Sales Force Compensation – Yesterday’s Solutions and Today’s Challenges

For decades, we’ve helped our clients address the critical question, “How should I compensate my sales force?”  And generally, the answers are pretty much the same.  The tried and true methods have always been to pay sales staff on some incentive-based program, usually a commission on gross sales.  But today’s economy is much different than the one that first gave rise to this approach.  And we believe those differences need to be considered carefully when developing compensation plans for sales people.

The first thing to remember is that by and large, people will always do what they get paid to do.  I know this sounds pretty basic, but if you think about it, there are ramifications from this simple truth that are often over-looked.  In the case of salespersons, if compensation is based on the gross sales they produce, the result may be that their goals, and that of the company, are not the same.  For sales people who are compensated on gross sales, they obviously are going to be motivated to produce the largest invoice total.  But is that always what’s best for the company?  Perhaps not.  A number of things can come into play here, with the result being that the sales person is likely to be motivated to make a sale that gives them the highest return, in terms of personal income, but does not maximize the company’s benefits.  Let me give you an example from the printing industry.

With the changes in technology in the printing industry over the past few years, it’s now possible for a printer, utilizing sophisticated data mining techniques, and a digital press, to reduce dramatically the size of a mailing, and increase significantly the return they receive.  In such cases, it’s actually possible to get a much higher return per piece for the printing job, which in some cases can mean that the gross profit on such a job is actually higher in absolute dollar terms, than would be the case for a much larger size order, using more traditional print technology.  For instance, a printer might find that a traditional job, selling for $20,000, would only have a margin of 15%, or $3,000, where a job that might sell for $12,000 could have a margin of 30% or more.  In this case, the sales person does better with the large job, but the company does better with the smaller one.  Is this the right type of incentive?

Better methods for compensating sales people are those that provide for a commonality of goals between the company, and the employee.  These goals should be based on the Company’s strategic plan.  For instance, if a company is in a growth mode, then revenues from new customers should be seen as more valuable than revenues from current ones.  If the company is seeking to penetrate new markets, then sales to customers in those markets should be more valuable.  Most of the time, regardless of the specific goals the company has, a focus on higher profit sales should be encouraged through the structure of sales compensation used.  As I said before; people will do what you pay them to do.

It may be time to rethink your sales compensation plan.  If you would like to explore different methods to bring both the sales force and your company’s goals into better alignment, talk to us.
Signing off,  Gerry

Tax Reporting Issues for Printers – Q & A

Few issues generate the intensity of feelings among business owners as taxes. Yet few business owners—including those in the printing industry—have clear understanding of how their business must be reported for tax purposes.  As a result, many printers use incorrect tax accounting methods, and are therefore subject to tax liabilities they don’t even know about as well as interest and penalties.

Unfortunately, few tax advisors have enough knowledge of or experience with printers to correctly report their taxable income.  This lack of industry specific knowledge extends even more so to IRS auditors.  Some audits of printers overlook or misapply the applicable tax law, openly to have a subsequent audit catch them.  As a result, returns with significant errors often survive IRS audit, leading printers to conclude erroneously that they are reporting correctly for tax purposes.

The purpose of this blog post is to highlight three frequently overlooked tax accounting rules applicable to printers and address some inevitable questions:

1. First, printers must calculate inventory at the beginning and end of each tax year. 
2. Second, inventory must include work in process.
3. Third, because printers must calculate inventory, they are also required to use the accrual method of accounting for determining income from sales, and expenses on product sold.

We have published a much longer white paper explaining in detail why these rules apply to printers.  Here, we’ll just address the most frequently asked questions:

“My company is quite small.  Do I still have to comply with these tax accounting rules?  After all, I’m not General Electric!”

Unfortunately, the tax code and the regulations are “blind” to the relative size of taxpayers.  All businesses, from General Electric to the local quick printer, must follow the same set of rules.  Being small, is no defense.

“I’ve adopted accrual accounting and reported my paper and ink as inventory at year end.  However, my work in process is negligible.  Can’t I ignore the rules on work in process?”

If your work in process is negligible, why not estimate its value to demonstrate your good faith intent to comply?  The compliance cost will also be negligible.  If you make a reasonable effort to comply, and the IRS later determines you understated inventory you may avoid penalties.  If not, you may be penalized for “willful intent to avoid taxes.”

“I don’t carry inventories of paper or ink.  I order for every job.  Why can’t I just ignore this issue?”

The biggest reason is that in nearly every case—even where the statement above is management’s intent—there is actually inventory on hand.  One of the first things an auditor will do is tour your facility.  Why not do the same?  If you see “inventory” in your plant, so will the auditor.  Remember, the burden will be on you to prove the situation was different at the beginning and end of the year under audit.  Is it really reasonable to believe that as a printer you had no paper on hand at year end?

“My accountant has always prepared my tax returns on a cash basis (or with no inventories).  Why do I need to worry about this?”

…Because those tax returns are wrong.  Far too often, we see tax returns prepared for printers that are incorrect on their face.  Frequent examples include incorrect answers to questions relating to accounting methods, inventory valuation methods, section 263A, and the company’s line of business.  Don’t assume the fact that you paid someone—even an experienced CPA—to prepare your tax return means it is correct.  It pays to use a tax preparer who thoroughly understands the business you are in.

