Category: Uncategorized

The Changing Landscape of Sales Taxes (Segment II)

By Jacob M. Dietz, CPA

The Wise Steward

Let’s suppose Justin owns a business where he sells most of his various products online. The only state in which he has a physical presence is Pennsylvania, and in the past, he has only been collecting sales tax for Pennsylvania. While eating lunch one day, he receives a call from his accountant Reuben regarding the South Dakota v. Wayfair, Inc. Supreme Court case.

Justin questions him about whether he will need to file sales tax in South Dakota. His accountant Reuben inquires of Justin how many transactions pertain to South Dakota, and how many dollars do the transactions total annually? Reuben asks these questions to help determine if Justin’s business meets an exception.

As Justin chews another bite of hamburger, he suddenly realizes that he doesn’t know the answer to any of these questions. To make matters worse, he is not sure how to get answers without spending hours looking at invoices. Justin realizes that he should upgrade his information-gathering on sales, and he asks Reuben what changes could be made to his accounting system to start tracking these changes. Together they develop a plan to track product sales to various states.

After reviewing the specifics of Justin’s business, Justin and Reuben realize that in the future, Justin will need to collect and remit South Dakota sales tax. Justin realizes that charging sales tax will likely come as an effective price increase to his customers, although the extra money is going to the government instead of staying with him. His accountant Reuben advises him to save up some extra cash so that he has sufficient working capital to weather a slight downturn in sales.

Although sales take a slight dip, most of the customers still buy Justin’s products even though he is collecting and remitting sales tax.

Two years pass. Out of the blue, South Dakota audits Justin. Reuben helps Justin navigate the audit. South Dakota lets Justin go with no additional taxes or penalties because he faithfully collected and remitted sales.

The Oblivious Businessman

On the other hand, suppose Justin’s competitor, Kaden, runs a business very comparable to Justin’s, and it is 30 miles away. As Kaden ate lunch one day, he saw an article about the Supreme Court Wayfair decision. Kaden does not like to read about boring court cases, so he finds another article to educate himself while eating his hamburger. Unfortunately, no one calls Kaden and warns him that the sales tax environment is changing.

Kaden also sells into South Dakota, and he should start collecting and remitting sales tax, based on the specific facts of his business. Kaden, however, has a clear conscience because he does not realize he should be collecting and remitting sales tax. He is quite pleased because he sees a slight uptick in sales. Although he does not realize the reason, some customers that formerly bought from Justin’s business switched to Kaden’s business because Kaden is now cheaper since Justin started collecting sales tax.

Two years pass. Out of the blue, South Dakota audits Kaden. Unfortunately, they find that he should have been collecting and remitting sales tax. Unlike Justin, Kaden did not collect the sales tax that he owed. If South Dakota forces him to pay the sales tax now, it directly affects his profitability. Furthermore, if they charge interest and penalties, that would decrease his profitability even more. Although Kaden was unaware of the danger, nevertheless he still suffered because he passed on without realizing the danger and taking steps to avoid it.

Complexity

There are thousands of sales tax jurisdictions in the United States, and the jurisdictions do not always follow the same rules regarding taxability. Furthermore, the same type of item may be taxable or not taxable depending on the situation. Pennsylvania charges sales tax on some labor, but not other labor. If you are uncertain if your product or services are subject to sales tax, consider seeking help. It would be better to start collecting and remitting now, if necessary, than to get audited later and learn then that you should have been collecting and remitting. Foresee the danger and take steps to protect your business.

This article is general in nature, and does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

 

Preface: This blog is for entrepreneurs who are hereby advised to apply appropriate tax planning for their businesses activities to optimize the tax benefits and nuances of the new Section 199A tax laws, beginning with the 2018 tax year.

A Summary of the New Tax Laws For Section 199A

Tax Implications and Planning Features with the Qualified Business Income Deductions

Credit: Donald J. Sauder, CPA, CVA

Surpass the Threshold

What if you surpass the $315,000 MFJ and $157,500 Section 199A threshold? Well, tax planning becomes more complex and is then subject to certain individual tax planning nuances. First, the service business deduction goes to zero when exceeding the threshold. Further, qualifying businesses have a separate individual limitation on two levels 1) applicable to W-2 wages amounts, or 2) the combined W-2 wages and a 2.5% capital factor.

