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Good News from the IRS for S-Corp Shareholders!

 

Bona fide indebtedness determination lowers hurdle to obtain debt basis.

S Corp ShareholdersFor S corporation shareholders, borrowing from one company they own to fund another is a common way to inject some cash into a growing business—especially in these days of conservative lending. But previously, if the funded company experienced losses and you wanted to take deductions for those losses on your personal tax returns, you had to meet a high bar to prove that loan increased your debt basis in the company.

As a result of the previous position of the IRS and tax courts, shareholders who borrowed from one related entity in order to loan to another had a particularly hard time defending their debt basis. But thanks to final rules from the IRS, that bar has been lowered and S corporation shareholders are now more likely to qualify for tax deductions for entity losses that have been passed through to them.

Bona Fide Indebtedness Determination

On July 23, the IRS issued final regulations on debt basis determinations for S corporation shareholders (T.D. 9682). These final rules implement a “bona fide” debt basis determination as opposed to the controversial “economic outlay” doctrine that has been developed by the courts over the last several years. 

Under the economic outlay doctrine, in order to obtain debt basis an S corporation shareholder must incur a true economic outlay through a transaction, which when fully consummated, left the taxpayer poorer in a material sense.

On the other hand, bona fide indebtedness is determined under general Federal tax principles and depends on all the facts and circumstances. Basically, a bona fide debt is one that creates a true debtor-creditor relationship that is based on a valid and enforceable obligation to pay a fixed or determinable amount of money. This means that shareholders who structure and document their loans to an S Corporation in the correct way can now qualify for debt basis in that S corporation, and as a result, can claim current tax deductions for their share of any losses that S corporation experiences.

This is a win for both the shareholder and the company.  The shareholder has potential for additional deductions and the company gets a cash infusion that has potential tax minimizing opportunities for the shareholder.

Back-to-Back Opportunity

Previously, the IRS and tax court often used the economic outlay doctrine to deny debt basis to shareholders for funds borrowed from a related entity and then loaned to the S corporation by the shareholder. These transactions are often referred to as back-to-back loans. The reasoning was that, by borrowing from Peter to pay Paul, the shareholder was not considered to be making a true economic outlay.

But with the new debt basis rules, shareholders who structure and document their back-to-back loans to qualify as bona fide indebtedness (see below) are more likely to obtain debt basis—and claim tax deductions—as result of those loans.

The Look-Back Opportunity

While the final debt basis rules were issued with minimal changes to the proposed regulations, one significant highlight is that the final rules did expand their application to open tax years.

What does this mean for you? In addition to the potential tax benefits of restructuring related entity loans going forward, shareholders who have made back-to-back loans in any open tax year and didn’t increase their debt basis now have the opportunity to go back and claim deductions for any previously disallowed losses—if they can demonstrate there was bona fide indebtedness.

Determining Bona Fide Indebtedness

While there is no bright-line test to prove that a debt is bona fide, the key is to demonstrate that there is a true debtor-creditor relationship. Based on federal tax principles, the following steps can help support the determination of bona fide indebtedness:

  1. Make sure there is documentary evidence of the transaction (i.e. a written loan agreement).
  2. Both parties should reflect the transaction as a loan in their records.
  3. Setup a fixed repayment schedule and make efforts to follow the schedule in order to create a history of regular repayments.
  4. The loan should require interest and the rate should be at least as much as the Applicable Federal Rate (AFR).
  5. Consider collateral to secure the debt.
  6. A demand for repayment should be issued if necessary.
  7. There needs to be intent to create a valid debtor-creditor relationship and the lender must have an expectation of receiving repayment at the time of the loan.

Review S Corporation Financing Strategy

If you are a shareholder in one or more S corporations, work with your tax advisor to review any existing or prospective loans for the opportunity to demonstrate bona fide indebtedness—and therefore obtain debt basis to claim current tax deductions for any entity losses in the future and/or any suspended losses in open tax years.

Going forward, you and your CPA might find that funding S corporations with properly structured back-to-back loans provides a tax-advantaged way to finance a new venture with funds from a more established company.

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Samuel C. DiSalvo to Speak at the Knowledge Group’s ASC 740

 

New York, NY, May 17, 2014 --(PR.com)-- The Knowledge Group/The Knowledge Congress Live Webcast Series, the leading producer of regulatory focused webcasts, has announced today that Samuel C. DiSalvo, Tax Director, Freed Maxick CPAs, P.C. will speak at the Knowledge Group’s webcast entitled: “ASC 740: Income Tax Accounting for 2014.” This event is scheduled for October 16, 2014 from 12:00pm – 2:00pm (ET).