“I have my own way of calculating inventory value.  What make the IRS think it can do it better than I can?” 

Congress has specifically given the IRS Commissioner the authority to determine the inventory valuation methods for tax purposes.  The IRS doesn’t care how you value inventory for other purposes.

“I was audited and the IRS didn’t say a thing about these issues.  Why should I believe you?”

There are many possible reasons for this.  I’ll give you two:  First, the audit may have been focused on specific issues.  If the auditor was trying to resolve a particular issue, he or she may not have looked at these issues.  Second, the auditor may have erroneously missed them.  Again, these issues are sometimes missed by experienced CPAs with degrees in accounting or taxation.  You only need a bachelor’s degree and 30 hours of accounting course work to become an IRS Agent.  The fact is, IRS Agents can and often do overlook these issues.  That doesn’t mean the return was correct.

“Okay, I get the idea.  But I haven’t done either the accrual method or calculated inventory, for years.  Now what do I do?  Why not just let sleeping dogs lie?”

This is a great question.  There reason is simple.  If the IRS finds the mistake on audit, then it gets to decide the year in which to apply the accounting changes required to bring you into compliance, and how to calculate the amount of any understatement of taxable income upon which it will assess tax.  You lose the right to do so.  The IRS will also assess the entire amount of the tax, as if it was due when the return under audit was filed.  That means any tax due will already be delinquent and will have interest and probably penalties added.  Moreover, it will all be due immediately.

Fortunately, the IRS has a procedure that allows a taxpayer to correct their method of accounting without penalty.  Moreover, the IRS usually gives the taxpayer an opportunity to spread the effect on taxable income, and therefore on tax, over four years.

“Fine, I get the picture.  I can’t use cash basis, I have to include work-in-process in inventory, I have to use the IRS approved methods to value work-in-process, and it makes more sense and is cheaper for me to change now, rather than wait for the IRS to catch me.  But one last question.  Why can’t I wait until I am about to be audited, then ask for permission to change before the audit actually starts?”

This would be a great idea, if the IRS hadn’t thought of it first.  Unfortunately, the IRS took away this option, with a revenue procedure which says that once you have received notice from the IRS employee that it intends to audit you, even if that notice is verbal, you no longer have the right to elect to change on your own.

In summary, the IRS wants you to comply voluntarily with its rules and regulations.  Therefore, it provides a method and incentive for getting back into compliance voluntarily.  The alternative to this “carrot” is the possibility of being dragged back into compliance involuntarily by the IRS, which will cost much more in time, money and aggravation.  Take the carrot.  Avoid the stick.

-Dante Driver

Charitable Contribution Deduction – Where’s the Documentation?

History
In the “good old days”, which for this discussion was prior to 2007, the amounts donated to charitable organizations in the form of cash and non-cash items showed us to be very generous – at least based upon amounts claimed on our tax returns.  A canceled check or credit card receipt was often the only form of documentation required for one to claim the deduction.  The IRS seldom even challenged cash amounts supposedly added to the weekly collection plate as long as it was reasonable.  All that changed with the 2006 Tax Act when the law started requiring substantiation by the recipient charitable organization.

New Requirements Proving Contributions
In the generalist of terms, the taxpayer must be able to prove two things – the amount of the contribution, and the receiving organization was a qualifying charitable organization.  These provisions are basically the same as in prior years.  However, beginning in 2007, the donee organization must provide written and contemporaneous documentation evidencing receipt of the gift for contributions in excess of $250.  In many respects, the tax lawmakers removed many of the “opportunities” for aggressive tax positions by soliciting the services of the charitable organizations themselves to address the more abusive positions.

The Income Tax Regulations are quite specific in the information required in this written acknowledgement letter.  Specifically, the letter provided by the donee organization must include:

• The amount of money and a description of the value of any other non-cash property received;
• Whether the charitable organization provided any goods or services in consideration for the cash or property received; and if so
• A description and good faith estimate of any goods or services provided by the organization.

The lawmakers added another provision regarding the acknowledgment letter that can not be emphasized enough – namely, it must to timely received.  This is defined as being received on or before the earlier of 1) the date the taxpayers files the original return for the year the deduction is claimed, or 2) the due date, including extensions, for filing the original return.  There was a recent court case in which taxpayers contributed value art to a qualifying organization.  Upon audit, the Service did not contest the value of the contribution or the charitable status of the recipient organization.  The taxpayer lost the case simply because the acknowledgement letter, requested only at the time of the audit, was outside of the window prescribed by law.

One Step Further – Unreimbursed Expenses Incurred on Behalf of the Charity
Each year we encounter taxpayers who are involved with charitable organizations giving a considerable amount of their time and personal expenses in the course of their volunteer efforts.  There is no issue that out-of-pocket costs incurred by a taxpayer that are not reimbursed are allowed as valid deductions.  This may range from someone paying for airfare traveling across country or the world to sit on a charitable organization’s board, to a volunteer hockey coach traveling weekly to tournaments incurring costs on behalf of a qualified organization.  These costs, though not paid directly to the charity, are allowed as a deduction because of the benefit provided.  The issue is how to best ensure they are allowed if ever challenged by a taxing authority – especially if they exceed $250.  A recent court case concluded these costs fall within the same acknowledgement parameters stated above – namely, the recipient organization must issue written proof of the services provided by the taxpayer.

