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A Sum-Up of the Tax Cuts and Jobs Act Applicable to Individuals and Businesses

 Donald J. Sauder, CPA

With President Trump’s signature, the week before Christmas, the Tax Cuts and Jobs Act has legislated major changes to US tax laws. Most notably, lower tax rates for both individual taxpayers and businesses. The new tax rates for individuals remain effective until 2025, when they revert again to the 2017 rates.

The Tax Cuts and Jobs Act Individual Taxes

The new individual tax rates are as follows:

Rate	Married Filing Jointly	Individual Filing
10%	$0 -$19,050	$0 – $9,525
12%	$19,050 – $77,440	$9,525 – $38,700
22%	$77,400 – $165,000	$38,700 – $82,500
24%	$165,000 – $315,000	$82,500 – $157,500
32%	$315,000 – $400,000	$157,500 – $200,000
35%	$400,000 – $600,000	$200,000 – $500,000
37%	Over $600,000	Over $500,000

 

Personal exemptions have been omitted from the calculation of individual taxes until 2025; along with this reduction in deductions to taxable income, the standard deduction has been increased from $12,000 to $24,000 for joint filers, and from $6,000 to $12,000 for individual filers. This increase has reduced the benefit of itemized deduction for 2018 to an increasing number of taxpayers. Filing requirements will now be subject to applicable new deduction thresholds.

The bill also prevents prepayment of state and local income taxes in 2017, and allows only $10,000 of property taxes to be deducted on Schedule A. The new law repeals all miscellaneous itemized deductions subject to the two percent floor, e.g. portfolio deductions, unreimbursed employee expenses, etc. Medical expenses have a lower threshold to deduction of 7.5% of adjusted gross income.

Although the increased standard deduction will trim the balance of taxpayers itemizing on Schedule A, charitable contributions deduction threshold will increase from 50% to 60% of income. Therefore, more charitably favoring taxpayers will obtain greater opportunity to reduce taxes. If you maximize the 50% rule every year, this is in the new bill just for you.

The child tax credit increases from $1,000 to $2,000 with a $1,400 refundable feature per child. Families who will forfeit tax dollars on the standard exemption, will now be rewarded from the family friendly higher child tax credits.

The federal estate and gift tax threshold increases from the $5.49m 2017 exemption to $10m; the new exclusion will permit married couples to exempt up to $22m for 2018. Heirs will continue to receive a “stepped up, date of death” basis for inherited assets on costs basis for following transactions. This exclusion will help families retain more of what they’ve accumulated, and pass it to the next generation. The generation skipping transfer exemption has also doubled.

The student loan interest deduction is retained in the bill, and the American Opportunity Tax Credit is not overhauled, supporting students and the incentive to higher levels of education.

 The Tax Cuts and Jobs Act Business Taxes

The new tax bill features a 21% corporate tax rate in 2018, and a 20% deduction on taxes for small business, e.g. pass-through ownership of say a partnership or S-Corporation. Therefore, partnership income tax rates will be 80% of the calculation from the prior table, after applicable thresholds. This pro-business tax atmosphere is designed to stimulate business activity, and support entrepreneurial ventures.

Businesses also benefit from a 100% bonus depreciation allowance for new assets placed in service after September 27, 2017, and before January 1, 2023. All new equipment placed in service before December 31, 2017 qualifies for the 100% bonus addends. The new law places a $10,000 cap on first year vehicles for business. Section 179 expensing, a well-regarded business tax planning feature, has been increased to $1,000,000 for 2018, from prior year $500,000.

The “free expense” know as Section 199 domestic production activities deductions is eliminated in 2018; the research and development credit stays in place.

Net operating losses are limited to 80% of taxable income from losses after December 31, 2017, and carrbacks are denied in most cases, with indefinite carryforwards, subject to certain limits. The new law keeps the “Johnson Amendment” in place, generally restricting 501(c)(3) organizations from political activities.

The law repeals the Affordable Care Act (ACA) individual shared responsibility requirement, making the payment $0, a change effective for penalties after 2018. The IRS has cautioned that full-year coverage compliance is required for 2017, or applicable exemption. If absent, a shared responsibility payment will be assessed.

The historic tax legislation is the largest in the US in at least 30 years, and to quote:

According to the Tax Foundation’s Taxes and Growth Model, the plan …….. would lead to a 1.7 percent increase in GDP over the long term, 1.5 percent higher wages, and an additional 339,000 full-time equivalent jobs.

