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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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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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Private companies: Are you on track to meet the 2022 deadline for the updated lease standard?

Updated accounting rules for long-term leases took effect in 2019 for public companies. Now, after several deferrals by the Financial Accounting Standards Board (FASB), private companies and private not-for-profit entities must follow suit, starting in fiscal year 2022. The updated guidance requires these organizations to report — for the first time — the full magnitude of their long-term lease obligations on the balance sheet. Here are the details.

Temporary reprieves

In 2019, the FASB deferred Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), to 2021 for private entities. Then, in 2020, the FASB granted another extension to the effective date of the updated leases standard for private firms, because of disruptions to normal business operations during the COVID-19 pandemic.

Currently, the changes for private entities will apply to annual reporting periods beginning after December 15, 2021, and to interim periods within fiscal years beginning after December 15, 2022. Early adoption is also permitted.

Most private organizations have welcomed these deferrals. Implementing the requisite changes to your organization’s accounting practices and systems can be time-consuming and costly, depending on its size, as well as the nature and volume of its leasing arrangements.

Changing rules

The accounting rules that currently apply to private entities require them to record lease obligations on their balance sheets only if the arrangements are considered financing transactions. Few arrangements are recorded, because accounting rules give lessees leeway to arrange the agreements in a way that they can be treated as simple rentals for financial reporting purposes. If an obligation isn’t recorded on a balance sheet, it makes a business look like it is less leveraged than it really is.

The updated guidance calls for major changes to current accounting practices for leases with terms of a year or longer. In a nutshell, ASU 2016-02 requires lessees to recognize on their balance sheets the assets and liabilities associated with all long-term rentals of machines, equipment, vehicles and real estate. The updated guidance also requires additional disclosures about the amount, timing and uncertainty of cash flows related to leases.

Most existing arrangements that currently are reported as leases will continue to be reported as leases under the updated guidance. In addition, the new definition is expected to encompass many more types of arrangements that aren’t reported as leases under current practice. Some of these arrangements may not be readily apparent, for example, if they’re embedded in service contracts or contracts with third-party manufacturers.

Act now

You can’t afford to wait until year end to adopt the updated guidance for long-term leases. Many public companies found that the implementation process took significantly more time and effort than they initially expected. Contact us to help evaluate which of your contracts must be reported as lease obligations under the new rules.

© 2021

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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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Simple retirement savings options for your small business

Are you thinking about setting up a retirement plan for yourself and your employees, but you’re worried about the financial commitment and administrative burdens involved in providing a traditional pension plan? Two options to consider are a “simplified employee pension” (SEP) or a “savings incentive match plan for employees” (SIMPLE).

SEPs are intended as an alternative to “qualified” retirement plans, particularly for small businesses. The relative ease of administration and the discretion that you, as the employer, are permitted in deciding whether or not to make annual contributions, are features that are appealing.

Uncomplicated paperwork

If you don’t already have a qualified retirement plan, you can set up a SEP simply by using the IRS model SEP, Form 5305-SEP. By adopting and implementing this model SEP, which doesn’t have to be filed with the IRS, you’ll have satisfied the SEP requirements. This means that as the employer, you’ll get a current income tax deduction for contributions you make on behalf of your employees. Your employees won’t be taxed when the contributions are made but will be taxed later when distributions are made, usually at retirement. Depending on your needs, an individually-designed SEP — instead of the model SEP — may be appropriate for you.

When you set up a SEP for yourself and your employees, you’ll make deductible contributions to each employee’s IRA, called a SEP-IRA, which must be IRS-approved. The maximum amount of deductible contributions that you can make to an employee’s SEP-IRA, and that he or she can exclude from income, is the lesser of: 25% of compensation and $58,000 for 2021. The deduction for your contributions to employees’ SEP-IRAs isn’t limited by the deduction ceiling applicable to an individual’s own contribution to a regular IRA. Your employees control their individual IRAs and IRA investments, the earnings on which are tax-free.