One way is for the organization to pay the actual expenses, and then have the taxpayer reimburse the expenses.  In theory this works and may be an option for large ticket items such as airfare and hotel, but probably an unrealistic approach for mileage allowance and other minor costs.  The second approach to ensure the appropriate deduction is to:

• Get contemporaneous documentation from the qualifying organization as to the nature of the services being provided and the various related expenses that may be incurred in carrying out these services (get this annually); and
• If the amounts are significant (airfare, hotel, car rentals), provide a listing of expenses to the organization for inclusion in the letter

We anticipate most taxpayers and qualifying organization are aware of the aforementioned reporting and retention requirements as they pertain to outright gifts.  However, we also suspect that those taxpayers giving of their time and incurring out-of-pocket expense are not aware of how the IRS has broadened the scope of the acknowledgment provisions.

There are many other provisions related to the contribution of non-cash that are well beyond the scope of this note.  We strongly encourage you to follow up with your tax advisor to be sure of compliance with the rules and regulations.

-Mike Benusa, CPA and Partner in our St. Cloud Office

Banking in America – Finding Business Financing Continues to Get Harder

Yesterday’s New York Times online edition includes an article with a somewhat sobering headline, “Is Bank of America trying to shed small business customers?” (New York Times, January 18^th, Business Day section).  The article includes reference to other publications’ coverage of this, and of course some denials by Bank of America (BofA) officials that this is actually happening, but the fact remains.  From 2006 to 2010, BofA’s SBA lending fell a stunning 89%!  With those kind of statistics, it is really difficult to believe that it’s still “business as usual.”  However, while BofA may be the most visible example of shrinking small business credit, it’s certainly not the only one.

A recent study conducted by Biz2Credit, a New York firm specializing in helping small businesses access loans, found that during 2010 and 2011, Chase Bank had rejected 33% of all small business loan applications while the rejection rate at Citibank was 16%.  These were all applications from companies or individuals with credit scores above 650, who had all been in business at least two years, and perhaps most surprisingly, were already bank customers at the time they made the application for the loans.  It’s very difficult to avoid the conclusion that large banks in America are avoiding loans to small business at higher rates than at almost any time in recent memory.  As the recovery continues, even at the modest current rate, small business credit is going to become even more important to the financial health of this vital sector of the economy.

At Carlson Advisors, we have worked for over three decades with firms in this group, and rarely have we seen the availability of traditional bank credit more threatened.  Continuing worries about the European financial community, the inability of US banks to return to solid financial footing following the near collapse of the banking sector, as evidenced by their still depressed stock prices, and continuing uncertainties in the economy, are all combining in an unhealthy witch’s brew of bad news.  And with the increase in governmental oversight, many bankers are simply afraid to take on the same levels of risk that they previously were able to justify. So what should owners of managers of small to medium sized firms be doing in the face of these developments?  I’ll offer a few suggestions.

First, understand that this is very likely a permanent change in the environment in which small business will need to operate.  It’s extremely unlikely that credit will be available on terms similar to what were available just 5 or 6 years ago, in the coming years.  Banks simply aren’t interested in the risk of small business lending, given the somewhat slim rewards they can get.  And unfortunately, they have other places to put their capital to work.  So understand that the current situation is unlikely to get much better, and may even get worse.

Second, develop alternatives to your current lending relationships by identifying “fallback” lenders, should your bank decide to change the game without warning.  This simply means identifying potential replacement lenders for your current bank, and opening discussions with them.  Be clear that you are not seeking to change banks today, but you don’t want to be totally reliant on your current lender in the current financial environment.  Bankers will see this as an opportunity for obtaining new business, and will be happy to have such discussions with you.  We’ve seen a number of recent situations where, after many years of lending to one of our clients, their banks simply decided to call the loan, forcing the borrower into unfavorable and expensive payoff plans that seriously jeopardized their ability to continue to do business as before.  In some cases, this occurred when the borrower was not only profitable, but was in full compliance with all the terms of their loan agreement.  The banks in these cases simply decided they didn’t want to make loans such as the ones they had already made.

Third, look very carefully at the reasons your firm has to borrow, at least in the amounts you may have on the books.  A number of areas of your business should be carefully analyzed to determine if there are opportunities to improve your performance, and thereby reduce your need for bank funds.  Among these are:

• Excessive amounts in accounts receivable, possibly due to inattention, or questionable billing practices, or weak or non-existent credit policies.
• Inventory levels above what is needed to support current sales, in part due to a failure to properly manage inventory and purchasing functions.
• Under-utilized capacity, either because of unneeded equipment acquisitions, or an unwillingness to dispose of excess capability, or both.
• Inappropriate structuring of existing loans (i.e., misuse of short term borrowing to fund either operating losses, or long term assets, or both).
• Workflow problems which extend the production cycle and delay cash receipts by delaying both production, and billing.  How many days does it take from the time you receive an order, until your customer pays you?  The longer that cycle, the more cash you have tied up in operations.

