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Is an LLC the right choice for your small business?

Perhaps you operate your small business as a sole proprietorship and want to form a limited liability company (LLC) to protect your assets. Or maybe you are launching a new business and want to know your options for setting it up. Here are the basics of operating as an LLC and why it might be appropriate for your business.

An LLC is somewhat of a hybrid entity because it can be structured to resemble a corporation for owner liability purposes and a partnership for federal tax purposes. This duality may provide the owners with the best of both worlds. 

Personal asset protection

Like the shareholders of a corporation, the owners of an LLC (called “members” rather than shareholders or partners) generally aren’t liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are protected from the entity’s creditors. This protection is far greater than that afforded by partnerships. In a partnership, the general partners are personally liable for the debts of the business. Even limited partners, if they actively participate in managing the business, can have personal liability.

Tax implications

The owners of an LLC can elect under the “check-the-box” rules to have the entity treated as a partnership for federal tax purposes. This can provide a number of important benefits to the owners. For example, partnership earnings aren’t subject to an entity-level tax. Instead, they “flow through” to the owners, in proportion to the owners’ respective interests in profits, and are reported on the owners’ individual returns and are taxed only once.

To the extent the income passed through to you is qualified business income, you’ll be eligible to take the Code Section 199A pass-through deduction, subject to various limitations. In addition, since you’re actively managing the business, you can deduct on your individual tax return your ratable shares of any losses the business generates. This, in effect, allows you to shelter other income that you and your spouse may have.

An LLC that’s taxable as a partnership can provide special allocations of tax benefits to specific partners. This can be an important reason for using an LLC over an S corporation (a form of business that provides tax treatment that’s similar to a partnership). Another reason for using an LLC over an S corporation is that LLCs aren’t subject to the restrictions the federal tax code imposes on S corporations regarding the number of owners and the types of ownership interests that may be issued. 

Review your situation

In summary, an LLC can give you corporate-like protection from creditors while providing the benefits of taxation as a partnership. For these reasons, you should consider operating your business as an LLC. Contact us to discuss in more detail how an LLC might benefit you and the other owners.

© 2021

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Financial statements: Take the time to read the entire story

A complete set of financial statements for your business contains three reports. Each serves a different purpose, but ultimately helps stakeholders — including managers, employees, investors and lenders — evaluate a company’s performance. Here’s an overview of each report and a critical question it answers.

1. Income statement: Is the company growing and profitable?

The income statement (also known as the profit and loss statement) shows revenue, expenses and earnings over a given period. A common term used when discussing income statements is “gross profit,” or the income earned after subtracting the cost of goods sold from revenue. Cost of goods sold includes the cost of labor, materials and overhead required to make a product.

Another important term is “net income.” This is the income remaining after all expenses (including taxes) have been paid.

It’s important to note that growth and profitability aren’t the only metrics that matter. For example, high-growth companies that report healthy top and bottom lines may not have enough cash on hand to pay their bills. Though it may be tempting to just review revenue and profit trends, thorough due diligence looks beyond the income statement.

2. Balance sheet: What does the company own (and owe)?

This report provides a snapshot of the company’s financial health. It tallies assets, liabilities and “net worth.”

Under U.S. Generally Accepted Accounting Principles (GAAP), assets are reported at the lower of cost or market value. Current assets (such as accounts receivable or inventory) are reasonably expected to be converted to cash within a year, while long-term assets (such as plant and equipment) have longer lives. Similarly, current liabilities (such as accounts payable) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year or operating cycle.

Intangible assets (such as patents, customer lists and goodwill) can provide significant value to a business. But internally developed intangibles aren’t reported on the balance sheet. Intangible assets are only reported when they’ve been acquired externally.

Net worth (or owners’ equity) is the extent to which the value of assets exceeds liabilities. If the book value of liabilities exceeds the book value of the assets, net worth will be negative. However, book value may not necessarily reflect market value. Some companies may provide the details of owners’ equity in a separate statement called the statement of retained earnings. It details sales or repurchases of stock, dividend payments and changes caused by reported profits or losses.