There are other requirements you’ll have to meet to be eligible to set up a SEP. Essentially, all regular employees must elect to participate in the program, and contributions can’t discriminate in favor of the highly compensated employees. But these requirements are minor compared to the bookkeeping and other administrative burdens connected with traditional qualified pension and profit-sharing plans.

The detailed records that traditional plans must maintain to comply with the complex nondiscrimination regulations aren’t required for SEPs. And employers aren’t required to file annual reports with IRS, which, for a pension plan, could require the services of an actuary. The required recordkeeping can be done by a trustee of the SEP-IRAs — usually a bank or mutual fund. 

SIMPLE Plans

Another option for a business with 100 or fewer employees is a “savings incentive match plan for employees” (SIMPLE). Under these plans, a “SIMPLE IRA” is established for each eligible employee, with the employer making matching contributions based on contributions elected by participating employees under a qualified salary reduction arrangement. The SIMPLE plan is also subject to much less stringent requirements than traditional qualified retirement plans. Or, an employer can adopt a “simple” 401(k) plan, with similar features to a SIMPLE plan, and automatic passage of the otherwise complex nondiscrimination test for 401(k) plans.

For 2021, SIMPLE deferrals are up to $13,500 plus an additional $3,000 catch-up contributions for employees age 50 and older.

Contact us for more information or to discuss any other aspect of your retirement planning.

© 2021

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Reporting profits interest awards

During the pandemic, cash has been tight for many small businesses, which may make it hard to attract and retain skilled workers. In lieu of providing cash bonuses or annual raises, some companies may decide to give valued employees a share of their future profits. While corporations generally issue stock options, limited liability companies (LLCs) use a relatively new form of equity compensation called “profits interests” to incentivize workers. Here’s a summary of the accounting rules that are used to account for these transactions.

Types of awards

Under U.S. Generally Accepted Accounting Principles (GAAP), profits interest awards may be classified as:

  • Share-based payments,
  • Profit-sharing,
  • Bonus arrangements, or
  • Deferred compensation.

Classification is determined by the specific terms and features of the profits interest. In most cases, the fair value of the award must be recorded as an expense on the income statement. Profits interest can also result in the recognition of a liability on the balance sheet and require footnote disclosures.

Valuation

Under GAAP, fair value is the price an entity would receive to sell an asset — or pay to transfer a liability — in a transaction that’s orderly, takes place between market participants and occurs at the acquisition date. If quoted market prices and other observable inputs aren’t available, unobservable inputs are used to estimate fair value.

One of the upsides to issuing profits interest awards is their flexibility. There’s no standard definition of a profits interest; the term “profits” can refer to whatever is agreed to by the LLC and the recipient of the award. In addition, profits interest units may be subject to various terms and conditions, such as:

  • Vesting requirements,
  • Time limitations,
  • Specific performance thresholds, and
  • Forfeiture provisions.

An LLC may offer multiple types of profits interests, allowing it to customize awards for various purposes. The varieties of terms and conditions that can be incorporated into a profits interest requires the use of customized valuation techniques.

Need for improvement

Many private companies struggle with how to report profits interests. In recent years, the Financial Accounting Standards Board (FASB) has discussed ways to simplify the rules, including scaling back the disclosure requirements and providing a practical expedient to measure grant-date fair value of these awards. No changes have been made yet, however.

For more information

Accounting complexity has caused some private companies to shy away from profits interest arrangements. But they can be an effective tool for attracting and retaining workers under the right circumstances. Contact us for help reporting these transactions under existing GAAP or for an update on the latest developments from the FASB.

© 2021

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Business highlights in the new American Rescue Plan Act

President Biden signed the $1.9 trillion American Rescue Plan Act (ARPA) on March 11. While the new law is best known for the provisions providing relief to individuals, there are also several tax breaks and financial benefits for businesses.

Here are some of the tax highlights of the ARPA.

The Employee Retention Credit (ERC). This valuable tax credit is extended from June 30 until December 31, 2021. The ARPA continues the ERC rate of credit at 70% for this extended period of time. It also continues to allow for up to $10,000 in qualified wages for any calendar quarter. Taking into account the Consolidated Appropriations Act extension and the ARPA extension, this means an employer can potentially have up to $40,000 in qualified wages per employee through 2021.