Improvements in any of these areas will reduce your company’s need for borrowing, and therefore reduce your reliance on your bank.

Managing the finances of small business has never been more important than it is today, as the availability of bank credit becomes increasingly limited.  You should be making plans to control those areas of your business that you can in order to reduce your need for outside funds, while at the same time identifying and developing alternative financing sources, should the need arise.

At Carlson, we can assist you in any of the above areas, should you wish to take steps to protect yourself.  To learn more about how we can help, contact us today.  Click here.

-Gerry

Resolve to Get the Most Out of Your Tax Return Preparer in 2012 Part II

2011 is history and you are probably receiving 2011 W-2s, 1099s, 1098s and other tax forms in the mail.  In order to get the most out of your tax return preparer in 2012, you should ask yourself the following questions:

• Am I using the right tax professional?
• How will I know I have all the 2011 information required to prepare my return?
• Why is providing complete tax 2011 return information important?
• How should I organize my 2011 tax return information?
• Why is organizing my 2011 tax return information important?
• When should I give my preparer my 2011 tax return information?

My last blog post answered the first two questions.  This one will answer the others.

Why is providing complete tax return information important?
Compiling complete tax return information is important for efficiency, economy and quality.  Every time your tax return preparer opens your file, it takes time and costs money.  The only question is whether you will bear that cost in the form of a higher fee, or the tax return preparer will bear the cost in the form of greater write-offs.  Also, repeated communications increase the likelihood of miscommunication, loss of information and tax return errors.  A series of emails and phone calls is probably the worst possible way to provide your tax return information.  Whenever possible, providing all of your tax return information at one time is best.

How should I organize my 2011 tax return information?
As you receive your 2011 tax return information you should organize it.  There are two easy ways to do so:

If your tax return preparer has given you a 2011 tax organizer, you should use that.  Just file each document behind the relevant page of the organizer.  For example, file your Form W-2 behind the organizer page for wages.

If your return is a business return, or if you have not received an organizer, you can use your 2010 return to organize your 2011 information.  Just organize the information in the same order as it appears on your 2010 return.  For example, on Form 1040, wages are reported first, followed by interest, dividends, etc.  After income, Form 1040 shows some adjustments.  Then, it may show itemized deductions from Schedule A.  Next, it shows the tax, tax credits, payments and the amount you overpaid or owe.  The 2010 return provides a general framework you can use to organize your 2011 tax return information.

If you have any questions about organizing your 2011 tax return information, you should ask your tax return preparer.  He or she should be ready, willing and able to help you organize.

Why should I organize my tax return information?
You should organize your tax return information for a couple reasons.  First, doing so will help you ensure your 2011 tax return information is complete.  Second, it will significantly reduce the amount of time required to prepare your tax return, which will save you money.

When should I give my preparer my 2011 tax return information?
There are several very good reasons to get your 2011 tax return information to your tax return preparer as soon as you can:

If you think you’ve overpaid your 2011 income taxes, you’ll want to get your returns prepared and filed as soon as you have the information required to do so.  Doing so will expedite any refund you may have coming.

If you think you’ve underpaid your 2011 income taxes, you also have reason to get your return prepared as soon as possible.  If your estimated payments or withholding was less than 100% of your 2010 tax (110% for taxpayers with adjusted gross income over $150,000) or 90% of your actual 2011 tax, or if you made estimated tax payments late, then filing your tax return and paying any tax due as soon as possible will minimize any estimated tax penalties.  Those penalties accrue, like interest, from the date the estimated tax was supposed to have been paid until it is actually paid.  The sooner you pay, the less you pay.

Even if you adjusted your estimated tax payments or withholding to avoid a large refund or liability, you should get ready to have your tax returns prepared and filed as soon as possible.  Estimates are just that, and your actual 2011 tax may be different.

Finally, most tax return preparers have hundreds of other tax clients who must all file their returns by the same deadline as you.  Many of those clients are procrastinators.  There are only so many days before the filing deadline, and only so many hours in each day.  Even the very best, most professional, most conscientious tax return preparers will be more hurried, more fatigued, and more likely to make mistakes right before a tax filing deadline than at any other time during “tax season.”  Therefore, delivering complete and well organized 2011 tax return information to your tax return preparer early will help ensure that your return is accurate.

In short, giving your preparer your 2011 tax return information early will get you any refund sooner, minimize any estimated tax penalties and help ensure your return is accurate.

Conclusion
Choosing the right tax professional and giving him or her complete and organized 2011 tax return information as soon as possible will minimize the time required to prepare your 2011 tax return and the associated fee, accelerate any refund, minimize any penalties and result in a more accurate return.  It will also be less stressful for you than waiting until the last minute.

-Dante

Resolve to Get the Most Out of Your Tax Return Preparer in 2012 Part I

2011 is drawing to a close and taxpayers will soon begin to receive 2011 W-2s, 1099s, 1098s and other tax forms in the mail.  In order to get the most out of your tax return preparer in 2012, ask yourself the following questions:

• Am I using the right tax professional?
• How will I know I have all the 2011 information required to prepare my return?
• Why is providing complete tax 2011 return information important?
• How should I organize my 2011 tax return information?
• Why is organizing my 2011 tax return information important?
• When should I give my preparer my 2011 tax return information?

