Anderson ZurMuehlen Blog

Seasonal business? Optimize your operating cycle

Every business has some degree of ups and downs during the year. But cash flow fluctuation OKs are much more intense for seasonal businesses. So, if your company defines itself as such, it’s important to optimize your operating cycle to anticipate and minimize shortfalls.

A high-growth example

To illustrate: Consider a manufacturer and distributor of lawn-and-garden products such as topsoil, potting soil and ground cover. Its customers are lawn-and-garden retailers, hardware stores and mass merchants.

The company’s operating cycle starts when customers place orders in the fall — nine months ahead of its peak selling season. So the business begins amassing product in the fall, but curtails operations in the winter. In late February, product accumulation continues, with most shipments going out in April.

At this point, a lot of cash has flowed out of the company to pay operating expenses, such as utilities, salaries, raw materials costs and shipping expenses. But cash doesn’t start flowing into the company until customers pay their bills around June. Then, the company counts inventory, pays remaining expenses and starts preparing for the next year. Its strategic selling window — which will determine whether the business succeeds or fails — lasts a mere eight weeks.

The power of projections

Sound familiar? Ideally, a seasonal business such as this should stockpile cash received at the end of its operating cycle, and then use those cash reserves to finance the next operating cycle. But cash reserves may not be enough — especially for high-growth companies.

So, like many seasonal businesses, you might want to apply for a line of credit to avert potential shortfalls. To increase the chances of loan approval, compile a comprehensive loan package, including historical financial statements and tax returns, as well as marketing materials and supplier affidavits (if available).

More important, draft a formal business plan that includes financial projections for next year. Some companies even project financial results for three to five years into the future. Seasonal business owners can’t rely on gut instinct. You need to develop budgets, systems, processes and procedures ahead of the peak season to effectively manage your operating cycle.

Distinctive challenges

Seasonal businesses face many distinctive challenges. Please contact our firm for assistance overcoming these obstacles and strengthening your bottom line.

Contact us for more information.

©2017

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How to Shape Up Your Working Capital

Working capital — current assets minus current liabilities — is a common measure of liquidity. High liquidity generally equates with low risk, but excessive amounts of cash tied up in working capital may detract from growth opportunities and other spending options, such as expanding to new markets, buying equipment and paying down debt. Here are some recent working capital trends and tips for keeping your working capital in shape.

Survey says

Working capital management among U.S. companies has been relatively flat over the last four years, excluding the performance of oil and gas companies, according to the 2016 U.S. Working Capital Survey published by consulting firm REL and CFO magazine. The overall results were skewed somewhat because oil and gas companies increased their inventory reserves to take advantage of low oil prices, thereby driving up working capital balances for that industry.

The study estimates that, if all of the 1,000 companies surveyed managed working capital as efficiently as do the companies in the top quartile of their respective industries, more than $1 trillion of cash would be freed up from receivables, inventory and payables.

Rather than improve working capital efficiency, however, many companies have chosen to raise cash with low interest rate debt. Companies in the survey currently carry roughly $4.86 trillion in debt, more than double the level in 2008. As the Federal Reserve Bank increases rates, companies will likely look for ways to manage working capital better.

Efficiency initiatives

How can your company decrease the amount of cash that’s tied up in working capital? Best practices vary from industry to industry. Here are three effective exercises for improving working capital:

Expedite collections. Possible solutions for converting receivables into cash include: tighter credit policies, early bird discounts, collection-based sales compensation and in-house collection personnel. Companies also can evaluate administrative processes — including invoice preparation, dispute resolution and deposits — to eliminate inefficiencies in the collection cycle.

Trim inventory. This account carries many hidden costs, including storage, obsolescence, insurance and security. Consider using computerized inventory systems to help predict demand, enable data-sharing up and down the supply chain, and more quickly reveal variability from theft.

Postpone payables. By deferring vendor payments, your company can increase cash on hand. But be careful: Delaying payments for too long can compromise a firm’s credit standing or result in forgone early bird discounts.

