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Know the ins and outs of “reasonable compensation” for a corporate business owner

Owners of incorporated businesses know that there’s a tax advantage to taking money out of a C corporation as compensation rather than as dividends. The reason: A corporation can deduct the salaries and bonuses that it pays executives, but not dividend payments. Thus, if funds are paid as dividends, they’re taxed twice, once to the corporation and once to the recipient. Money paid out as compensation is only taxed once — to the employee who receives it.

However, there are limits to how much money you can take out of the corporation this way. Under tax law, compensation can be deducted only to the extent that it’s reasonable. Any unreasonable portion isn’t deductible and, if paid to a shareholder, may be taxed as if it were a dividend. Keep in mind that the IRS is generally more interested in unreasonable compensation payments made to someone “related” to a corporation, such as a shareholder-employee or a member of a shareholder’s family.

Determining reasonable compensation

There’s no easy way to determine what’s reasonable. In an audit, the IRS examines the amount that similar companies would pay for comparable services under similar circumstances. Factors that are taken into account include the employee’s duties and the amount of time spent on those duties, as well as the employee’s skills, expertise and compensation history. Other factors that may be reviewed are the complexities of the business and its gross and net income.

There are some steps you can take to make it more likely that the compensation you earn will be considered “reasonable,” and therefore deductible by your corporation. For example, you can:

  • Keep compensation in line with what similar businesses are paying their executives (and keep whatever evidence you can get of what others are paying to support what you pay). 
  • In the minutes of your corporation’s board of directors, contemporaneously document the reasons for compensation paid. For example, if compensation is being increased in the current year to make up for earlier years in which it was low, be sure that the minutes reflect this. (Ideally, the minutes for the earlier years should reflect that the compensation paid then was at a reduced rate.) Cite any executive compensation or industry studies that back up your compensation amounts. 
  • Avoid paying compensation in direct proportion to the stock owned by the corporation’s shareholders. This looks too much like a disguised dividend and will probably be treated as such by IRS.
  • If the business is profitable, pay at least some dividends. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.

You can avoid problems and challenges by planning ahead. If you have questions or concerns about your situation, contact us.

© 2021

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Accounting for business combinations

If your company is planning to merge with or buy another business, your attention is probably on conducting due diligence and negotiating deal terms. But you also should address the post-closing financial reporting requirements for the transaction. If not, it may lead to disappointing financial results, restatements and potential lawsuits after the dust settles.

Here’s guidance on how to correctly account for M&A transactions under U.S. Generally Accepted Accounting Principles (GAAP).

Identify assets and liabilities

A seller’s GAAP balance sheet may exclude certain intangible assets and contingencies, such as internally developed brands, patents, customer lists, environmental claims and pending lawsuits. Overlooking identifiable assets and liabilities often results in inaccurate reporting of goodwill from the sale.

Private companies can elect to combine noncompete agreements and customer-related intangibles with goodwill. If this alternative is used, it specifically excludes customer-related intangibles that can be licensed or sold separately from the business.

It’s also important to determine whether the deal terms include arrangements to compensate the seller or existing employees for future services. These payments, along with payments for pre-existing arrangements, aren’t part of a business combination. In addition, acquisition-related costs, such as finder’s fees or professional fees, shouldn’t be capitalized as part of the business combination. Instead, they’re generally accounted for separately and expensed as incurred.

Determine the price

When the buyer pays the seller in cash, the purchase price (also called the “fair value of consideration transferred”) is obvious. But other types of consideration muddy the waters. Consideration exchanged may include stock, stock options, replacement awards and contingent payments.

For example, it can be challenging to assign fair value to contingent consideration, such as earnouts payable only if the acquired entity achieves predetermined financial benchmarks. Contingent consideration may be reported as a liability or equity (if the buyer will be required to pay more if it achieves the benchmark) or as an asset (if the buyer will be reimbursed for consideration already paid). Contingent consideration that’s reported as an asset or liability may need to be remeasured each period if new facts are obtained during the measurement period or for events that occur after the acquisition date.

Allocate fair value

Next, you’ll need to split up the purchase price among the assets acquired and liabilities assumed. This requires you to estimate the fair value of each item. Any leftover amount is assigned to goodwill. Essentially, goodwill is the premium the buyer is willing to pay above the fair value of the net assets acquired for expected synergies and growth opportunities related to the business combination.

In rare instances, a buyer negotiates a “bargain” purchase. Here, the fair value of the net assets exceeds the purchase price. Rather than book negative goodwill, the buyer reports a gain on the purchase.