For example, the first step planning item nuance with the Section 199A threshold for high income entrepreneurs, is that tax planning must now occur on a business by business approach, with segregations of the individual business activities to determine (QBI) qualified business income optimization. Therefore, for entrepreneurs with multiple ownership interests e.g. Sch. C’s or K-1’s, the tax activity grouping features are now imperative. Secondly, tracking income and expense, and W-2 wages for each business, and the corresponding basis of fixed assets is an additional feature now of yearly tax planning. This planning is an advised tax accountant task.

Tax Planning with Section 199A Threshold

It appears that prior tax year groupings for net investment income tax provisions, will continue to work with Section 199A. However, groupings of business on W-2 wages and fixed assets are now aggregate considerations. In other words, the grouping features of an individual taxpayer have a new feature of consideration, and future aggregation will require specific individual tax planning. These groupings are a separate tax planning topic.

Furthermore, the industry code applied to a business tax filing has become increasingly important. A once more trivial consideration, the industry code reported to the IRS on the business tax filings, will now result in potential audit flags if misclassified as a service based activity, i.e. the IRS will apply scrutiny of industry codes on service business as subject to audit adjustments even if business income qualifies as non-service QBI, because the tax filing has classified the activities as service sourced revenue.

Adding to the tax planning nuances, fixed asset schedules are another key area of tax planning for purposes of qualified property factors for Section 199A when taxpayers exceed the threshold. More tax planning variables occur with the 2.5% qualified property factor calculated in the Section 199A deduction that permit business property owned and in service at the end of the tax year and produces qualified business income, to provide a tax deduction in the absence of W-2 wages.

This is a welcome tax rule improvement from the prior Section 199 DPAD. The in- service property’s unadjusted basis remains applicable for 10 years after placed in service, or the last day of the last full year of MACRS depreciation. The accuracy of fixed assets is now a pivotally global tax filing attribute.

Surprisingly to the entrepreneur’s taxation favor, the unadjusted basis of fixed assets for the Section 199A is not reduced by Section 179, bonus depreciation, or regular depreciation. Adding to the benefits, the unadjusted basis of assets is used for the greater of the recovery period of 10 years. Property basis for Section 199A is only reduced or eliminated if the asset is no longer used in the qualifying business. Therefore, if a business purchases $500,000 of equipment on March 1 of 2018, if the business deducts the $500,000 galaxy of asset additions, with bonus depreciation rules during 2018, the qualified property basis is still $500,000 for the Section 199A capital limit, i.e. the 2.5% of property computation. Adding to tax complexity, uncertain tax positions will now be relevant in say real estate partnerships with allocations of land and building allocations because the QBI limit will be adjusted based upon qualifying depreciable property.

End of Segment II – to be continued

The Changing Landscape of Sales Taxes  (Segment I)

By Jacob M. Dietz, CPA

“A prudent man foreseeth the evil, and hideth himself; but the simple pass on, and are punished.” Proverbs 13:12

The landscape for collecting and remitting sales taxes is changing. If your business operates in more than one state, consider if you should be making any changes to hide yourself from unpleasant circumstances.

History

Decades ago, the Supreme Court ruled in the Quill case that merchants did not need to collect and remit sales tax in other states if they didn’t have a physical presence in that state. This exception allowed out-of-state merchants to sell items that would normally be subject to sales tax into another state without collecting and remitting sales tax.

The exception to collection and remission allowed merchants to avoid the hassle of determining if their product was subject to sales tax in a different jurisdiction. For example, just because something is subject to sales tax in Pennsylvania does not automatically mean it is subject to another state’s sales tax. On the other hand, a product that is exempt from PA sales tax is not automatically exempt under another state’s sales tax rules.

The exception to collection and remission also allowed merchants to avoid the time and expense of filing sales tax returns in other states. It takes time to file in other states. Also, it can make a significant difference in the price your customer pays. For example, suppose you are selling a $10,000 item to another state with a 5% sales tax rate. If you do not charge sales tax, then your price is $10,000. Suppose that you have a competitor with a physical presence in that state. They are selling the same item that you are selling, also for $10,000. Since they had a physical presence, however, they need to charge the 5% sales tax rate. If a customer buys from your competitor, they pay $10,500. If they buy from you, they pay $10,000. Merchants with no physical presence therefore had an advantage.