This blog post will help you answer the first three questions.  My next blog post will help you answer the last three questions.

Are you using the right tax professional?
First, be sure you’re using the right tax professional.  Among other reasons, as tax returns have gotten more complex, the number of incorrectly prepared returns has sky-rocketed.  Last year, the GAO released a study of S corporation returns prepared by paid preparers, which found 71% to be “non-compliant.”  Remember, you are legally responsible for what’s on your tax return no matter who prepares it, so consider the following when considering a tax professional:

• A paid preparer is required by law to sign the return.
• Avoid preparers who claim they can get you a larger refund.  If your return is prepared correctly, every preparer should derive similar numbers.
• Beware of preparers who base fees on a percentage of the refund.  The IRS prohibits charging a contingent fee for preparing an original tax return.
• Reputable preparers will ask you questions about and request support for income, exemptions, deductions credits and payments.  Doing so helps you avoid penalties, interest or additional taxes that could result from an IRS examination.
• Choose a preparer you will communicate and work with you throughout the year, and not just during tax season.  Ask who will actually prepare the return and who will review it before engaging services.  You should know exactly who works with your tax matters at all times and how to contact him or her.  Determine if the preparer is exporting your return to a foreign country for preparation.  Believe it or not, many firms—even CPA firms—have been doing that for years.  Foreign countries do not have the same security and privacy laws as the United States nor is there any recourse should your information be compromised as a result of lax or nonexistent privacy procedures.
• Check the preparer’s record at the Better Business Bureau.
• If the preparer is a CPA, check his or her status and record at the state’s board of accountancy.  There are tax preparers who call themselves CPAs falsely.
• Use a tax preparer who is a CPA, attorney or Enrolled Agent (EA).  Regulation of tax return preparers is lax, and virtually anyone can charge a fee to prepare a tax return.  Until recently, California and Oregon were the only states to regulate tax preparers, and the IRS only had jurisdiction over the person who signed the return.  CPAs, attorneys and EAs are regulated by the IRS, and are the only preparers who may represent you before the IRS in the event of an audit.  CPAs and attorneys are also regulated by the states and their professional organizations.
• Find out if the preparer is affiliated with a professional organization, such as the American Institute of Certified Public Accountants, American Bar Association, or National Association of Enrolled Agents, that requires its members to pursue continuing education and holds them accountable to professional and ethical standards.
• Be very skeptical of preparer who offer “refund anticipation loans,” “audit insurance,” “tax shelters” or other ancillary products.  The conflict of interest in these cases is obvious, but many people overlook this.
• Check IRS.gov for information regarding abusive shelters and other tax schemes and scams.  Remember, if it sounds too good to be true, chances are it is.

How will you know you have all the 2011 information required to prepare your return?
Next, start compiling the tax information your tax return preparer will need to prepare your 2011 return.  If you haven’t done so already, make sure anyone who may mail you 2011 tax documents has your current address.  Open all your mail promptly—Routine looking envelopes from banks, brokerage houses or other sources may contain important 2011 tax documents.  If you receive bank, brokerage or other statements electronically, now is the time to start checking your accounts for electronic versions of 2011 tax forms.  Don’t forget to check your spam folder.

How will you know when you have all of the 2011 tax information your tax return preparer will need to prepare your return?  Most tax professionals mail each of their individual income tax clients a tax “organizer” based on the prior year return.  The organizer will categorize your income, exemption, deduction, credit and payment amounts from 2010.  If nothing has changed, significantly from last year your 2011 items and amounts should be similar.  If something has changed, make sure your tax return preparer knows the details.

If you don’t receive an organizer, ask your tax return preparer for one.  If you are a new client, your tax return preparer can enter your 2010 return into his or her tax preparation application and print an organizer for you.  If all else fails, you can use your 2010 tax return as a guide.

As soon as you think you have all the information required to prepare your tax return, organize it (see below) and send it to your tax return preparer.  Your preparer should compare your current year information to the information you provided the prior year and question any significant differences.  Between the two of you, you should be able to ensure the information is complete.

Stay tuned!  My next blog post will discuss why it’s important to provide all your tax return information at once, if possible.  I’ll also discuss organizing your tax return information and why doing so is important, and why it is important to get your tax return information to your tax return preparer as early as possible.

-Dante

Goodbye to 2011 – We Won’t Miss You (we hope!)

As we come to the end of 2011, most of our clients are of the opinion that this particular year can’t end too soon.  Though there are some “signs of life” in a number of sectors of the economy, and some of our clients are beginning to see at least some return of economic growth, the year has produced wide variations in month to month activity, demand is still uncertain, and the overall economic climate remains extremely tenuous.  It’s true that 2011 was, for most clients, better than 2010, but that’s definitely a low hurdle to compare with.  In fact, I think the old saying that fits best here is, “…damning with faint praise.”  Faint indeed.