3. Cash flow statement: Where is cash coming from and going to?

This statement shows all the cash flowing in and out of your company. For example, your company may have cash inflows from selling products or services, borrowing money and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt.

Typically, cash flows are organized in three categories: operating, investing and financing activities. The bottom of the statement shows the net change in cash during the period. Watch your statement of cash flows closely. To remain in business, companies must continually generate cash to pay creditors, vendors and employees.

Read the fine print

Disclosures at the end of a company’s financial statements provide additional details. Together with the three quantitative reports, these qualitative descriptions can help financial statement users make well-informed business decisions. Contact us for assistance conducting due diligence and benchmarking financial performance.

© 2021

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Possible tax consequences of guaranteeing a loan to your corporation

What if you decide to, or are asked to, guarantee a loan to your corporation? Before agreeing to act as a guarantor, endorser or indemnitor of a debt obligation of your closely held corporation, be aware of the possible tax consequences. If your corporation defaults on the loan and you’re required to pay principal or interest under the guarantee agreement, you don’t want to be blindsided.

Business vs. nonbusiness

If you’re compelled to make good on the obligation, the payment of principal or interest in discharge of the obligation generally results in a bad debt deduction. This may be either a business or a nonbusiness bad debt deduction. If it’s a business bad debt, it’s deductible against ordinary income. A business bad debt can be either totally or partly worthless. If it’s a nonbusiness bad debt, it’s deductible as a short-term capital loss, which is subject to certain limitations on deductions of capital losses. A nonbusiness bad debt is deductible only if it’s totally worthless.

In order to be treated as a business bad debt, the guarantee must be closely related to your trade or business. If the reason for guaranteeing the corporation loan is to protect your job, the guarantee is considered closely related to your trade or business as an employee. But employment must be the dominant motive. If your annual salary exceeds your investment in the corporation, this tends to show that the dominant motive for the guarantee was to protect your job. On the other hand, if your investment in the corporation substantially exceeds your annual salary, that’s evidence that the guarantee was primarily to protect your investment rather than your job.

Except in the case of job guarantees, it may be difficult to show the guarantee was closely related to your trade or business. You’d have to show that the guarantee was related to your business as a promoter, or that the guarantee was related to some other trade or business separately carried on by you.

If the reason for guaranteeing your corporation’s loan isn’t closely related to your trade or business and you’re required to pay off the loan, you can take a nonbusiness bad debt deduction if you show that your reason for the guarantee was to protect your investment, or you entered the guarantee transaction with a profit motive.

In addition to satisfying the above requirements, a business or nonbusiness bad debt is deductible only if:

  • You have a legal duty to make the guaranty payment, although there’s no requirement that a legal action be brought against you;
  • The guaranty agreement was entered into before the debt becomes worthless; and
  • You received reasonable consideration (not necessarily cash or property) for entering into the guaranty agreement.

Any payment you make on a loan you guaranteed is deductible as a bad debt in the year you make it, unless the agreement (or local law) provides for a right of subrogation against the corporation. If you have this right, or some other right to demand payment from the corporation, you can’t take a bad debt deduction until the rights become partly or totally worthless.

These are only a few of the possible tax consequences of guaranteeing a loan to your closely held corporation. Contact us to learn all the implications in your situation.

© 2021

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Analytics software: A brave new world in auditing

Analytical software tools will never fully replace auditors, but they can help auditors do their work more efficiently and effectively. Here’s an overview of how data analytics — such as outlier detection, regression analysis and semantic modeling — can enhance the audit process.

Auditors bring experience and professional skepticism

When it’s appropriate, instead of manually testing a representative data sample, auditors can use analytical software tools to compare an entire data population against selected criteria. This process quickly identifies anomalies hidden in large amounts of data that can be tagged for further examination by auditors during fieldwork. Analytical software tools can test various kinds of data, including accounting, internal communications and documents, and external benchmarking data.

If unusual transactions or trends are found, auditors will investigate them further using the following procedures:

  • Interviewing management about what happened and why,
  • Conducting external research online and from industry publications to independently understand what happened or to verify management’s explanation, and
  • Performing additional manual testing procedures to determine the nature of the anomaly or exception.