From analysis to action

No magic formula exists for reducing working capital, but continuous improvement is essential. We can help train you on how to evaluate working capital accounts, identify strengths and weaknesses, and find ways to minimize working capital without compromising supply chain relationships.

 

Contact us for more information.

©2017

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Create a Strong System of Checks and Balances

 

The Securities and Exchange Commission (SEC) requires public companies to evaluate and report on internal controls over financial reporting using a recognized control framework. Private companies generally aren’t required to use a framework for the oversight of internal controls, unless they’re audited, but a strong system of checks and balances is essential for them as well.

A critical process

Reporting on internal controls is an ongoing process, not a one-time assessment, that’s affected by an entity’s board of directors or owners, management, and other personnel. It’s designed to provide reasonable assurance regarding the effectiveness and efficiency of operations, the reliability of financial reporting, compliance with applicable laws and regulations, and safeguarding of assets.

A strong system of internal controls helps a company achieve its strategic and financial goals, in addition to minimizing the risk of fraud. At the most basic level, auditors routinely monitor the following three control features. These serve as a system of checks and balances that help ensure management directives are carried out:

1. Physical restrictions. Employees should have access to only those assets necessary to perform their jobs. Locks and alarms are examples of ways to protect valuable tangible assets, including petty cash, inventory and equipment. But intangible assets — such as customer lists, lease agreements, patents and financial data — also require protection using passwords, access logs and appropriate legal paperwork.

2. Account reconciliation. Management should confirm and analyze account balances on a regular basis. For example, management should reconcile bank statements and count inventory regularly.

Interim financial reports, such as weekly operating scorecards and quarterly financial statements, also keep management informed. But reports are useful only if management finds time to analyze them and investigate anomalies. Supervisory review takes on many forms, including observation, test counts, inquiry and task replication.

3. Job descriptions. Another basic control is detailed job descriptions. Company policies also should call for job segregation, job duplication and mandatory vacations. For example, the person who receives customer payments should not also approve write-offs (job segregation). And two signatures should be required for checks above a prescribed dollar amount (job duplication).

Controls assessment

Is your company’s internal control system strong enough? Even if you’re not required to follow the SEC’s rules on assessing internal controls, a thorough system of checks and balances will help your company achieve its goals. Company insiders sometimes lack the experience or objectivity to assess internal controls. But our auditors have seen the best — and worst — internal control systems and can help evaluate whether your controls are effective.

Contact us for more information.

©2017

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3 Financial Statements You Should Know

Successful business people have a solid understanding of the three financial statements prepared under U.S. Generally Accepted Accounting Principles (GAAP). A complete set of financial statements helps stakeholders — including managers, investors and lenders — evaluate a company’s financial condition and results. Here’s an overview of each report.

1. Income statement

The income statement (also known as the profit and loss statement) shows sales, expenses and the income earned after expenses 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.

2. Balance sheet

This report tallies the company’s assets, liabilities and net worth to create a snapshot of its financial health. 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.

Net worth or owners’ equity is the extent to which the book value of assets exceeds liabilities. Because the balance sheet must balance, assets must equal liabilities plus net worth. If the value of your liabilities exceeds the value of the assets, your net worth will be negative.

Public companies may provide the details of shareholders’ 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

This statement shows all the cash flowing into 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.

Although this report may seem similar to an income statement, it focuses solely on cash. It’s possible for an otherwise profitable business to suffer from cash flow shortages, especially if it’s growing quickly.

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. To remain in business, companies must continually generate cash to pay creditors, vendors and employees. So watch your statement of cash flows closely.

Ratios and trends

Are you monitoring ratios and trends from your financial statements? Owners and managers who pay regular attention to these three key reports stand a better chance of catching potential trouble before it gets out of hand and pivoting, when needed, to maximize the company’s value.

Contact us for more information.

©2017

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Don’t Make Hunches – Crunch the Numbers

 

Some business owners make major decisions by relying on gut instinct. But investments made on a “hunch” often fall short of management’s expectations.

In the broadest sense, you’re really trying to answer a simple question: If my company buys a given asset, will the asset’s benefits be greater than its cost? The good news is that there are ways — using financial metrics — to obtain an answer.