Make accounting a forethought, not an afterthought

M&A transactions and the accompanying financial reporting requirements are uncharted territory for many buyers. Don’t wait until after a deal closes to figure out how to report it. We can help you understand the accounting rules and the fair value of the acquired assets and liabilities before closing.

© 2021

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May 2021 Short Bits

DEDUCTION ERRORS

According to the Treasury Inspector General for Tax Administration, the IRS allowed business owners to claim $57 million in potentially erroneous qualified business income deductions on 2019 tax returns. The way this pass-through deduction is written is very complicated, and it’s part of the reason for the deduction errors.

SLASHED CONTRIBUTIONS

The COVID-19 pandemic caused many businesses to change how they contribute to employees’ 401(k) accounts. It’s estimated that 46,000 401(k) plans were affected because companies paused discretionary funding to employees’ accounts, cutting back on matching contributions or ditching all matching contributions.

ECONOMIC EDUCATION

A new study in the Journal of Children and Poverty revealed that youths with a savings account in their name, regardless of the balance, were approximately six times more likely to attend college than those with no account. Additionally, growing up in a family that manages assets well — such as savings and equity in a home — shows that assets, not income is associated with college success.

MOM FACTS

According to a study by the Pew Research Center, the median age that a woman becomes a mother is 26, up from 24 in 1994. And highly educated women are increasingly becoming moms. Eighty percent of women with a Ph.D. or other professional degree have given birth. And a rising share of births to foreign-born mothers is increasing diversity as nearly one-third of all births in California, New York and New Jersey were to mothers who were born outside the US.

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May 2021 Questions and Answers

QUESTION:

I recently moved. How do I notify the IRS of my new address?

ANSWER:

You will need to officially notify them of your new address. Changing your address with the post office won’t cut it. You can accomplish this in a few different ways. First, you can complete Form 8822, the change of address form, or write a letter. If your address changes before filing your tax return, you can simply use your new address on your return and the IRS will make the update for you.

QUESTION:

Does providing my customers with an early payment discount make sense for my new business?

ANSWER:

Start with asking yourself do you need to have customers pay faster because you need the cash? If you’re in a pinch to make payroll or pay rent, then it might make sense. But remember that offering a discount cuts into your profit margin. So ensure your business can afford it. And just because you provide an early payment discount to speed up cash flow doesn’t mean your customers will take it. Be sure to have a backup plan to meet any short-term cash flow needs.

QUESTION:

How long should I keep my tax records?

ANSWER:

Generally, three years, but up to seven if you’re self employed or reported losses.

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Defining Company Culture

Company culture is defined as the values, goals, practices and attitudes that represent the personality of an organization. Worker satisfaction is highest when employees’ personal views are in sync with a clearly defined company culture.

WHAT DO YOU VALUE?

Start by establishing the beliefs, philosophies and principles that will drive business. Do you value individual effort or collaborative approaches? Do you stick with a traditional hierarchy or prefer something more fluid? Dialing in on these foundational views empowers your employees to make the right choices.

LET IT DEVELOP

After you’ve identified your company values, norms of behavior will naturally develop. If you value employee autonomy, you may allow employees to set their own schedules. Employees will learn that as long as they complete their work on time, it doesn’t matter when they get it done.

SUSTAIN IT

Your business success relies on maintaining your corporate culture. Openly and regularly communicate the company’s values with employees. Celebrate successes and include everyone, not just those who “sealed the deal”. Building a community reminds employees what they’re working towards.

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Big Changes to Child Tax Credit

The American Rescue Plan Act, signed into law in March 2021, made significant changes to the child tax credit for 2021 only — unless Congress extends these changes.

OLDER CHILDREN COVERED

The tax credit now includes children who are age 17 as of December 31, 2021.

INCREASED AMOUNT

The credit amount increased from $2,000 to $3,000 per child aged 6 to 17 and $3,600 for children under age six, as of December 31, 2021.

ELIGIBILITY

Calculating the total credit is difficult, because there are two phaseout rules that apply. The credit is reduced—or eliminated—for parents who earn above a certain amount. Your tax professional will be able to calculate how much, if any, tax credit you might receive.

ADVANCE PAYMENTS

The IRS will estimate your child tax credit for 2021 and half of it will be paid to you in monthly installments from July through December 2021.

The remaining amount due to you will be credited when you file your 2021 tax return. However, if you file your 2021 tax return and the advance payments you received exceeded your actual credit, with a few exceptions for low and moderate-income taxpayers, you’ll have to repay the excess.