Some states have a use tax for this situation. The use tax would be payable by the customer, so they would still owe $500 of tax, which they should report and pay themselves. The merchant would not need to bother with it. Unfortunately, compliance with use tax is low.

The Great Change

We have been addressing the past, but there has been a great change. South Dakota wanted tax money, and they passed a law to collect sales tax from out-of-state vendors even if they did not have a physical presence in the state.

The South Dakota law, however, did not require every out-of-state merchant to collect and remit sales tax. It used the threshold of $100,000 sales and 200 separate transactions. Therefore, an out-of-state merchant that sold $10,000 of products into South Dakota in 10 separate transactions would not be required to collect and remit sales taxes under South Dakota’s law.

This law, even with the threshold, contradicted the Supreme Court’s rulings in the past, so this law came before the Supreme Court. The Supreme Court sided with South Dakota in a 5-4 ruling. In South Dakota v. Wayfair, Inc., the Court overturned its decades old precedent requiring physical presence for the collection and remission of sales taxes.

How Will This Case Affect Businesses?

If a business is selling into another state, even without a physical presence in that state, it is possible that the business will be subject to sales tax in that state. Note that it is possible, it is not guaranteed. It depends on the specifics of the situation.

This article is general in nature, and does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

To be continued……

Preface: This blog is for entrepreneurs who are hereby advised to apply appropriate tax planning for their businesses activities to optimize the tax benefits and nuances of the new Section 199A tax laws, beginning with the 2018 tax year.

A Summary of the New Tax Laws For Section 199A

Tax Implications and Planning Features with the Qualified Business Income Deductions

Credit: Donald J. Sauder, CPA, CVA

Minted the Tax Cuts and Jobs Act, the newest business tax legislation relevant to the 2018 tax year, appears to have unique tax characteristics that are intentionally vague for taxpayers with regards to certain IRS code section interpretations. The summarized IRS tax code relevantly exemplified specifically to this blog are for the Section 199A or the Qualified Business Income Deduction.

To be confidentially advised towards IRS audit proof tax planning decisions for the 2018 tax year, it is imperative to understand how the new tax law of Section 199A are applicable to certain qualifying entrepreneurial activities and corresponding tax positions e.g. tax laws for service and non-service businesses, exact definitions of qualified business income (QBI) and individual tax filing threshold limits on Section 199A.

The new Section 199A tax code permits individual tax filers to deduct as much as 20% of qualifying 199A income for tax filing purposes beginning with the 2018 tax year. The qualifying Section 199A income includes qualified business income (QBI) from say partnerships, sole proprietorships, or S-Corporation. As with most new tax laws, Section 199A section has numerous tax planning nuances that we will outline in the following paragraphs.

A Section 199A Outline

So, what is Section 199A? It is a tax deduction akin to the prior Domestic Production Activity Deduction under Section 199. With the unique modifications to Section 199A (Section 199 called DPAD in prior years, was capped at 9% of qualifying income or 50% of W-2 wages), for the current tax year, business tax planning will encompass an entirely new level of tax variables with the introduction of this tax law modification.

The Section 199A deduction begins with the tax year 2018 and is currently legislated now, until 2025. Firstly, Section 199A is a standard 20% deduction of QBI from unadjusted income, with a threshold limit on individual taxpayer earnings, e.g. exceeding $315,000 MFJ or $157,500 otherwise. The Section 199A deduction limit phases out over $415,000 MFJ or $207,500 filing otherwise. Above these individual filing threshold’s, the Section 199A is limited to 1) the greater of the 50% of timely filed W-2 business wages, or 2) the combined sum of 25% of W-2 wages plus 2.5% of unadjusted qualifying business property.

The obviously unique characteristics of Section 199A from prior Section 199 DPAD also include capital gains, say from sales of stocks or bonds, being entirely deducted from QBI as non-qualifying income, and permitting a potential deduction for businesses that have zero W-2 income yet substantial unadjusted basis in property, i.e. in-service fixed assets.

Here’s how Section 199A works. If your taxable income is less than $315,000 MFJ or below $157,500 filing single, you receive a standard 20% Section 199A deduction from taxable income. Below the threshold level the Section 199A is a standard applicable 20% deduction for both service and non-service businesses, e.g. all entrepreneurs can supposedly participate in the tax benefits below that threshold.