Accounting payback

Perhaps the most common and basic way to evaluate investment decisions is with a calculation called “accounting payback.” For example, a piece of equipment that costs $100,000 and generates an additional gross margin of $25,000 per year has an accounting payback period of four years ($100,000 divided by $25,000).

But this oversimplified metric ignores a key ingredient in the decision-making process: the time value of money. And accounting payback can be harder to calculate when cash flows vary over time.

Better metrics

Discounted cash flow metrics solve these shortcomings. These are often applied by business appraisers. But they can help you evaluate investment decisions as well. Examples include:

Net present value (NPV). This measures how much value a capital investment adds to the business. To estimate NPV, a financial expert forecasts how much cash inflow and outflow an asset will generate over time. Then he or she discounts each period’s expected net cash flows to its current market value, using the company’s cost of capital or a rate commensurate with the asset’s risk. In general, assets that generate an NPV greater than zero are worth pursuing.

Internal rate of return (IRR). Here an expert estimates a single rate of return that summarizes the investment opportunity. Most companies have a predetermined “hurdle rate” that an investment must exceed to justify pursuing it. Often the hurdle rate equals the company’s overall cost of capital — but not always.

A mathematical approach

Like most companies, yours probably has limited funds and can’t pursue every investment opportunity that comes along. Using metrics improves the chances that you’ll not only make the right decisions, but that other stakeholders will buy into the move. Please contact our firm for help crunching the numbers and managing the decision-making process.

©2017

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Few Changes to Retirement Plan Contribution Limits for 2017

Retirement plan contribution limits are indexed for inflation, but with inflation remaining low, most of the limits remain unchanged for 2017. The only limit that has increased from the 2016 level is for contributions to defined contribution plans, which has gone up by $1,000.

Type of limit
2017 limit
Elective deferrals to 401(k), 403(b), 457(b)(2) and 457(c)(1) plans
$18,000
Contributions to defined contribution plans
$54,000
Contributions to SIMPLEs
$12,500
Contributions to IRAs
$5,500
Catch-up contributions to 401(k), 403(b), 457(b)(2) and 457(c)(1) plans
$6,000
Catch-up contributions to SIMPLEs
$3,000
Catch-up contributions to IRAs
$1,000

Nevertheless, if you’re not already maxing out your contributions, you still have an opportunity to save more in 2017. And if you turn age 50 in 2017, you can begin to take advantage of catch-up contributions.

However, keep in mind that additional factors may affect how much you’re allowed to contribute (or how much your employer can contribute on your behalf). For example, income-based limits may reduce or eliminate your ability to make Roth IRA contributions or to make deductible traditional IRA contributions. If you have questions about how much you can contribute to tax-advantaged retirement plans in 2017, check with us.

 

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Employee, Partner or Both? Recent Developments Help You Decide

Are you an employee, a partner, a partner who doesn’t know it — or a combination of these classifications? The answer can have serious tax implications. If you participate in a business that’s operated as a partnership or a limited liability company, here are some recent developments that you need to know.

IRS Position on Dual Status

Longstanding IRS guidance in Revenue Ruling 69-184 states that a partner can’t also be an employee of the same partnership. taxrulescourtwpHowever, this policy has recently come into question. Some tax experts have been prodding the IRS to allow dual employee/partner status in certain circumstances.

For example, it can be argued that dual status is appropriate when an employee of a partnership receives a small interest in the partnership as equity-oriented compensation. Continued status as an employee would allow the individual to continue to participate in tax-favored employee benefit programs sponsored by the partnership.

In a recently issued temporary regulation, the IRS stated that, until further notice, there’s no exception to the Revenue Ruling 69-184 stipulation that a partner in a partnership can’t also be an employee of the same partnership. So, for now, once an employee of a partnership receives an ownership interest in the partnership, that individual is treated as a partner — regardless of how small the partnership interest may be.

However, the IRS says it might consider changing this stance if it can be shown that allowing dual employee/partner status in certain cases is desirable and wouldn’t lead to abuse of tax rules.