For further details, please visit: http://theknowledgegroup.org/event_name/asc-740-income-tax-accounting-for-2014-live-webcast

About Samuel C. DiSalvo
Samuel C. DiSalvo is a Director with Freed Maxick’s Tax Practice. Prior to joining the Firm, Sam spent over 25 years in the accounting profession with both Big Four firms and private industry. During this time, he gained significant experience with mergers and acquisitions, corporate taxes and compliance, and financial statement tax accounting.

Sam is responsible for providing day-to-day tax advisory services, coordinating, and supervising the preparation of the corporate income tax returns, and reviewing the annual and quarterly provisions for income taxes for both publicly held and privately held corporations. Sam concentrates his practice on joint venture tax matters, merger and acquisition issues, and corporate taxes as well as ASC 740 issues such as purchase accounting, valuation allowances, and international issues. He also has significant experience in identifying tax opportunities in connection with the due diligence reviews of companies’ prior year tax returns.

About Freed Maxick CPAs, P.C.
Freed Maxick CPAs, P.C. is one of the largest accounting and consulting firms in Upstate New York and a Top 100 largest CPA firm in the United States. Serving SEC companies, closely held businesses, governmental and not-for-profit clients across New York as well as nationally and internationally, Freed Maxick mobilizes high-performance professionals to guide client growth, compliance, and innovation. They specialize in the healthcare, manufacturing, real estate, banking, agribusiness and private equity sectors and have more than 280 professional and administrative personnel, with offices in Buffalo, Batavia, Rochester and Syracuse, New York. Freed Maxick’s Tax Practice is the largest of any accounting firm in Upstate New York with over 110 personnel, including 12 tax directors. Freed has built a significant SEC Practice through years of experience in auditing a wide variety of companies and has extensive knowledge in handling public and private capital transactions.

Event Synopsis:
In this two-hour Live webcast, a panel of distinguished professionals and thought leaders will help Finance Executives, CPAs, Attorneys, Enrolled Agents, Tax Practitioners, and other related professionals understand the important aspects of this significant topic. They will provide an in-depth discussion of the significant issues related to tax accounting rules and latest developments in ASC 740. Speakers will also offer best practices in developing and
implementing an effective income tax accounting strategies.

Key topics include:

− An overview of ASC 740: Income tax accounting

− Review issues/considerations on significant areas including valuation allowances, business combinations and uncertain tax positions

− Guidelines and best practices

− Latest tax accounting and regulatory developments and a lot more.

About The Knowledge Group, LLC/The Knowledge Congress Live Webcast Series
The Knowledge Group, LLC was established with the mission to produce unbiased, objective, and educational live webinars that examine industry trends and regulatory changes from a variety of different perspectives. The goal is to deliver a unique multilevel analysis of an important issue affecting business in a highly focused format. To contact or register to an event, please visit: http://theknowledgegroup.org

 

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Are tax issues making dividing a CRT difficult?

 

As you know, dividing assets in divorce can be complicated. But, typically, charitable remainder trusts (also known as CRTs) are divided 50-50 into two separate trusts, in accordance with IRS Revenue Ruling 2008-41. But tax issues can make these divisions trickier than they might first appear.

How do you Spell Relief from Excise Tax?

charitable remainder trustsThere are two types of CRTs: 1) charitable remainder annuity trusts (CRATs) and 2) charitable remainder unitrusts (CRUTs). They are considered “split-interest trusts,” which means they generally are subject to Internal Revenue Code (IRC) Section 507(a) just as if they were private foundations. The provision levies a termination or excise tax when a private foundation’s tax status is terminated. But the question remains: Does transferring assets from a private foundation (or CRT) to another private foundation (or CRT) — as when divorce assets are split — trigger that tax?

According to Revenue Ruling 2008-41, if a transfer is pursuant to an “adjustment, organization or reorganization” that includes a significant disposition of assets, the transferee foundation isn’t treated as a newly created organization. Thus, the excise tax doesn’t apply. Significant disposition of assets encompasses the transfer of a total of 25% or more of the fair market value (FMV) of the net assets of the original private foundation to one or more private foundations. In the above scenario, 100% of a CRT’s FMV would be transferred. Therefore, no excise tax applies.