Example: Bob and Brenda are married filing jointly. Brenda has QBI from a non-service business of $30,000. Their joint income is $375,000 for the tax year. Brenda receives a wage allocation of $40,000 from the business. The 50% of W-2 wages is $20,000. The $20,000 of wages are reduced from the $30,000 of QBI by the $60,000/$100,000 or 60% (excess of income from $315,000 threshold) equaling $12,000. So, the Section 199A is the $30,000 QBI subtracting the $6,000 threshold limit, equaling $2,400 of Section 199A tax benefits. Interesting math say?

End of Segment I — to be continued.

Preface: “God never made a promise that was too good to be true” – D.L. Moody.  The Pennsylvania EITC is good and it is true, and gives Pennsylvania taxpaying constituents and parents of children in private K-12 grade school, something to smile about today.

Too Good to Be True: Funding Education with Tax Dollars?

Credit: Jacob Dietz, CPA

The Congress and the President handed the American people tax reform. Tax reform has various benefits that could make you smile, but it also has some reductions in certain tax benefits, such as the SALT (State And Local Tax, it has nothing to do with table salt) deduction cap.

SALT Cap

The SALT deduction has been capped at $10,000 starting with 2018, although the standard deduction has been increased for taxpayers that choose not to itemize. This new cap prevents a taxpayer from deducting more than $10,000 for their real estate taxes, state income tax, and local income tax as part of the taxpayer’s itemized deductions. Please note that this new rule does NOT limit the real estate taxes that can be deducted for real estate rentals or as part of a business. For some taxpayers, this cap will affect their bottom line.

For example, assume Melvin paid $8,000 in real estate taxes, $4,500 in PA income taxes, and $2,000 for local taxes. Under the old tax rules, Melvin’s SALT deduction would have been $14,500 if he itemized his deductions. Tax reform caps Melvin’s SALT is deduction at $10,000. Melvin therefore pays $4,500 of PA income taxes but he receives no increased deduction for it.

Is There a Solution?

Is there anything Melvin can do? Melvin could reduce his PA taxes if his business received the Pennsylvania Educational Improvement Tax Credit (PA EITC) by contributing to a qualified institution. The PA EITC is a tax credit against various PA taxes on eligible donations to qualifying organizations. If you want more details on the PA EITC, click here to read this blog.

Assume like Robert Louis Stevenson said, “Children are certainly too good to be true” and Melvin’s grandchildren attend a Christian school, and he endorses their education already, personally donating funds to the school. Melvin also owns and operates a single member limited liability company (SMLLC.) Instead of donating personally, Melvin could apply for the PA EITC for donations made to the school through his SMLLC. If approved, he could get a 90% Pennsylvania tax credit for his contributions with a 2-year commitment to contribute.

Let’s put some numbers to the scenario. Melvin’s SMLLC filed for and received approval for a 90% credit ($4,500) for a $5,000 contribution for two consecutive years. The company therefore pays $5,000, and the majority of that $5,000 makes it to his grandchildren’s school (a fee goes to administrative costs if he pays via a conduit scholarship fund say.) Pennsylvania gives his single-member LLC business a $4,500 (90% of $5,000) credit for the contribution, which he can pass down to use on his personal tax return.

Melvin avoids paying the $4,500 of PA taxes that would have been nondeductible under the new tax reform, and he contributed to education at the same time. Since he owes no state income tax, then the total remaining taxes of $10,000 ($8,000 real estate taxes and $2,000 local taxes) are not limited by the $10,000 cap. Melvin therefore used his money to build the Kingdom while still complying with the government’s rules.

Reason to Smile

If the tax reform SALT cap caused you to frown, and if you live in Pennsylvania, consider if the PA EITC is right for you. The PA EITC gives taxpayers and parents of children in school something to smile about.

Preface: Do you own a house whose value has increased since you bought it? If so, you might be curious about the tax consequences if you sell it. The taxes for selling a house vary depending on the scenario. This article explores some of the tax consequences when selling houses.

Tax Planning on Residential Real Estate Transactions (Segment II)

Credit: Jacob M. Dietz, CPA

Business of Buying and Selling

For this scenario, assume the profitability of buying and selling houses impressed John so much that he decided to quit his construction job to buy and sell houses full-time. He started buying houses, fixing them up himself, and then selling them at a profit. John managed to sell a house about every 2 months. In this scenario, John operates a business. The profits therefore would not be capital gains even if he managed to hold onto a property for more than a year. Furthermore, if John does not have an approved Form 4029 exempting him from self-employment tax, then John would owe self-employment tax on the earnings from his house-flipping business.