The enormity and speed of the tax legislation is no less surprising than the pro-business environment that it supports.

If you have questions regarding the newly passed tax laws from the Tax Cuts and Jobs Act, please contact our office.

This blog is not to be construed as advice for tax or accounting, or any other purposes; it is for informational purposes only. Please consult with your advisors before making any decision applicable to this information.

As the Holiday Season is here again, we find ourselves reflecting on the past year and on those who have helped to shape our business in a most significant way.

Thank you!

We value our relationship with you and look forward to working with you in the year to come.

We wish you a very Merry Christmas and Happy New Year, filled with peace and prosperity for you and yours!

Merry Christmas and Happy New Year!

Sauder & Stoltzfus

Preface: Optimizing the tax code is in a few instances effortlessly simple. The domestic production activity, remaining for the 2017 tax year, is one tax attribute that can save some clients thousands + in tax dollars. The Tax Cuts and Job Act did not continue this “free” tax deduction, but for this years tax filing– here’s how it works. 

The Free Expense for Domestic Production Activities

Credit: Jacob Dietz, CPA

The domestic production activities deduction (DPAD) is a taxpayer-friendly part of the tax law that allows taxpayers to deduct an expense that cost them zero additional cash. It is a “free” expense! The DPAD is going away with the passage of tax reform, but it is still available for open years before the tax reform takes effect. The American Jobs Creation Act of 2004 created this deduction, which allows certain taxpayers to deduct up to 9% of qualifying income as a DPAD, subject to certain limitations.

What types of activities and industries qualify for the DPAD? Generally, agriculture, real property construction, and manufacturing qualify, as well as some other industries. Qualifying activities can include dairy farming, crop farming, metal fabrication, furniture making, general construction contracting, construction subcontracting, and the list could go on.

Since the DPAD is 9% of qualifying income, it only applies if a taxpayer earns a profit. If the taxpayer shows a loss, then the DPAD is zero. Guaranteed payments paid to the owners are subtracted from income. The taxpayer cannot include them as income when calculating the DPAD, even though it is money earned from the company.

Another qualification for the DPAD is that it cannot exceed 50% of W-2 wages. If a company only reports guaranteed payments to partners on a K-1, and files no W-2s, then their W-2 wages are zero, and therefore the DPAD is zero as well. The DPAD is also zero for a company that subcontracts everything, or has all the work done by a sole proprietor who does not receive a W-2.

Let’s give an example of how the DPAD could save money for an entrepreneur. Suppose ABCDEF Construction, LLC is a single-member LLC owned by Abner C. Deffler. It earned a profit of $100,000 and paid W-2 wages to its construction employees of $90,000. The company constructs real property, such as barns, so the activities qualify for the DPAD. Secondly, the company earned a $100,000 profit, so there is income available to take the DPAD. The DPAD should be $9,000, which is 9% of the $100,000 profit. Thirdly, $9,000 is less than 50% of W-2 wages, so the 50% W-2 wage limitation does not reduce the DPAD. Abner will deduct the full $9,000 DPAD based on the activity of ABCDEF Construction, LLC. If Abner’s top federal tax rate is 25%, then that DPAD could save him $2,250 in federal income taxes. If Abner had the same numbers three years in a row, then the DPAD could potentially save him $6,750 over those three years.

If you own a profitable business that pays W-2 wages in the construction, agriculture, or manufacturing industry, check if your tax return includes the DPAD. If it doesn’t, ask an accountant who is familiar with the DPAD why it is not there. Did your business income fail to qualify, or was it perhaps missed on your tax return? If it was missed, and your company has been profitable in recent years, it is possible that amending previous returns to include the DPAD could save you thousands of dollars. The DPAD gives certain entrepreneurs the opportunity to be good stewards of their money by saving on taxes using a “free” expense.

 

Preface: The Tax Cuts and Job Acts passage in Congress this week results in a triumphant step for President Trump towards Making American Great Again. Entrepreneur’s should appreciate the tax bill as pro-business.

Trump is Making American Great Again

Credit: Donald Sauder, CPA

The US Congress passing the Tax Cuts and Jobs Act this week, and President Trump’s subsequent signature is the economic equivalent of Trump’s Washington singing to America taxpayers “We wish you a Merry Christmas and a Happy New Year, good tidings we bring to your and kin, good tidings for Christmas, and a Happy New Year.”