Defining Disqualified Persons

CRATs and CRUTs also are subject to IRC Sec. 4941(a)(1). It imposes an excise tax on each act of self-dealing between a private foundation and a disqualified person. Self-dealing may include any direct or indirect transfer of the assets or income of a private foundation to a disqualified person. It also includes use of such assets or income by — or for the benefit of — a disqualified person. Disqualified persons encompass (among other substantial contributors to the foundation) foundation managers, and members of the family of a substantial contributor or foundation manager.

Revenue Ruling 2008-41 states that divorcing spouses can be disqualified persons with respect to their original trust, which creates the potential for self-dealing. But it also concluded that spouse recipients are protected from self-dealing with respect to their interests upon the trust’s division. Because distributions are made pro rata, neither spouse will receive any additional interest in the original trust’s assets, the original trust’s remainder interest is preserved for charitable interests and no self-dealing transaction occurs.

Dividing Trusts

Typically, trusts which are properly divided during divorce will still qualify as CRTs — avoiding certain excise taxes. Make sure you and your clients work with experienced financial professionals when it’s time to handle these types of assets.

© 2014

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When Are Daubert Challenges Justified?

 

A district court strikes testimony in a patent case

Daubert ChallengesRecently, a district court judge noted that the overall percentage of successful Daubert challenges to damages in patent cases is “exceedingly small.” Yet, he went on to say that, “every once in a great while, a Daubert challenge to a patent damages expert is justified.” This judge found that to be the case in Dynetix Design Solutions, Inc. v. Synopsys, Inc., where the patent expert’s reasonable royalty testimony was neither tied to the facts nor reliable.

The ins and outs of the expert’s testimony

As you know, calculating a reasonable royalty is a two-step process. In the first step, an expert determines the revenue pool that’s implicated by the infringement (that is, the royalty base). Next, the expert determines the percentage of that pool adequate to compensate the plaintiff for that infringement (that is, the royalty rate).

In the Dynetix case, the plaintiff’s expert started by determining the royalty base. The patented feature was just one of numerous features in the defendant’s product. Nonetheless, the expert determined that the royalty base would be the entire sales of the product simply because the defendant hadn’t separately sold any smaller unit with the patented component. And he also didn’t further apportion the royalty base to account for nonpatented features.

As to the royalty rate, the expert divided the gross margin of the infringing product equally between the two parties. And then he applied the Georgia-Pacific factors for determining reasonable royalties in order to alter the rate. When focusing on the third and fourth factors (the nature and scope of the hypothetical license in terms of exclusivity and the licensor’s policy for maintaining its patent monopoly by limiting licensing), he then reduced the royalty rate to 19%.

After he made a couple more adjustments, the expert arrived at a royalty rate of 14.25%. He then applied that rate to the royalty base for the relevant time period, thus concluding that the reasonable royalty would be around $156 million. Because only one of the two components originally accused of infringement remained in the case, he then apportioned 75% of the royalty to the remaining component, which resulted in a royalty of some $117 million.

The court weighs in

The district court ultimately rejected the royalty base, finding that the expert had failed to apportion profits between the numerous noninfringing features in the defendant’s product and the patented feature. So, even though he was correct that the smallest salable infringing unit was the defendant’s entire product, he should not have ended his analysis there. Moreover, he needed to determine the infringing component’s value relative to the entire product’s other components. This failure to apportion justified the exclusion of his opinion.

But the court also rejected the royalty rate. It found that the expert’s analysis only compounded the problems with his opinion. Although half of the gross margin for the infringing profits may indeed have been “one reasonable starting point,” the law required the expert to customize the royalty rate to the specific facts of the case — including the particular industry, technology or party. And, as the court explained, “an arbitrary starting point is impermissible under Uniloc.”

The Federal Circuit in Uniloc rejected a “25% rule of thumb” profit margin for starting the royalty rate calculation. And the 50% starting place, the district court said, was even more arbitrary because the expert based it solely on his own judgment and experience, without even considering analogous licenses offered in the industry or the nature of the patented component as an optional and small feature in the product.

The court’s striking of the expert testimony wasn’t the end of the matter. The court then granted the plaintiff five days to submit a new expert report on the damages.

The bottom line

Many have questioned the “gatekeeper” role of courts in evaluating and admitting the reliability of expert testimony. But many courts still exclude testimony based on Daubert objections. It’s critical that attorneys keep on top of developments in this area and work with qualified experts who’re unlikely to face Daubert challenges.

Sidebar: Limits to the gatekeeper role

The Supreme Court’s decision in Daubert assigned district courts a type of “gatekeeper” role in admitting expert testimony and evaluating its reliability. A recent case, Manpower, Inc. v. Insurance Co. of the State of Pennsylvania, demonstrates that this role has limits.

