventory on your site or nearby, allowing you to wait to buy it but still having it quickly available.
3. Set aside some cash when it is available to fund inventory increases when they are necessary
4. Considering negotiating longer payment terms with creditors
5. Consider obtaining a line of credit from the bank

Although the tendency of cash may be to fly away, use the statement of cash flows to understand the flight patterns of your cash. If the flight patterns of cash are understood, then you may find it easier to plan to have cash on hand. If you are not currently viewing your statement of cash flows periodically, consider starting to look at this informative statement. If it is confusing or inaccurate, ask an accounting professional for help.

Preface: This blog out lines the proposed changes in the tax laws from the Tax Cuts and Job Acts introduced by the House on November 2.

Summary of Proposed Tax Legislation for Individuals and Businesses

Credit: Donald J. Sauder

The House introduced a tax revision to individual and business tax codes on November 2, 2017. The 400+ pages of the introduced tax plan, propose lower tax rates for both business and individual taxpayers. In addition a change to numerous tax credits, and other tax provisions in the plan are for individual taxpayers relevant to say itemized deductions and exemption modifications.

While the tax bill has additional hurdles to clear before passage to law, we think it relevant to keep you apprised of tax code revisions pertinent to your tax filings looking towards 2018.

Individual Highlights

Firstly, individual tax rates are proposed to be simplified to four rates in 2018, e.g. 12, 25, 35, and 39.6 percent. Individual tax payers would be in a 12% effective rate up to $90,000 MJF income or $45,000 filing individually. The 25% bracket would be from $90,000 – $260,000 for MFJ filers, and $45,000 – $200,000 for individual filers; over a $1m would be taxed at 39.6% for MFJ filers. The child tax credit would increase, with a $300 credit for non-child dependents. The proposed plan does not change taxation of qualified dividends or capital gains, nor the Affordable Care Act (ACA) net investment tax or additional Medicare taxes. A joint proposal was filed on November 1, to repeal the employer shared responsibility and individual responsibility required form the ACA.

Standard deductions with the plan are proposed to increase 100% to $24,200 for MFJ filers and $12,200 for individual filers. This is designed to result in fewer itemized deductions. With the increased itemized deduction, it is believed that charitable contributions will decline to non-profit organizations, with less encouragement on the tax benefits for 20%+ of taxpayers who will not benefit from itemized taxes, i.e. simplified tax code. Secondly, with a higher itemized deduction, it is thought to likely have an impact on real estate prices from lower incentive for home mortgage deductions on itemization. The real estate tax deduction would be limited to $10,000.

Federal estate taxes are proposed to be repealed after 2023, with an increased estate exemption increased to $11.2m per person, or $22.4m for couples, for the 2018 tax year. AMT taxes would be erased with the proposed tax provisions beginning in 2018.

Business Highlights

The proposed House Bill sets a 20% corporate tax rate; with a current maximum of 35%, it provides relief for corporations taxed at towering tax costs, and provides incentive to keep businesses from shifting activity out-side borders. In addition, qualified property could be deducted 100% in the current year of purchase, for five-year property, placed in service after October 1, 2017. The Bill would also temporarily increase Section 179 expensing limits to $5m, with a phase-out at $20m for tax years before 2023. This increase would benefit capital expenditure intensive businesses, e.g. transportation and agricultural.

The Code Section 199 domestic production activities deduction, and non-real property like kind exchanges would be eliminated entirely. Those repealed current tax benefits would result in higher taxable income, albeit, at a lower rate for some businesses. The Bill keeps the research and development credit intact. Companies with higher interest costs would have a cap at 30% of adjusted taxable income on interest expenses, with exceptions for some entrepreneurial businesses.

Partnerships, S-Corporations and sole proprietorships paying tax at the pass-through rates currently in place for 2017, would see a top tax rate of 25% for 2018. The Bill proposes a tax fence for services provides, e.g. doctors or lawyers, to prevent the converting of service compensation to business income at the flat 25% rate.

Although there are numerous benefits to the proposed Bill, as with all tax changes, this proposed plan has both rewards and costs relevant to specific taxable circumstances.

This is not to be construed to be tax advice, and is for informational purposes only. Please consult with your tax advisor for specific tax advice and/or before making any tax decisions.

Preface: Construction contract accounting can get complicated, and the IRS allows taxpayers various methods to account for it. This blog will look at the completed contract method of accounting. The completed contract method is a method of accounting for long-term contracts; this blog assesses both advantages and disadvantages of the accounting method.

Construction Finance with Completed Contract Accounting

Credit: Jacob M. Dietz, CPA

How does it work?

The completed contract method of accounting records the income and related costs of a contract in the accounting period in which it is completed. For example, suppose ABC Construction, LLC begins building a house addition on 9/1/17. ABC completes the job on 2/1/18. The total contract price is $200,000, and the total contract costs are $190,000. The taxpayer would wait until 2018 to include the $200,000 in income, and to deduct the $190,000.

What are some disadvantages?

A disadvantage of this method is that income can potentially be grouped into one year, which could throw the taxpayer into a higher bracket and phase them out of deductions and credits. For example, if a big job was started in July of 2016, and finished in January of 2017, then potentially 1 ½ years of revenue could be reported in 2017. 2016 would have less income. Specific tax circumstances vary, but these swings could hurt the taxpayer.

Furthermore, some lenders may request tax returns to grant credit. If the most recent year happens to have low income because a large contract was not completed, then the lender may be less likely to grant credit.

The taxpayer must track the revenue and contract costs per contract for this method to work. Contractors should track this anyway for financial management purposes, but it does take time. It would likely take more time to adjust the books appropriately for the completed contract method than for accrual or cash basis methods.

What are some advantages?

So why would anyone want to use the completed contract method? Perhaps the number one reason is tax deferral. Using the earlier example, suppose ABC Construction, LLC has a $200,000 project started in 2017 but not finished until 2017, the company expects to earn a profit. The completed contract method allows the taxpayer to defer that income until the next year.

Although the completed contract method naturally causes swings in revenue based on when jobs are completed, this method reports the cost of the contract in the same period as the revenue. If applied appropriately, the taxpayer’s gross profit may swing, but the gross profit percentage should not experience the wild swings that can come from getting contract costs in a different period than contract revenue. Also, the taxpayer doesn’t need to worry if billings don’t match the costs for financial management purposes. Both the billings and costs of the contract will be deferred until the contract is finished. If using the accrual or cash method, and if the billings are not in line with the costs, then income skews. The skewed numbers make it harder to understand the company’s profitability.

The taxpayer doesn’t even need to track the percentage of completion for financial reporting purposes, except possibly towards the end. (If it is 95% done, and the owner starts using the building, then it can be considered completed.) Avoiding the percentage of completion calculation simplifies the accounting and potentially reduces the risk of errors. The taxpayer doesn’t need to worry about entering the correct estimated cost to complete, or if change orders increased anything. The taxpayer, however, still needs to track the contract costs and billings related to the project to keep them off the profit and loss statement until completion.

As you read down the blog, did any of the advantages or disadvantages stick out to you? If you meet the IRS qualifications, various contract accounting methods are available for you. There may not be one right answer. Consider both the pros and cons, and discuss with your accountant which method makes the most sense for your business.