Legendary financial and geopolitical analyst Martin Armstrong, says the Tax Cuts and Job Act passage is very, very positive for the US economy. The pro-business bill, will grow jobs, and help small businesses succeed. “Canadian companies are already saying they will have to relocate to US if this keeps up” to quote Armstrong. This bill could make the US look like the place to be for business. “It’s monumental” Armstrong adds. “We could hire ten more people (just with this bill passage.)” Armstrong continues that he was called to London and Brussels this week as the result of Trumps tax bill being game changing and pro-business with global implication.

So what’s in the new tax bill? The historic bill legislated lower tax rates for both individuals and business, enhanced child tax credit and repealing of the individual shared responsibility payment in 2018; the foreign deferred overseas held earnings repatriation rates and territorial tax system internationally are the major drivers to Armstrong’s opinions.

Highlights:

The standard deduction increased 100% from $12,000 to $24,000 for married individuals, and from $6,000 to $12,000 for individuals. Tax bill incentivizes families with a $2,000 credit per qualifying child.

Education provision provide 529 plan contributions for elementary and secondary schools.

Corporate tax rates are set at 21% and bonus depreciation increases to 100% until 2023. In addition, Section 179 expensing increases to $1,000,000 from the prior $500,000.

Small business owners will receive a deduction of 20% on threshold tax amounts.

The estate and gift tax exclusion increases to $10,000,000 for tax years 2018 – 2025.

The Tax Cuts and Jobs Act is giant step towards Trump’s plan to make American Great Again.

Armstrong continues that he expects interest rates to increase rapidly until 2021, within expectations with Janet Yellen’s Federal Reserve guidance earlier this month. This would result in bond market turbulence, so there is so reason for cautious optimism, but the tax savings for businesses both inside and outside American borders, are very pro-business and will put more money in individual wallets at the end of day.

We will have a more comprehensive report on the tax implication of the bill after the holiday.

Merry Christmas!

This blog is not to be construed as tax, investment, accounting legal advice. It is for informational and entertainment purposes only. Please consult with your trusted advisors with regards to information reported in this blog before making any decisions.

Preface: Sell-side due diligence prepares your business for the potential bidders  before your business reaches the marketplace. Exit planning can never begin to early. History supports the data that every business owner will eventually exit or transfer ownership. Plan ahead. Be prepared. Performing sell-side due diligence with your accountants and/or third part advisors  will reduce risks and build buyers confidence; ultimately adding substantial value. Within reach, the best investment bank tombstones are the result of applied logical business algorithms. 

Sell-Side Due Diligence

Credit: Donald J. Sauder, CPA

If you are thinking of selling your business, be proactive and not near-sighted in planning that sale. Sell-side due diligence is a reverse due diligence where you ask accountants or third-party advisors to perform proactive due diligence on your business, gearing it up for sale. These due diligence experts scrutinize your business for deal breakers and increase value. Investing in sell-side due diligence most often pays off for every seller.

First, sell-side due diligence helps identify problems and provide an opportunity to resolve those problems well in advance of presenting your business to a buyer. For instance, you have multi-state tax nexus, requiring your business to file tax returns in various states from activities in those tax jurisdictions.

If you have not filed taxes in various states that your business has nexus in, this potential liability could reduce value. Sales tax liabilities could another risk. Or, let’s say you have a warranty liability on a new product, sell-side due diligence will help you identify and resolve these potential problems well in advance of gearing your business up for sale. If you don’t correct these value reducers before taking your business to market, you could potentially break a deal or lose value at the negotiation table. Your sell-side due diligence team will create options to resolve these value reducers before they are brought to your attention from the buy-side due diligence team.

Secondly, what surprises do you need to avoid? How accurate are your internal financial statements for the years that will be scrutinized? How meticulous is your accounting software? What operations risk does your business have, or personnel resource concentrations ? Will your business’s greatest intangible–your experienced employees–stay if you sell the business? Do you need an accountant to fine tune your internal financial statements, to provide solutions to tax risks or to resolve book to tax differences? What about independent appraisals of fixed assets such as equipment or real estate?

Thirdly, a sell-side due diligence team will help you add value to the sale of your business asset. The objective analysis of your business’s financial performance, credibility of revenue forecasts, and specific niche buyer values, will help prepare you to contact buyers that could benefit from a strategic purchase of your business. Thinking through the questions that a buyer will raise and preparing responses will assist in making negotiations more smooth. Financiers will have questions about options on tax structures of the sale such as an asset sale or stock sale.