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May 2021 Client Profile

The Roberts family hired a live-in au pair to help care for their children while the parents work. One of their co-workers mentioned something about a “Nanny Tax,” and the Roberts aren’t sure if it applies to their situation.

In the IRS’s eyes, au pairs and nannies fall into the category of household employees. With a few exceptions, if your au pair is considered an employee because you control when and how they work, you’ll need to withhold and pay Social Security and Medicare taxes if they earn at least $2,300 in 2021. You may also need to pay federal unemployment tax if they earn more than $1,000 in a calendar quarter. This is on top of any state employment taxes you may be required to withhold or pay.

And while you’re not required to withhold federal income tax, your employee may ask you to. You would need to get a Form W-4 from them. If you withhold any taxes from your employees, you’ll need to provide a W-2 each January. Incorrectly classifying your au pair as an independent contractor to avoid paying payroll taxes can have harsh consequences.

Client Profile is based on a hypothetical situation. The solutions we discuss may or may not be appropriate for you.

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Understanding Your Business Insurance Binder

Insurance paper on businessman desk in Office Business

Whether you’re insuring your business against liability or protecting your employees with a workers’ compensation policy, your insurance agent will provide a binder that can serve as your temporary proof of insurance before an insurance policy is issued.

ASK FOR IT BY NAME

When you apply for an insurance policy, you should always ask your agent to provide you with the binder. Sometimes your agent might call this a certificate of insurance or refer to the process as binding coverage. Having this written document gives you the chance to review your coverage and confirm it is correct.

WHAT’S INCLUDED

Your insurance binder won’t be in a physical 3-ring binder. Instead, it is usually two or three pages of legal paperwork that spells out your policy’s details. Your business insurance binder should include the following key elements:

  • The type of risk insured.
  • The liability coverage amounts.
  • The deductible amount.
  • The named insured(s).
  • The start and end date of the policy.
  • The name of the insurance company and insurance agent.

While the binder acts as a temporary policy with an expiration date, it will not cover you once it lapses. Also, it does not guarantee that a policy will be issued. You’ll still have to go through the company’s underwriting process. So it’s always good to follow up with your insurance agent to ensure that the formal policy is issued. As with all critical business documents, be sure to get a complete copy of the policy for your files.

NOT A DECLARATION

Typically the declaration page is provided with the policy after is has made its way through underwriting and been approved. A declaration page provides a summary of your insurance policy. While it will contain a lot of the same information as the binder, they aren’t the same thing.

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Professional Financial Designations

When it comes to managing your personal finances, you need the right financial professional on your team. Knowing the differences between the various professional designations will help.

CPA (Certified Public Accountant):

One of the more widely recognized certifications. These professionals are tax and accounting specialists who can help with reducing taxes, preparing tax returns, and organizing investments.

CFP (Certified Financial Planner):

These experts can help with investment, estate and retirement planning. And they have a fiduciary duty to make decisions with their client’s best interest in mind.

IA (Investment Advisers):

They are regulated by either the Securities and Exchange Commission or a state regulator and are able to give advice or recommendations about specific investments. An investment adviser may also be a CFP.

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Valuing Your Business

Knowing how much your business is worth can do more than figure out how much money you can get when you sell it. Creating an accurate valuation is part of an ongoing business strategy.

COMPARING AND PROJECTING

Think of a business valuation as an appraisal, which is generally created by analyzing a company’s tangible and intangible assets relative to its liabilities and debts. Some valuation methods will also consider how profitable the company is on an annual basis, and others will compare your business’s financial statements with similar companies. There are numerous valuation methodologies and which one is best for you will depend on your business.

KNOW WHEN

Business valuations are most often completed when a company is being sold. But valuations can also be useful when there are tax disputes with the IRS or when additional owners are brought in, or old partners are cashing out and leaving. And if a business wants to secure a sizable loan or investor funding, a valuation can offer credibility to justify the risk.

Valuations also help owners measure progress, identify hiccups or gaps in company infrastructure, and provide a benchmark as to how your company performs against your peers or industry best practices.

Maybe you weren’t planning to sell. But if the value of your business has increased significantly, selling now might make sense.

MAKE A CHOICE

You can run your own informal valuation at any time. But if you need a third-party valuation, you’ll need an experienced independent appraiser trained to use unbiased methods. And if your company operates in a heavily regulated industry, hiring someone with in-depth regulatory knowledge is a must.

BEYOND VALUATION

Make sure all aspects of your operation are up-to-date. A few examples include: record-keeping, outstanding legal matters, insurance coverage and intellectual property documentation.