The real question, however, is whether or not businesses in the industries we serve can expect 2012 to be much better.  Unfortunately, no one really knows the answer.  It is true that recent economic activity reports seem to be improving, there has been a slight down-tick in the unemployment rate (at least nationally) and there does not seem to be much inflation on the horizon.  However, business and consumer confidence indicators continue to be shaky, at best.  In the long run, when it comes to economic activity, perception has a tendency to become reality.  If people don’t think things are getting better, they will make choices that will result in things not getting better.  And right now, we don’t see a whole lot of reason to be positive, based on that.

In a recent report, Wells Fargo cited three major concerns regarding how quickly we can expect the recovery to really kick in:

• First, the recession exposed the credit dependency of many U.S. households, which, after a rapid decline in wealth caused by the crash in housing values, have realized the need to adjust current consumption more in line with current income.
• Second, housing, one of the major drivers in the economy for half a century, cannot be counted upon to drive economic growth the same way it has in previous cycles; demand has fallen because there is a downside risk to wealth from unstable housing prices, and mortgage lending has become much more difficult to obtain.
• Third, the slower pace of economic growth seen in this recovery will limit state and local government revenues and make it difficult to cover the spending promises of prior generations.

These all affect the willingness of consumers to begin spending again, even if they are employed.  But what about the unemployed?  We think this may be at least as big a problem as those above, and will likely slow down any recovery for some time.  The fact is that for many people currently out of work, they have not received the training or the education to compete successfully for jobs in the economy of today.  Simply ask most hiring managers how easy it has been to fill job openings in the past six months.  Our clients are constantly telling us that in spite of high rates of unemployment, finding qualified applicants is a real challenge.  And the continued high unemployment rate is just another drag on our economy.

What does all of this mean for our clients in the business community?  I believe that the following are all important considerations for any owner or manager for the next few years.

• First, avoid being overly pessimistic or optimistic.  The truth is that though overall the economy has problems, individual companies will thrive even during these times.  And even those companies that may not thrive all the time will find opportunities that they need to be prepared to take advantage of.  This means staying very close to your markets and engaged with your customers more intensely than ever before.  It doesn’t matter what the economists or the politicians say about the economy; what matters is what your customers are saying.  Listen to them and make sure all of your employees are doing the same.
• It’s always good advice to avoid unnecessary borrowings, but now more than ever, companies should be extremely careful about incurring additional debt.  While intelligent borrowing can be a real benefit to any company, it’s important to carefully examine each and every assumption that any new loans are based on.  For instance, borrowing in order to expand capacity has to be critically reviewed in terms of whether or not there will be real demand for the new capacity.  The days of “if you build it, they (the customers) will come” are long gone…if they ever actually existed to begin with.
• Develop and have available for rapid implementation “contingency plans” to allow your business to deal with a sudden downturn in the economy.  We’ve seen already what can happen to companies that don’t do this.  When the economy moves, the companies that will do the best are the ones that are most prepared.  Don’t wait until the storm hits to buy rain gear!
• Be prepared to accept the fact, no matter how unpleasant it may be, that when the economy is not strong, prices suffer.  You have to be able to accept the prices the market is willing to pay for your product or services, not bemoan the fact that your costs tell you that those prices are too low.  When the market cost for your product is lower than your costs, you can’t change the market, but you can at least consider changing your costs.  Focus on what you can change, not what you can’t.
• Finally, focus on the real inner strengths of your business.  Even in the worst of times, companies that focus on the things they do best will experience demand for their products or services.  Understand what your real strengths are, and be ready to play to those strengths.

Of course, 2012 may be a breakout year for the economy, but at this point, betting on that could be dangerous.  We recommend that you prepare for more of what we’ve had over the past 12 to 18 months for at least another year.  We have no doubt that the US economy will come back strong as ever.  The trick is to be able to take advantage of it when it does.

-Gerry

Don’t Look This Gift Horse in the Mouth

Joel Henley’s November 9 blog post—”How to give it away, without really giving it away?”—introduced the unified credit against estate and gift tax, which excludes up to $5 million of the taxpayers estate and lifetime gifts from tax in 2011 and 2012, and the opportunity it presents.  This post looks a little more closely at the $5 million exclusion and the unfortunately named “claw back” concept, which may scare some people away this fleeting opportunity.

The “claw-back” question is:
If the tax law reverts back to the predecessor law and/or reduces the exclusions below $5 million, will the system “claw back” (retrieve and tax) lifetime gifts made in 2011 and 2012 and charge tax on those gifts upon death?

Some commentators say yes, some no.  Whatever is said is speculative.  Congress and/or the IRS will have to resolve the issue one way or the other.  Either way, claw back is a worst case scenario that is not that bad.  If its name reflected its tax consequences—“freezing” $5 million of a taxpayer’s estate and deferring tax until his or her death—we would still see it as a great estate planning opportunity.  “Freeze and defer” may not be as good as permanently excluding $5 million from both gift and estate tax, but it sounds much nicer than “claw back” and is still significantly better than the status quo before 2011.

Claw back is possible because the tax code has used “adjusted taxable gifts” to compute the Federal estate tax since 1976.  Adjusted taxable gifts—the sum of post-1976 taxable gifts—is added to the taxable estate, the estate tax is computed on the total, and then the gift tax previously paid is subtracted.  Unfortunately, after 2012 the exemption for lifetime gifts may be greater than the exemption for estate tax purposes for the first time since 1976. That creates the possibility of subjecting 2011 and 2012 tax exempt gifts to estate tax in a subsequent year.