Since it is a business, John should carefully track expenses associated with it. Levi asked John to track which expenditures add basis to the property and which can be deducted immediately. Levi explained that certain fees paid when purchasing should be added to the basis, such as recording fees and transfer taxes. Construction costs to improve the house, such as adding a bathroom or a new retaining wall, should also be added to the basis. When John sells the property, the basis will then be subtracted from the sales price, reducing John’s income.   John and Levi should also consider if there are any filing requirements for his business, such as 1099s.

“One such advantage is the Section 199A Qualified Business Income Deduction. This taxpayer-friendly part of the tax system allows John to deduct up to 20% of net income from his house-flipping business, subject to certain restrictions”.

Although there is a higher tax rate if he is in the business of flipping houses instead of investing in properties for more than a year, there are also some advantages. One such advantage is the Section 199A Qualified Business Income Deduction. This taxpayer-friendly part of the tax system allows John to deduct up to 20% of net income from his house-flipping business, subject to certain restrictions.

Buy and Use as Principal Residence

Let’s change up the first scenario. Suppose John buys the brick rancher for 200,000, and he really likes the house. He likes it so much that he moves in after marrying Rose, and they live there for 3 years. When John and Rose sell the house 3 years and 1 month after purchase, they sell it at a spectacular $100,000 gain. Before selling, John called Levi to ask him what his federal tax bill would be. Levi explained how the federal tax system allows them to exclude that gain. If a taxpayer is married filing joint, he and his spouse can exclude up to $500,000 (it would only be $250,000 if John were single) of the gain on a house that was their principal residence for at least 2 out of the last 5 years.

This exclusion can only be taken once every 2 years. Levi also mentioned that there are various exceptions to the rules which could help taxpayers exclude at least part of the gain even if they do not meet the normal requirements but have special conditions. Special conditions include the death of a spouse, a health-related move, a work-related move, and others. John and Rose met all the requirements, and therefore they gained $100,000 without needing to pay a dime in federal taxes on the gain.

“Levi explained to them that they could exclude the gain from the sale of the lot as part of the transaction of selling their home, if they sold the lot within two years of selling the home, and if the total gain did not exceed $500,000”.

Let’s change up the principal residence scenario. Suppose that when John purchased the home, he also purchased a vacant lot on a separate deed next to it. John and Rose planted grass on the vacant lot, and treated it as part of their home’s yard. Levi explained to them that they could exclude the gain from the sale of the lot as part of the transaction of selling their home, if they sold the lot within two years of selling the home, and if the total gain did not exceed $500,000.

Final Thoughts

As you can read, taxes on house sales really varies. If you want to sell a house, talk with a tax expert before finalizing the sale. The tax expert may be able to help you find a benefit, such as waiting a little longer until a time deadline passes. Furthermore, if you will owe taxes, then the tax expert may be able to estimate roughly your tax liability so you can stow away some money to pay what is owed.

 

Preface: Do you own a house whose value has increased since you bought it? If so, you might be curious about the tax consequences if you sell it. The taxes for selling a house vary depending on the scenario. This article explores some of the tax consequences when selling houses.

Tax Planning on Residential Real Estate Transactions (Segment I)

Credit: Jacob M. Dietz, CPA

Buy and Sell Same Year

Assume John Georges had some money to invest, and he purchased a house at the advice of his father. He bought a $200,000 brick rancher in June 2018. John heard real estate prices were climbing rapidly in his area, so he decided to wait for a buyer instead of renting it out.

“John therefore sold it to them at a $25,000 gain. The income would be a short-term capital gain since John owned it for less than a year”.

In August 2018, John’s realtor that helped him buy the house called him and said another buyer desperately wanted to buy the house, and they were willing to pay John’s asking price. John therefore sold it to them at a $25,000 gain. The income would be a short-term capital gain since John owned it for less than a year. Short-term capital gains are taxed at ordinary tax rates. Note that only the gain (sale price less purchase price less other adjustments such as selling costs) is taxable, not the entire sales price.