Important note: These considerations apply equally to multimember LLCs that are treated as partnerships for tax purposes and their employees and members.

IRS Position on Partners in Partnerships that Own Disregarded SMLLCs

In a recently issued temporary regulation, the IRS clarified the federal employment tax treatment of partners in a partnership that also owns a disregarded single-member (one-owner) LLC (SMLLC). A disregarded SMLLC is generally ignored for federal tax purposes. So, a disregarded SMLLC that’s owned by a partnership is simply treated as an unincorporated branch or division of the partnership, and all of the SMLLC’s tax items are included in the partnership’s tax return.

The new temporary regulation says that partners in the parent partnership can’t also be treated as employees of the disregarded SMLLC. Therefore, these individuals may be subject to self-employment tax on income passed through from the disregarded entity and they’re prohibited from participating in certain tax-favored employee benefit programs sponsored by the disregarded SMLLC. The new temporary regulation is effective as of the later of:

  • August 1, 2016, or
  • The first day of the latest-starting plan year following May 4, 2016, of an affected employee benefit plan.

An affected plan would include any employee benefit plan sponsored by the disregarded SMLLC that was adopted before and in effect as of May 4, 2016.

Important note: These considerations apply equally when a disregarded SMLLC is owned by a multimember LLC that is treated as a partnership for tax purposes.

Appeals Court Ruling on Oil and Gas Working Interest Income

The self employment (SE) tax is the government’s way of collecting Social Security and Medicare taxes on net income from self employment. What you may not know is that profits from passive investments in oil and gas working interests are subject to SE tax, according to a Tax Court decision that was recently affirmed by the 10th Circuit Court of Appeals. (Methvin v. Commissioner, 117 AFTR 2d 2016-2231, June 24, 2016.)

The taxpayer in this case owned small percentage working interests in several oil and gas properties. Owning a working interest entitles you to a percentage share of the net profits, if any, from an oil and gas property. The taxpayer had an agreement with the operator of the properties that allocated the taxpayer a share of the revenue and expenses from the properties. He had no right to be involved in the management or operation of the properties, and he had no expertise in oil and gas drilling or extraction. (His background was as a computer company executive.)

The taxpayer’s working interests represented no more than about a 2% to 3% interest in any single property, and they weren’t part of any formal business organization — such as a partnership, limited partnership, LLC or corporation — that was registered under applicable state law. Instead, the working interests were governed by a purchase and operation agreement entered into by the taxpayer, other working interest owners and the operator/manager of the properties.

Despite these informal arrangements, the oil and gas ventures that the taxpayer was involved in constituted partnerships for federal income tax purposes. However, the parties involved in the ventures exercised their right to be excluded from the partnership tax rules found in the section of the Internal Revenue Code that applies specifically to partnerships.

Consequently, there wasn’t a requirement to file annual partnership returns for the ventures. Instead, the operator provided the taxpayer with annual accounting summaries that showed the revenues and expenses allocated to the taxpayer’s working interests. The operator also issued an annual Form 1099-MISC to the taxpayer that showed his share of the net revenues from his working interests.

While the taxpayer reported the net revenue on his federal income tax returns, he didn’t pay any SE tax on the net revenue. After auditing his 2011 return, the IRS claimed that the taxpayer’s net profits from the oil and gas working interests were subject to SE tax because they constituted income from a business carried on by a partnership.

The taxpayer contended that he wasn’t engaged in the oil and gas business and wasn’t a partner in any oil and gas partnership. He argued that his minority working interests were merely investments in which he had no active involvement. Therefore, the taxpayer believed he didn’t owe SE tax on his working interest income, and he took his case to the U.S. Tax Court.

Court Decisions

The Tax Court noted that taxpayers who aren’t personally active in the management or operation of a business may nevertheless be liable for SE tax on their share of net SE income from the business if the business is carried on by a partnership in which the taxpayer is a member. In this case, the taxpayer and other parties involved in the oil and gas ventures elected out of the partnership federal income tax provisions. However, the election out applied only to tax provisions that are included in Subchapter K of the Internal Revenue Code (such as the requirement to file an annual partnership return on Form 1065). The SE tax provisions are not found in Subchapter K.