In addition, confirmations and representation letters from attorneys, customers and other external parties may corroborate what management says and external research reveals.

Audit findings may require action

Often, auditors conclude that irregularities have reasonable explanations. For instance, they may be due to an unexpected change in the company’s operations or external market conditions. If a change is expected to continue, it may alter the auditor’s expectations about the company’s operations going forward. Sometimes, a change discovered while auditing one part of the financials may affect audit procedures (including analytics) that will be performed on other accounts.

Alternatively, auditors may attribute some irregularities to inadvertent mistakes or intentional fraud schemes. Auditors usually communicate with the audit committee or the company’s owners as soon as possible if they discover any material errors or fraud. These irregularities might require adjustments to the financial statements. The company also might need to take action to mitigate financial losses and prevent the problem from recurring.

For example, the controller may need additional training on recent changes to the tax and accounting rules. Or management may need to implement additional internal control procedures to safeguard against dishonest behaviors. Or the owner may need to contact the company’s attorney and hire a forensic accountant to perform a formal fraud investigation.

Audit smarter

Today, companies generate, process and store massive amounts of electronic data on their networks. Increasingly, auditors are using analytical tools on this data to conduct basic audit procedures, such as vouching transactions and comparing data to external benchmarks. This frees up auditors to focus their efforts on complex transactions, suspicious relationships and high-risk accounts. Contact us for more information about how our auditors use analytical software tools in the field.

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September 2021 Short Bits

IRS ISSUES REFUNDS

The IRS has issued more than 2.8 million in refunds to taxpayers who paid taxes on unemployment compensation before the American Rescue Plan Act excluded $10,200 in unemployment compensation for 2020. Approximately 13 million taxpayers may be eligible for adjustments that the IRS will automatically make to avoid needing taxpayers to file amended tax returns.

FINANCIAL LITERACY

Fifty seven percent of American adults are financially literate according to a report by Standard & Poor’s. Other advanced economies had high levels of financial literacy. Canada, Germany and the United Kingdom all came in with over 65% adult literacy rates. Understanding basic financial concepts allows people to make informed financial choices about saving, spending and borrowing.

2020 CENSUS DATA

The results of the 2020 census are in. The US has over 331 million residents, with California, Texas and Florida topping the list with the most residents; while Wyoming and Vermont are the least populated. Utah and Idaho saw the largest percentage increase in their populations with 18.4% and 17.3% respectively. Texas saw the largest increase with almost four million new residents since the 2010 census. There were over 350,000 citizens in the military or working for the federal government overseas.

FOREIGN INVESTMENT

In 2018, the US Department of Commerce facilitated $20.1 billion in foreign investment into the US, which created over 22,000 jobs. The largest foreign investment came from the United Kingdom, Canada and Japan. Forty-five percent of the foreign investment went into the manufacturing industry. As of 2018, a total of $4.3 trillion has been invested in the US by other countries.

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September 2021 Questions & Answers

QUESTION:

What’s a registered agent and does my business need one?

ANSWER:

A registered agent is a person or business designated to receive official documents on behalf of a business. All companies must have a registered agent and it has to be mentioned when the company files with the Secretary of State. The registered agent could be you, as the business owner, another key employee, your corporate attorney or a hired registered agent business. Just make sure it’s someone you trust to communicate important information about your business promptly.

QUESTION:

What’s the difference between interest rates and annual percentage rates?

ANSWER:

Interest rates are the rates you are quoted when seeking a loan. For example, you might receive an interest rate of 6% when purchasing a new $20,000 car. Your interest expense will be $1,200 a year.

An annual percentage rate (APR) is a more effective rate to consider when comparing loans. The APR includes not only the interest expense on the loan but also all fees and costs in obtaining the loan. The APR is often expressed as a percentage and generally should always be equal to or greater than the interest rate.

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Employee vs Independent Contractor: What’s the Difference?

Tax rules differ for employees vs. independent contractors, so consider income taxes when you need to hire help for your business.

HIRE AN EMPLOYEE

The IRS looks at the degree of control you have over a worker’s behavior and finances, along with the type of relationship you have. For example, the IRS deems workers to be employees if you control when and how they perform the work, control how they are paid and provide them with supplies to do the job. This means you’ll need to collect and pay payroll taxes and abide by federal and state employment laws.