Buy and Sell plus other Goods

This scenario is the same as the first scenario, except when John sold the brick rancher, he received an additional $25,000 for items left in the house by the previous seller. These items included furniture for all the rooms. The additional 25,000 increased his income to $50,000, taxed at ordinary rates.

Buy and Sell after more than a Year

In this scenario, the facts are the same as in scenario 1 except for the sale date. John owned the house without receiving any offers for nearly a year.

“Levi explained to John the difference between short-term and long-term capital gains. If John sells a house he owned for a year or less, it is a short-term capital gain”.

Shortly before a year ended, a realtor contacted John with an offer. John was pleased with the price, but he called his accountant, Levi, before deciding. Levi explained to John the difference between short-term and long-term capital gains. If John sells a house he owned for a year or less, it is a short-term capital gain. Levi explained that short-term capital gains are taxed at ordinary rates. On the other hand, houses owned over a year receive long-term capital gain treatment.

“Levi recommended that John go ahead and accept the offer, which would bring John a $25,000 profit, but Levi also advised that John wait to settle on the house until more than a year after the purchase date”.

The tax rate varies for long-term capital gains, but it is lower than ordinary income tax rates. Levi recommended that John go ahead and accept the offer, which would bring John a $25,000 profit, but Levi also advised that John wait to settle on the house until more than a year after the purchase date. By waiting a few weeks to close, John benefitted from the lower long-term capital gain rates.

Conclusion of Segment I.

Preface: “We must go beyond textbooks, go out into the bypaths and untrodden depths of the wilderness and travel and explore and tell the world the glories of our journey.” — John Hope Franklin

“I vividly remember a conversation I had many years ago in 1974, which marked a turning point in my leadership journey. I was sitting at a Holiday Inn with my friend, Kurt Campmeyer, when he asked me if I had a personal growth plan. I didn’t. In fact, I didn’t even know you were supposed to have one.” — John C. Maxwell

Navigate Business with a Good to Great Balance Sheet (Segment II)

Credit: Jacob M. Dietz, CPA

If you want more accurate financial numbers, take the time to adjust your businesses balance sheet accurately. Trying to navigate a course for your business using inaccurate financial reports can be like trying to navigate with a 50-year-old atlas. You may miss your intended destination on the journey. Alternatively, you might reach your destination, but it may take you on a long route. Using accurate financials can help you reach your goals on your journey.

Liabilities

Liabilities are what the company owes, and they should be examined as well.

If your company has Accounts Payable, review an aging schedule. Does your accounting system indicate that you owe invoices that you really do not owe? If so, clean them up. Why would it show that you owe money that you don’t owe? One scenario could be that your company did owe that amount once, but that it was entered twice. Your company paid one entry, but the other entry still lingers in your books as a payable. If this scenario happened to your company, then the lingering entry should be fixed.

If you company purchases with credit cards, are the credit cards reconciled? Business expenses purchased on a credit card should be recorded in the accounting system. Verifying the ending balance could detect if some credit card purchases were not entered that should have been.

If your company has any debt, either to a bank, an individual, or anything else, verify if the ending balance is accurate. If you receive statements, the balance sheet can be compared to that. If it is a loan to a person, you may want to compare to an amortization schedule that you both agreed to in the beginning of the loan.

As with assets, consider if there are any liabilities not on the books that should be recorded. For example, did someone loan the company money but it’s not recorded in the accounting system? If your company uses the accrual system of accounting, consider if there are any accruals, such as for payroll, that should be entered or adjusted.

Equity

Equity shows the ownership interest in a company. Does the equity on the balance tie to the tax return, or the accounting records that were used to prepare the tax return? If it doesn’t, then you might overpay in taxes. How could this happen? Assume that your accounting records show an invoice of 5,000 on December 31 that is included in income. Your accountant receives your accounting records and prepares a tax return reporting the $5,000 from that invoice as income. Later, for some reason, the date of the invoice is changed to January 1.   If your accountant later looks at the profit and loss for the next year, the $5,000 will show up again. Thus, the $5,000 could get taxed twice. Moving the invoice from December to January will change equity, however, so reviewing total equity can help detect this change.

If the company has multiple partners, then consider breaking down equity by partner. If equity is broken down by partner, then generally it should tie to the K-1s in the tax filing. The accounting software likely will not allocate the equity for you properly, so it may need to be done manually. For example, the earnings from the previous year may get dumped into a single account by the accounting software. Your accountant should be able to help you allocate the equity among the partners.