Is your business worth more as an entire unit, or could you sell divisions of your business in a “carve out” for more value? Where is the value in your business? Is it in real estate, intangibles (like goodwill or patents), equipment and machinery, or inventory?

Understanding what will interest a buyer, how they will pay for the purchase, and how it benefits them, will make closing the deal easier. Proper sell-side due diligence puts you in control during the sale, minimizes surprises, and adds value for you and the buyer .

Summary

Sell-side due diligence is about preparing for the potential buyer of your business before your business reaches the marketplace. Most businesses will be sold at some point due to family transitions, retirement, or other reasons. When yours does, plan ahead. Perform sell-side due diligence with your accountants and/or third part advisors. They will help you build trust and ultimately add value in the marketplace.

 

 

Preface: The incorporation of extraordinary customer service values, superior client satisfaction values, and a value of team excellence developed in your business,  you will ultimately reward you as an entrepreneur. Every aspect of your business culture develops from values. Extraordinary value is the result of extraordinarily developed teamwork values.  

The Values in Value

Credit: Donald J.  Sauder, CPA

Your business values determine your business’s value in the long term. Values are the desired culture of your business–-the behaviors of your company. Why should your business develop and adhere to values? It gives your business a philosophical heartbeat; it’s what you do for your customers. Simply, that’s how you develop value in business–with the value of your business’s services and/or products.

Bright Horizon Family Solutions employs 25,000 people in the US and UK. When Roger Brown and Linda Mason started the business in 1986 to provide high quality child care at workplace centers, little did they imagine what was in store. Less than 30 years later the company has $1.2 billion in revenues with 16,000 employees in the US. With early education and preschool services, Bright Horizon Family Solutions has a simple core value statement with the acronym HEART–-Honesty, Excellence, Accountability, Respect, and Teamwork. This is the culture of the business. Employees of Bright Horizons demonstrate these cultural values every day. And it works, because employees are committed to continuing a cultural value of honesty, excellence, accountability, respect, and teamwork, every day in the workplace. It’s the guiding compass to the service they provide to their clients-–the parents who entrust their children’s care to Bright Horizons.

Today’s business environment often has debased values. But that’s not to say your business should debase values, too. Bright Horizons wouldn’t be at $1.2 billion in revenue in their industry without adhering to extraordinary core values.

What can adhering to core values do your for business? Four categories of values can exist, according to Patrick Lencioni. They include core values, aspirational values, permission-to-play values, and progress values.

Core values are those deeply engrained in management and the board’s actions and behaviors. Core values are the cultural cornerstones of a business. Core values should be adhered to at all costs. Core values provide a solid foundation for setting the cultural tone as new opportunities and markets develop.

Aspirational values are those values that a business strives to obtain in the future. The aspirational value of better balance between work and home life may develop, with the desire to work around the schedules of employees who need flex time , or the flexibility to work a certain number of hours within a set time frame. Maybe today your business cannot provide flex hours, but it can strive towards that value in the future.

Permission-to-play values are the minimum standards required to get hired. You can create a set of permission-to-play values for new employees. But permission-to-play values should not be core values.

Progress values arise from marketplace trends. For instance, the value of autonomous employees can develop as your culture grows and your workforce learns what’s required to succeed, a culture that’s more than just a paycheck.

Why should you set values in your business? You need to develop a culture built on a set of principles that are fundamental and strategically sound for building your business. To relook at Bright Horizons values, it is the belief in the work environment of Honesty, Excellence, Accountability, Respect, and Teamwork that earned them the trust of millions of customers–and billions in revenues.

You need to weave core values into every area of your business, from marketing, to hiring, to research and development, to installation. If your employees come to work every day understanding that they work for a business with extraordinary values, where they are held to high standards or extraordinary standards, you will differentiate your business from the competition. You will achieve more from everyone on the team.

Don’t for a moment think that incorporating values is easy. It’s not. But if a little work on exceptional core values seems daunting, think about fixing the problems resulting from the absence of values. You probably already have values that govern your business, but maybe they are unwritten and not communicated or not understood. Document what your business values and what you envision those business values too be.

If you incorporate extraordinary values, or develop them in your business, when every aspect of your business culture grows from those values, you will ultimately reward yourself and your employees with extraordinary value (tangible and intangible).