For example, if a taxpayer who made no previous taxable gifts makes $5 million of taxable gifts in 2012, no gift tax will be due.  He or she will simply have used up the gift tax exemption.  However, assume that the taxpayer dies in 2020 with a $10 million taxable estate, that the unified exemption has decreased to $3.5 million and that the tax rate has increased to 45%. What happens to the difference between the $5 million of exempted 2012 gifts and the $3.5 million unified exemption in 2020?  The answer depends on how line 7 (total gift tax paid or payable) of the estate tax return is calculated.  Specifically, it depends on whether the date of the gift or the date of death is used to calculate the total gift tax paid or payable.

Under the assumptions above the gift tax paid or payable that is subtracted from the tax will be $400,000 greater, and the tax will be $400,000 lower, if we calculate the total gift tax paid or payable on the date of death.  If we calculate the total gift tax paid or payable on the date of the gift, $400,000 in tax will be “clawed back”.  However, the taxpayer still effectively “froze” $5 million of his or her estate and deferred any tax consequences of the gift until his or her death in 2020.  That may not be as good as the alternative, but it is still much better than the result he or she could have achieved before 2011 without the $5 million exclusion.

Could estate tax equal or exceed assets at death?  Our crystal ball does not think this probable.

You should consider the benefit of tax-free or tax-deferred gifting under the temporary $5 million exclusion, if your situation warrants it.

Don’t let “claw back” scare you out of considering the $5 million exclusion.

-Dante

A Holiday Surprise from the IRS

We hate to spoil the holidays, but for many firms there may be a lump of coal in their holiday stocking, courtesy of the IRS.  You may want to take a moment to be sure that your business is not one of them.  This isn’t because of any change in the tax code, or expiration of some tax provision that was extended during the past few years.  It’s because the US tax code is based on the assumption that the economy will, for the most part, be in a permanently expanding mode (occasional recessions being no more than “periodic adjustments”).   For the past nearly 8 decades, this assumption has been pretty accurate, but the continued slowdown in the US economy seems to be upsetting that belief.

The tax code rewards businesses that invest in maintaining or even helping to create  growth, through the inclusion of numerous provisions that accelerate deductions, on the assumption that company’s higher after-tax profits in the short run will be re-invested in growth in the long run.  Most people see this is good economic policy, and most businesses enjoy the benefits of this approach, most notably through the use of accelerated depreciation or write-off of major investments.  Essentially, the tax code allows businesses that invest in new equipment to write off that investment over a shorter period of time, with the write-off equaling 100% of the cost of the investment, regardless of the depreciation that is used for financial statement purposes.  Often, this results in profits on a tax return being lower than the profits shown on the company’s financial statements.  Accountants call this a “timing difference,” but usually it’s more than that because the entire investment is written off, even though the financial statements may not write off the entire amount invested.

Sounds great, right?  You get to reduce your income on your tax return, but you still are able to demonstrate reasonable financial statement profits to your lenders, investors, and others.  But there’s a catch.  And here’s where that growth assumption I mentioned earlier becomes an issue.  Because this write-off is really just a “timing difference.”, ou get bigger write-offs now, in exchange for fewer write-offs later.  The previous expectation was that since the economy was in a constantly growing mode, and businesses would always be making investments in equipment, etc. to support that growth, “later” never came.  New investments with more accelerated tax write-offs were always going to be available to offset the lower write-offs from older investments.  But when the economy basically stopped growing, excess capacity in many businesses meant that very little new equipment investments were likely to occur.  With the current state of the economy, that may be a very real situation for a number of years.

What can happen is startling, and is best illustrated by a very good client of ours, a printer that has experienced both great financial success and occasional financial challenges over the past ten years.  They keep their books on Generally Accepted Accounting Principles, as required by their lenders, and were making reasonable investments in equipment as they grew.  However, when the economy started to weaken, they postponed equipment investments starting in late 2007, and have made none until this year, as the economy continued to struggle.

In 2009, they were showing a small loss on their books, after having reduced a number of expenses in response to a drop of around 15% in sales.  Because they felt that professional fees were an expense they could minimize, especially tax planning, given the fact that they were showing losses, they cancelled the normal quarterly tax planning update they had done in previous years.  With losses showing, they didn’t think they needed to worry about tax deposits.  That’s when the coal slipped into their Christmas stocking.

Primarily, as a result of accelerated equipment write-offs for tax purposes (but not for book) in previous years, even though they were showing a loss on their financial books, they in fact had significant “taxable income”.  The clientended up with significant income taxes due, as well as penalties and interest on the amount of tax due for failing to estimate and pay on a quarterly basis their taxes, as is required by the IRS.  Even though they ended the year with a loss for book purposes, they still ended up having to pay a large tax bill.  Simply put, their “timing advantages” of just a few years earlier turned into an unpleasant surprise when their needs no longer required continued investment in new equipment.

Many firms are likely so see similar results in their 2010 tax returns, though possibly not as severe as was the case I mention.  Remember, in most cases, tax “benefits” eventually do reverse.  Constant monitoring of your company’s potential tax liability, regardless of what your book income may be, is worth doing.