Navigate with a Good Map

This article discusses clean books, but it takes more time to adjust books accurately than it does to read this article. The benefits of accurate accounting records, however, can be great.

If your balance sheet is as inaccurate as a 50-year old map, start adjusting it accurately right up to the FICA taxes. Systematically go through the balances and review if they are accurate and if beginning numbers tie to the prior year return. Although an accurate balance sheet doesn’t guarantee an accurate profit and loss statement or statement of cash flows, it puts you in a better position to prepare and accurate profit and loss statement and statement of cash flows. Travel with modern maps, and navigate your business with an accurate balance sheet.

Preface: “One’s destination is never a place, but always a new way of seeing things.” — Henry Miller.

“Success is about dedication. You may not be where you want to be or do what you want to do when you’re on the journey. But you’ve got to be willing to have vision and foresight that leads you to an incredible end”. — Usher

Navigate Business with a Good to Great Balance Sheet (Segment I)

Credit: Jacob M. Dietz, CPA

Where is your business, and where is it going? Good to great financial reporting helps answer these questions, but too often the accounting records of a business cannot be trusted because of inaccuracies. If you want more accurate numbers, take the time to clean up your balance sheet. Trying to navigate a course for your business using inaccurate financial reports can be like trying to navigate with a 50-year-old atlas. You may miss your intended destination on the journey. Alternatively, you might reach your destination, but it may take you on a long route. Using accurate financials can help you reach your goals on your journey.

General Principals

If you crave an accurate profit and loss statement and statement of cash flows, start with an accurate balance sheet and end with an accurate balance sheet. If the balance sheet is wrong, then the profit and loss statement and the statement of cash flows may be wrong as well.

If the balance is wrong, how do you fix it? Begin with the beginning balances. Generally, treat the balances that were used to prepare the last tax return as correct. If the tax return contains significant problems, however, then consider starting with balances used for an earlier tax return. For this example, assume that there are no known problems with the last tax return. Let’s explore how to generate accurate balances.

Assets

The first part of the balance sheet lists what the company owns. Accountants call these items assets. Assets include bank accounts, inventory, accounts receivable, etc. Verify that the beginning balances for the year equal the ending balances used for the tax return. In a balance sheet, the asset ending balance for the previous year is the beginning balance for the current year. Sometimes accountants adjust the balance sheet when preparing the tax return but don’t adjust the company’s accounting records. If the beginning balances do not tie, adjust the balance sheet dated at the end of the previous year to tie the beginning balances to the ending balances used for the tax return.

What adjustments might be made by an accountant but not entered in a company’s accounting records? Accountants frequently adjust inventory at year end through cost of goods sold. If your accountant adjusted inventory for the tax return, but that adjustment was not made in your accounting records, then adjust your inventory to match the inventory that was used on the tax return. Accountants frequently adjust depreciation when preparing a tax return. Depreciation adjustments affect the balance sheet account Accumulated Depreciation. If Accumulated Depreciation in your accounting system doesn’t match the balance sheet used for the tax return, then adjust it to match.

If all the beginning balances match the ending balances used on the last tax return, examine the ending balances of the period being considered. A balance sheet is a snapshot of a company’s finances at a specific point in time. It is therefore important to know which date is being considered. For this example, assume that the balances are for December 31. Examine every line item in the asset section of the balance sheet, and consider if it is accurate.

Start with cash. If petty cash is listed on the balance sheet, is it accurate? If there is only $25 in the petty cash drawer, but the balance sheet says $1,500, then adjust petty cash to match the counted value. If an item is small, judgment can be used regarding how much verification to do. For example, if petty cash says $45, you might decide to skip counting petty cash since it is insignificant.

Verify the ending balances for bank accounts. Each account should have either a bank statement or a bank reconciliation that ties to the amount on the balance sheet. If a checking account has outstanding checks, review the outstanding check list to see if there are any old items there. For example, suppose there are 2 checks listed from 11 months ago. Why did those 2 checks not clear? Were they duplicated in the accounting system?

If there is inventory on the balance sheet, is it counted regularly? Many companies need to count inventory regularly or else the balance will be incorrect. If the balance differs from a physical inventory count, then adjust the balance to match the count.