 

 

 

 

 

Preface: Tax practitioners are often requested to provide advice for entrepreneurs starting a new business. Although non-tax angles are an important degree and should not to be discounted even slightly, often entrepreneurs are more concerned with the central tax considerations of a new venture. This blog is written to help entrepreneurs navigate business entity decisions from a tax perspective.

Taxing Decisions – Business Entity Taxation

 Credit: Donald J. Sauder, CPA

The three main business entities often considered with entrepreneurial ventures are 1.) partnerships 2.) corporations 3.) limited liability company (LLC).

Partnerships

A partnership is pass-through entity with all business revenues and expenses attributable to profit motivated activities transferring from the business tax filing, e.g. Federal Form 1065, to the owners via a Form K-1. The K-1 encompasses the tax attributes applicable to the holder(s) of the partnership interests, i.e. an individual or say another partnership.

For example, let’s say a partnership has $5,000 of net income for the year with three owners at 33.3% interests would pass through $1,665 of income on each K-1 to the individuals to report as revenue on their individual 1040 tax filing. The revenue would be taxed at the applicable tax filing status and rate, differing for each owner’s specific taxable position. Typically, personal tax rates are lower for married filing jointly tax payers, under current tax laws vs. single. Partnerships can be either general or limited liability. Talk with your trusted counsel with regards to applicable legal risks on partnership structures.

Limited Liability Companies

Limited liability companies (LLC) can be taxed as either a partnership, corporation or sole proprietorships. LLC’s are here to stay and have a practical place in entity selection in today’s business marketplace. An LLC taxed as a partnership files the same Federal Form 1065 as a partnership, but provides owner with limited liability protection, e.g. a veiling of state legislated legal protection only afforded corporations in prior decades. LLC’s taxed as partnerships can be either member managed, or manager managed. Management is determined by the operating agreement. Talk with your trusted counsel with regards to applicable legal risks on LLC structure relevant to your state. LLC’s also have the option to be taxed as C-Corporations or S-Corporations in the State of Pennsylvania.

Corporations

C-Corporation taxation assesses a tax on income of a business at a tax rate separate from the individual shareholder. For discussion purposes, net income more than $50,000 is taxed a higher rate exclusive the shareholders individual tax position. Losses in C-Corporations are suspended inside the business, and cannot offset income from other sources for active owners. After paying the tax in a C-Corporation, the dividends distributed to ownership are again taxed at qualifying dividend rates, i.e. 15%. The distribution of the net taxed earnings, taxed again, resulting in double taxation. For this reason, there are few reasons for small businesses to use the C-Corporation tax structures. In addition, C-Corporations in Pennsylvania pay taxes at a rate of 9.99% vs. individual rates of 3.07%. Therefore every $25,000 of earnings in a C-Corporation costs $1,730 more than pass-through earnings on a K-1, say in a partnership just on the state tax. A C-Corporation in Pennsylvania earning $100,000 could easily pay in-excess of $50,000 in taxes per year, on net distributed income, or greater than a 50% tax rate. Current laws plan to reduce Federal tax rates only to 20%. State rates and dividend rates would remain at similar current 2017 percentages.

Corporations can elect S-Status with a Form 2553 filing, if they meet certain requirements, e.g. one class of stock, fewer than 100 shareholders, qualifying stockholders, i.e. individuals say. S-Corporations provide veiling protections, as does an LLC, but under the stated corporation umbrella. Earnings and losses pass-through to owners on a K-1, like the partnership taxation.

Entity selection for your business is both a taxing tax and legal question. Compensation of ownership, methods of accounting, ownership tax rates, social security tax implications on business and wage earnings, and projected future revenues are all pertinent factors in decided on a business entity that is optimal.

Wrap-Up

There are often ambiguous answers and no bold lines to the entity selection decisions in many entrepreneurial situations. Appropriate counsel is advised. However, in Pennsylvania the LLC is an increasingly common entity vehicle, providing permissible tax flexibility for a “belt or suspenders” option with regards to partnership or corporate taxation, when multiple owners are involved; or with one owner, sole proprietor or corporate taxation. Opinions vary. You are now advised to make an informed decision.

This blog is written for education and informational purposes only and is not to be construed as tax, legal or accounting advice. Consultation with your accredited advisors are imperative and advised before making any business decision, especially entity selection in this context.

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.