The “Manpower” case involved a dispute over reimbursement for business interruption losses under an insurance policy. The insured’s forensic accounting expert expressed an opinion on the total loss, and the insurance company moved to exclude the testimony, saying it wasn’t the product of reliable methodology.

The district court found that the expert had, indeed, followed the insurance policy’s prescribed methodology for calculating losses. But the reliability of the expert’s calculations turned on whether he’d used reliable methods when he selected numbers for the projected total expenses and revenues. The court held that the method for projecting revenues was unreliable due to his estimated growth rate, so it excluded his testimony. The insured party then appealed.

The court of appeals acknowledged that district court judges have a lot of leeway when determining whether particular expert testimony is reliable. It pointed out, however, that a district court “usurps the role of the jury … if it unduly scrutinizes the quality of the expert’s data and conclusions rather than the reliability of the methodology.”

The appellate court determined that the district court’s concerns weren’t due to the reliability of the expert’s methodology, but the resulting conclusions. The district court then took issue with his selection of particular data. But the selection of data inputs to apply in a model is a question that’s separate from the reliability of the methodology reflected in the model itself.

The appellate court warned that it wasn’t saying that an expert can rely on data with no quantitative or qualitative connection to the methodology. Experts should use the type of data on which specialists in the field would reasonably rely.

© 2014

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Understanding Standards of Value

 

Lawyers aren’t expected to be valuation experts. That’s why they choose to hire professional appraisers when their clients need a company or business interest valued for tax, litigation or other purposes. But having a basic understanding of the various standards of value allows you to work more effectively with your expert — and better serve your client.

The ins and outs of FMV

fair market valueDid you know that the most widely recognized standard of value is fair market value (FMV)? It’s almost always used for valuing business interests for estate and gift tax purposes. The IRS defines FMV as “the price at which the property would change hands between a hypothetical buyer and seller who have reasonable knowledge of the relevant facts and are under no compulsion to enter into the transaction.”

Fair market value reflects the price at which a transaction would occur under the conditions that existed as of the valuation date. For many standard-setting bodies, FMV represents the highest and best use that the property could be put to on the valuation date, taking into account special uses realistically available. It doesn’t matter if the owner has actually chosen that use for the property.

Understanding “Fair Value”

According to the Financial Accounting Standards Board (otherwise known as FASB), fair value is the price it would take (in an orderly transaction between market participants) to transfer a liability or sell an asset in the market where the reporting entity would typically transact for the asset or liability.

The fair value standard is often applied for financial reporting purposes. But it’s also used in shareholder or divorce litigation, and is typically defined by state law in such cases. In many states, fair value for litigation involving dissenting shareholders is considered to be the pro rata share of a controlling level of value. So, control and/or marketability discounts generally aren’t applied.

Understanding Investment Value

Investment value (also known as “strategic value”) represents the value of an asset to a specific investor. For real estate purposes, it’s often defined as the value of an investment to a particular investor or class of investors based on their investment requirements. Value is determined by discounting an anticipated income stream while also considering potential benefits from synergies such as lower expenses or revenue enhancement.

Investment value varies from FMV for a couple of reasons, such as contrasting estimates of future income and different perceptions of risk. There may also be income status differences and synergies with other operations that are owned or controlled by the investor.

When it comes to shareholder litigation, investment value carries a different meaning, however. Here, investment value is based on earning power, but the appropriate capitalization rate or discount is typically a consensus rate that isn’t specific to any investor.

Understanding Intrinsic Value

Intrinsic value is usually employed when valuing an equity share to determine its “real worth.” Intrinsic value (also known as fundamental value) is calculated by looking at an asset’s primary value factors. Relevant factors include:

  • The value of the company’s physical assets,
  • Expected future earnings,
  • Expected dividends payable and future interest, and
  • Expected future growth rate.

It’s true: Defining intrinsic value can be rather tricky. Many appraisers use the term to refer to investment value, while others use it to describe the independent analysis of an investment analyst, banker or financial manager. Trouble is: Courts don’t always clearly define the term, either. So, appraisers are challenged to establish an upfront, clear definition with their clients and attorneys.

Understanding the options

So, with so many options to choose from, how do valuation experts decide which standard to apply when performing a business valuation? The appropriate standard is often determined by specific court orders, state or federal statute, or case or administrative law. Corporate documents, such as articles of incorporation or buy-sell agreements, also might dictate the applicable standard.

A valuator’s professional judgment factors into the decision, as well. For this reason, it’s important that you work with an experienced and qualified appraiser. It might just mean the difference between testimony that’s accepted in court or that which is rejected.