When inventory is adjusted, the other side of the adjustment is cost of goods sold, which is on the profit and loss statement. If the beginning and ending inventory balance is not correct, then cost of goods sold may also be wrong, leading to an incorrect profit and loss statement. Therefore inventory, a balance sheet account, impacts cost of goods sold on the profit and loss statement.

If the company has accounts receivable (AR), examine an aging report for accuracy. Does the report list amounts that will never be collected? Consider if any AR should be written off as bad debt.

If there are other items in the asset section of the balance sheet, consider if they are accurate. Also, consider if there are items that are not in the asset section that should be. For example, did the company loan money to another company? If so, ensure that the loan receivable is recorded in the accounting system.

Segment I Summary: Where is your business, and where is it going? Good to great financial reporting helps answer these questions, but too often the accounting records of a business cannot be trusted because of reporting inaccuracies. The above steps as a good beginning step, with the guidance of your CPA, can begin to create an accurate map of your business financials.

Working Capital Tools for Successful Business Performance (Segment V)

Credit: Donald J. Sauder, CPA, CVA

 Looking Towards the Future

Working capital management is imperative to successful entrepreneurship because agreement on its relevance is a real deal when transitioning business ownership. Working capital requirements are often a key valuation feature in business exits.

Let’s look at some relevant marketplace data from Keystone Business Transitions for confirmation:

• You are far from the only fish in the sea. Estimates indicate that there are approximately 7.5 million business owners in the United States, and 65% of survey respondents planned to leave their company within a decade or less. That could result in a glut of companies on the market, driving down valuations and giving new leverage to buyers.
• If you are a Baby Boomer (born between 1946 and 1964) the generation following you is not nearly as big so expect far more sellers than buyers in the marketplace. This too, adds to the glut.
• Even during boom times less than half of the owners who tried to sell their business actually were able to sell.
• Unless your company is superior to its competitors because there’s something about it that a buyer can use to make more money than you do (or other businesses in your industry do) a rising tide is going to lift you only as much as it lifts that glut of competitors.

If three out of every five businesses plan to sell in the decade, the a superior business should have adequate working capital levels to gain an edge in the increasingly competitive transaction marketplace.

If your business lacks adequate working capital, at best, your business will only confabulate with regards to exit planning because it will not have the cash available to appropriately prepare qualified successors for ownership, e.g. adding and developing partnership/successor trainee(s),  or pay advisors to gear-up the business for  a successful sale, and further, substantiate that your business has an appropriate [any] value for a vertical or horizontal industry integration, i.e. even the tykes like the big fish; and those small fish, why bother right?

Entrepreneurship can be likened unto the Parable of the Talents in Matthew 25. Your business is an alike talent. There is risk, but if you’ve counted the cost, and faithfully apply your expertise, there are often rewards, i.e. your working capital levels will flourish. Similarly, your working capital levels will likely lead to entropy if you or your employees do not put diligent effort forth to continually develop the business.

It is advised to measure working capital levels, i.e. how many fish you have, and how many fish you need for the month, to keep the business continually flourishing financially. If your business faces continual pressures on working capital levels, your advised to get advice [early] on how you too can develop adequate working capital balances with improved business processes, communications, and strategies for successful business performance, e.g. acting [quickly] on working capital concerns improves your probabilities of being a long-term profitable servant.

Businesses succeed because of others, i.e. customers and clients. Some businesses cajole for development, and for others, “Honor lies in honest toil” to quote Homer. Yes, absent a customer(s) or client(s) to transact with in the marketplace community, their would be no business at all; people needs businesses, and businesses need people. Every big fish, began as a small fish, and the big fish are the result of a conducive environment i.e. working capital levels always sustained developments.

While the unprofitable servant likely didn’t realize he should pay an advisor, in addition, he took zero action towards profitability. If you’re investing in your future and your businesses future, you’re likely not an unprofitable servant.

Working capital and sparkling water have shared a value. Too few realize how precious it truly is. Effective management of working capital and the effective management of operating capital and the cash flow cycle is imperative for successful business performance, e.g. the fish will flourish and you will too.

Adequate working capital is your businesses sparkling well. If you’re one of three out of five entrepreneurs transitioning ownership in the next ten years, you’re now advised why you should start investing in the necessary financial tools to measure and manage working capital.