Employer-Provided Dependent Care Assistance. In general, an eligible employee’s gross income doesn’t include amounts paid or incurred by an employer for dependent care assistance provided to the employee under a qualified dependent care assistance program (DCAP).

Previously, the amount that could be excluded from an employee’s gross income under a DCAP during a tax year wasn’t more than $5,000 ($2,500 for married individuals filing separately), subject to certain limitations. However, any contribution made by an employer to a DCAP can’t exceed the employee’s earned income or, if married, the lesser of employee’s or spouse’s earned income.

Under the ARPA, for 2021 only, the exclusion for employer-provided dependent care assistance is increased from $5,000 to $10,500 (from $2,500 to $5,250 for married individuals filing separately).

This provision is effective for tax years beginning after December 31, 2020.

Paid Sick and Family Leave Credits. Changes under the ARPA apply to amounts paid with respect to calendar quarters beginning after March 31, 2021. Among other changes, the law extends the paid sick time and paid family leave credits under the Families First Coronavirus Response Act from March 31, 2021, through September 30, 2021. It also provides that paid sick and paid family leave credits may each be increased by the employer’s share of Social Security tax (6.2%) and employer’s share of Medicare tax (1.45%) on qualified leave wages.

Grants to restaurants. Under the ARPA, eligible restaurants, food trucks, and similar businesses that provide food and drinks may receive restaurant revitalization grants from the Small Business Administration. For tax purposes, amounts received as restaurant revitalization grants aren’t included in the gross income of the person who receives the money.

Much more

These are only some of the provisions in the ARPA. There are many others that may be beneficial to your business. Contact us for more information about your situation.

© 2021

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Analytical procedures can help make your audit more efficient

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The use of audit analytics can help during the planning and review stages of the audit. But analytics can have an even bigger impact when these procedures are used to supplement substantive testing during fieldwork.

Definition of “analytics”

Auditors use analytical procedures to evaluate financial information by assessing relationships among financial and nonfinancial data. Examples of analytical tests include:

  • Trend analysis,
  • Ratio analysis,
  • Reasonableness testing, and
  • Regression analysis.

Significant fluctuations or relationships that are materially inconsistent with other relevant information or that differ from expected values require additional investigation.

4 steps

Auditors generally follow this four-step process when performing analytical procedures:

1. Form an independent expectation. The auditor develops an expectation of an account balance or financial relationship. Expectations are based on the auditor’s understanding of the company and its industry. Examples of data used to develop expectations include prior-period information (adjusted for expected changes), management’s budgets or forecasts, and ratios published in trade journals.

2. Identify differences between expected and reported amounts. The auditor must compare his or her expectation with the amount recorded in the company’s accounting system. Then, any difference is compared to the auditor’s threshold for analytical testing. If the difference is less than the threshold, the auditor generally accepts the recorded amount without further investigation and the analytical procedure is complete. If not, the auditor moves to the next step.

3. Investigate the reason. The auditor brainstorms all possible causes and then determines the most probable cause(s) for the discrepancy. Sometimes, the analytical test or the data itself is problematic, and the auditor needs to apply additional analytical procedures with more precise data. Other times, the discrepancy has a “plausible” explanation, usually related to unusual transactions or events, or accounting or business changes.

4. Evaluate differences. The auditor evaluates the likelihood of material misstatement and then determines the nature and extent of any additional auditing procedures. Plausible explanations require corroborating audit evidence.

For differences that are due to misstatement (rather than a plausible explanation), the auditor must decide whether the misstatement is material (individually or in the aggregate). Material misstatements typically require adjustments to the amounts reported and may also necessitate additional audit procedures to determine the scope of a misstatement.

A win-win for everyone

Done right, analytical procedures can help make your audit less time-consuming, less expensive and more effective at detecting errors and omissions. Analytics also may be easier to perform remotely than traditional, manual audit testing procedures — a major upside during the COVID-19 pandemic. To avoid surprises in the coming audit season, notify us about any major changes to your operations, accounting methods or market conditions that occurred during the reporting period.

© 2021