REMAIN INDEPENDENT

There is no magic set of rules that make a worker an employee or not. But having a worker sign an independent contractor agreement doesn’t automatically mean they’re a contractor. You’ll need to look at the totality of the relationship between you and the worker. And if you’re ever in doubt, you can submit a Form SS-8 for the IRS to determine your worker’s status.

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Cryptocurrency Basics

Cryptocurrency is an alternative form of payment and works through a technology called blockchain, a decentralized processing and recording system making it nearly impossible to counterfeit and it comes with tax reporting requirements.

REPORTING BASICS

The IRS has stepped up investigations into unreported cryptocurrency income. Your Form 1040 asks whether you transacted in cryptocurrency during the year. Answer truthfully. However, the IRS has stated that if your only crypto activity was using hard cash to purchase cryptocurrency, you can answer this question with a no.

IRS VIEWS

The IRS views cryptocurrency as property, not cash. That means crypto is more like a house than a bank account in the eyes of the IRS. So, when you exchange your digital currency for cash or other goods or services you’ll recognize a capital gain. If you held the crypto for a year or less, it’s considered a short-term capital gain which is taxed at ordinary income tax rates. If held longer than a year it will be taxed at capital gain rates. Report your cryptocurrency transactions on Form 8949 and Schedule D.

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September 2021 Client Profile

My retail store has been very successful and time consuming, so I need to hire a bookkeeper to take care of the finances. What questions should I ask candidates to ensure that I hire a competent bookkeeper?

Hiring a bookkeeper for the first time marks a milestone for a small business. In addition to ensuring the applicant has the right personality and soft skills to be successful in their role with your company, you’ll want to make sure the new hire has the technical knowledge required to do the job. When you’re interviewing or screening a potential candidate consider asking the following technical questions:

  • Do you have experience working in this particular industry?
  • What accounting software have you worked with in the past?
  • When do we send Form 1099 to vendors?
  • How often are payroll tax returns due?
  • Does the accounts payable account usually have a debit or credit balance?
  • What would you do if your bank reconciliation was off by a few dollars?

Since this person will handle the crucial details of your business, the answers to these questions will let you know if they have the accounting skills you need.

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

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What to Know About 401(k)s

One of the common retirement plans offered by employers is a 401(k) plan. These plans make saving for retirement convenient. But make sure you understand the basics so you can capitalize on plan options and determine how your 401(k) fits into your overall retirement strategy.

ELIGIBILITY RULES

Some employers allow new hires to enroll in the company 401(k) plan on day one, and some even offer automatic enrollment. But employers can have waiting periods of a few months to a year before you’re eligible to participate. To get the most from the plan, however, sign up as soon as you’re allowed.

IT’S A MATCH

Many companies offer a matching contribution to employees who participate in the company plan. While amounts vary, matching contributions are usually a fixed percentage on a predetermined portion of an employee’s annual salary. For example, an employer may contribute fifty cents for every dollar you contribute, up to 10% of your salary. So if you earn $60,000 per year, you could receive a $3,000 annual contribution from your employer, provided you contribute $6,000 each year.

KNOW YOUR LIMITS

The IRS places limits on the amount you can contribute to qualified retirement plans each year. For 2021, the limit is $19,500, but if you’re 50 or older you can contribute an additional $6,500. Any 401(k) plan can set its own contribution limits, which may be less than the IRS limits.

VESTING

The money you contribute to a 401(k) is yours to keep from day one. But the contributions from your employer may come with a contingency, also known as a vesting schedule. That means you may need to work for the company for a year or more before you gain 100% ownership of the company’s contributions.

TAKE OUT

Although you may not plan on tapping your 401(k) account before retirement, sometimes life’s events require you to do so. Some plans will let you take a loan that you repay with interest over time. Or you may be able to take a hardship withdrawal that doesn’t require repayment. But you’ll have to pay income tax on the amount withdrawn and if you are under age 59½ there is an additional 10% federal tax penalty. Consider this option as your last resort, because that money will no longer be there to grow for retirement.