Therefore, the Tax Court ruled that the oil and gas ventures were still considered partnerships for SE tax purposes and that the taxpayer owed SE tax on his net income from his working interests.

On appeal, the 10th Circuit agreed, affirming that those working interests should be treated as partnership interests and that the profits from the investments were subject to SE tax.

Bottom Line

Business arrangements, including employment and compensation arrangements, can have surprising (and sometimes costly) tax consequences. For that reason, seeking advice from a tax professional before entering into arrangements is a smart idea. That way, there won’t be unpleasant surprises, and better tax results can often be achieved with some advance planning.

Contact us for advice.

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Putting Your Home on the Market? Understand the Tax Consequences of a Sale

As the school year draws to a close and the days lengthen, you may be one of the many homeowners who are getting ready to put their home on the market. After all, in many locales, summer is the best time of year to sell a home. But it’s important to think not only about the potential profit (or loss) from a sale, but also about the tax consequences.

Gains

If you’re selling your principal residence, you can exclude up to $250,000 ($500,000 for joint filers) of gain — as long as you meet certain tests. Gain that qualifies for exclusion also is excluded from the 3.8% net investment income tax.

To support an accurate tax basis, be sure to maintain thorough records, including information on your original cost and subsequent improvements, reduced by any casualty losses and depreciation claimed based on business use. Keep in mind that gain that’s allocable to a period of “nonqualified” use generally isn’t excludable.

Losses

A loss on the sale of your principal residence generally isn’t deductible. But if part of your home is rented out or used exclusively for your business, the loss attributable to that portion may be deductible.

Second homes

If you’re selling a second home, be aware that it won’t be eligible for the gain exclusion. But if it qualifies as a rental property, it can be considered a business asset, and you may be able to defer tax on any gains through an installment sale or a Section 1031 exchange. Or you may be able to deduct a loss.

Learn more

If you’re considering putting your home on the market, please contact us to learn more about the potential tax consequences of a sale.

 

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Tax Treatment of NQSOs Differs from That of Their Better-Known Counterpart

With nonqualified stock options (NQSOs), if the stock appreciates beyond your exercise price, you can buy shares at a price below what they’re trading for. This is the same as for the perhaps better-known incentive stock options (ISOs).

The tax treatment of NQSOs, however, differs from that of ISOs: NQSOs create compensation income — taxed at ordinary-income rates — on the “bargain element” (the difference between the stock’s fair market value and the exercise price) when exercised. This is regardless of whether the stock is held or sold immediately. Also, NQSO exercises don’t create an alternative minimum tax (AMT) preference item that can trigger AMT liability.

When you exercise NQSOs, you may need to make estimated tax payments or increase withholding to fully cover the tax. Keep in mind that an exercise could trigger or increase exposure to top tax rates, the additional 0.9% Medicare tax and the 3.8% net investment income tax.

Have tax questions about NQSOs or other stock-based compensation? Let us know — we’d be happy to answer them.

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Tax Impact of the Supreme Court’s Same-Sex Marriage Decision

On June 26, the U.S. Supreme Court ruled that same-sex couples have a constitutional right to marry, making same-sex marriage legal in all 50 states. For federal tax purposes, same-sex married couples were already considered married, under the Court’s 2013 decision in United States v. Windsor and subsequent IRS guidance — even if their state of residence didn’t recognize their marriage.

From a tax planning perspective, the latest ruling means that, in states where same-sex marriage hadn’t been recognized, same-sex married couples no longer will need to deal with the complications of being treated as married for federal tax purposes but not married for state tax purposes. So their tax and estate planning will be simplified and they can take advantage of state-level tax benefits for married couples. But in some cases, these couples will also be subject to some tax burdens, such as the “marriage penalty.”

Same-sex married couples should review their tax planning strategies and estate plans to determine what new opportunities may be available to them and whether there are any new burdens they should plan for. Employers will need to keep a close eye on how these developments will affect their tax obligations in relation to employees who have same-sex spouses. Please contact us if you have questions.

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