-Gerry

Research and Development Credit

Like most successful businesses, yours probably works hard to develop new or improved products or services and internal processes and techniques in order to stay competitive.  Whether you know it or not, some of those efforts probably constitute “qualified research expenses,” a portion of which can be claimed as an R&D tax credit on your tax returns.  This is true even if you don’t have a formal “research” department or think of yourself as a “high-tech” company.  You may be missing substantial tax savings compared to simply deducting your R&D expenses as a result.

History of the R&D Credit
The R&D credit was enacted as temporary legislation in 1981 to attract foreign capital and make U.S. businesses more competitive by promoting technological innovation.  Since then, it has expired eight times and been extended thirteen times, most recently through December 31, 2011.

Effective January 1, 2007, Congress enacted “alternative simplified credit” rules, to make it even easier for U.S. businesses to claim the credit because many U.S. businesses were outsourcing R&D to countries with more generous R&D tax benefits.  Ironically the IRS designated the R&D credit a “Tier 1 issue”—flagging it for heightened scrutiny—the same year.   Fortunately, court cases and other guidance have subsequently clarified prerequisites for claiming the credit.

What is a “Qualified” Research Expense?
Qualified research expenses are those paid or incurred in your trade or business for supplies or other personal property, qualified services, wages paid for such services or contract research.  To qualify for the credit, research expenditures generally must satisfy four tests:

1. Permitted Purpose: The research must be intended to be useful in the development of a new or improved “business component” (generally, any product, process, computer software, technique, formula or invention).
2. Technological in Nature: The research must rely on the principles of the physical or biological sciences, engineering or computer science.  Research activities relating to style, taste, cosmetic or seasonal design factors are not qualified.
3. Process of Experimentation: Substantially all (≥80%) of the research activities must constitute a process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result, or the appropriate design of that result, is uncertain.  The process must be evaluative and should be capable of evaluating more than one alternative.  However, there is no requirement that the process actually evaluate more than one alternative.
4. Elimination of Uncertainty: The research must involve the identification of uncertainty concerning the development or improvement of a business component.

Certain investments in internal and external software may also qualify.

Do Your Activities Qualify?
Our firm has a library of R&D examples available to help you determine if your activities qualify.  When determining if your activities qualify, the following questions are helpful:

• Did you develop new technology or apply existing technology in a new way?
• Did you use new materials in an existing product on process?
• Did you add new equipment intended to serve a new market?
• Did you develop a new product?
• Did you develop or improve production/manufacturing processes?
• Did you develop software?
• Did you automate internal process?
• Did you build or test new prototypes or models?
• Did you solve complex requirements?
• Did you develop and test new concepts?

Successful businesses innovate and much of what they do relates to these questions.  We can help you take a hard look at your operation to see if your activities qualify for the R&D credit.

R&D Credit Benefits
The tax benefits of the R&D credit can be substantial.  The credit replaces part of the tax deduction for R&D expenses.  However, unlike a deduction, a credit is an actual dollar-for-dollar reduction in tax, and the R&D credit is typically 5 to 8% of qualified research expenses.  Moreover, any unused R&D may be carried back three years and then carried forward for up to twenty.  Finally, many states also offer a similar—but often even more generous—R&D credit.

R&D Credit Costs and Risks
As mentioned previously, the IRS has identified the R&D credit as a “Tier I” issue.  That means it is subject to heightened IRS scrutiny, so returns claiming the credit are more likely to be audited.  The R&D credit claims must be well supported and thoroughly documented, or it may be reduced or disallowed on audit.  Claiming a state R&D credits may likewise increase state audit risk, so such claims should also be well supported and thoroughly documented.

In the event of an audit, the IRS typically attacks the “nexus” or relationship between qualified research expenses and a business component (as defined above) and the supporting documentation.  Project accounting systems often substantiate qualified research expenditures and their relationship to business components.  Unfortunately, most other accounting systems do not.  As a result, taxpayers typically must use a combination of project and cost center methods based on the available records to support the credit. Frequently, the manner in which the information is compiled does not support the relationship between the accounting records and the qualified research expenditures and business components to the IRS’s satisfaction.

Our Approach
Carlson Advisors understands our clients’ businesses, their industries and the relevant tax law.  Our knowledge and experience give us a uniquely ability to help you determine if claiming the R&D credit is worthwhile.  If it is, we can help you claim, substantiate, and—if necessary—defend the credit.  Our process is as follows:

Assessment – Our professionals perform an initial review of your company’s business—particularly its R&D activities as they relate to business components.  Next, we will review the process with your team and develop a work plan to review R&D within your organization.

Information Gathering/Documentation – After the initial assessment, we gather the required information and document the technical qualities of your activities.

Reporting/Tax Preparation – Next, we prepare a summary to support the R&D claims and prepare or amend your tax returns to claim the credit.

Systems – Lastly, for the future, we help you develop systems for identifying and recording information about R&D activities as they relate to business components.

Please contact Carlson Advisors to learn more about the R&D credit.  We offer a free presentation that provides more information about the R&D credit, and would be happy to meet with you to discuss the feasibility of a complete R&D credit study.

- Dante