© 2014

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Ways That Financial Statements Can Reveal Corporate Fraud

 

At long last, the U.S. economy seems to be recovering from the effects of the recession. But at least one major financial risk remains — corporate fraud. The good news is: A fraud expert can help investors and companies minimize losses from fraudulent conduct by simply scrutinizing a business’s financial statements.

Fictitious finances

fraudCorporate fraud often is concealed when a business intentionally misrepresents material information in its financial reports. These misrepresentations may result from overly aggressive estimates of figures, the misapplication of accounting principles and material omissions. For instance, financial statements may conceal expenses or liabilities or report fictitious revenues in order to make a business appear more profitable than it really is.

In order to cover fraud, a perpetrator often conceals or omits information that can damage or improperly change the bottom-line results appearing in financial statements. Such omissions might include:

  • Liabilities such as loan covenants or contingency liabilities.
  • Significant events that are likely to affect future statements, such as potential lawsuits, impending product obsolescence and new competition.
  • Accounting changes that materially affect financial statements and are subject to disclosure rules, such as methods of accounting for depreciation, revenue recognition or accruals.

Perpetrators also might engage in fraudulent manipulation, particularly in the areas of revenues, reserves, expenses and one-time charges. A falsified financial statement can improperly value sales transactions (by, for example, inflating the per unit price), recognize sales prematurely or report phantom sales that never occurred. On the other hand, expenses can be manipulated by simply delaying their recognition — whether to match expenses with their corresponding revenue or to avoid reporting a loss. Another scheme is to improperly capitalize expenses so they appear on the business’s balance sheet rather than on its income statement.

In many cases, fraudulent financial statements may show reserves that have been calculated using bad-faith estimates. For instance, a fraudster can justify a smaller amount of reserves simply by underestimating the percentage of uncollectible receivables. One-time charges, such as a charge for research and development costs for a specific product, or a write-off of goodwill, can further distort financial statement figures and help hide fraudulent activity.

Unusual trends and relationships

When fraud is suspected, a CPA can examine complex financial statements and uncover manipulation that might not be apparent to the untrained eye. A fraud expert typically begins by reviewing suspicious statements for unusual trends and relationships. Any leads are then followed by more intensive forensic accounting work. This may include analysis of journal entries, specific transactions, work papers and supporting documentation — going far beyond a standard annual audit.

Moreover, a CPA may employ several types of analyses. For instance, a vertical analysis compares the proportion of every financial statement item — or groups of items — to a total within a single year that can be measured against industry norms. A horizontal analysis compares current data with data from prior years in order to detect patterns and trends. And a financial ratio analysis can calculate ratios from the current year’s data and then compare those with previous years’ ratios for the business, comparable companies and the relevant industry. Of course, the expert must have tremendous experience in the subject industry and be able to recognize any noncompliance with Generally Accepted Accounting Principles.

Noncompliance is a huge red flag for financial statement fraud. The Association of Certified Fraud Examiners (ACFE) has identified several behavioral red flags, including executives who exhibit a cavalier attitude toward internal controls, live beyond their means, have excessive organizational pressure to perform, and are unwilling to share duties or information with colleagues.

fraudFraud costs

The ACFE has estimated that the median loss in financial statement fraud schemes is around $1 million. But there are other damages as well, such as the public relations damage that rogue executives who manipulate the numbers can cause. A qualified CPA can help limit your clients’ losses by finding critical omissions and manipulations.

© 2014

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To Reduce the Risk of Lending, ABL’s Need to Scrutinize Audit Opinion Letters

 

Author: Robert Wood

Different types of opinions have different implications for understanding the issue of “going concerns”

ABL Audit OpinionsAccountants reconsider the “going concern” assumption each time they audit a financial statement. When the long-term viability of a borrower is in doubt, it may cause a CPA to issue a qualified audit opinion. And in a worst-case scenario, the accountant may withdraw from the job altogether.

Financial statements are typically prepared with an assumption that the company will remain a going concern. That is, the entity is expected to continue to meet its obligations in the ordinary course of business and generate a positive return on its assets.

Viability Concerns affecting Financial Statements

At times, auditors discover adverse events and conditions that can cast substantial doubt on a company’s ability to continue as a going concern over the next year.

Some possible red flags include:

  • Working capital deficiencies,
  • Loan defaults and debt restructurings,
  • Pending lawsuits and investigations,
  • Negative operating cash flow, and
  • Labor union conflicts and work stoppages.

When an auditor rejects the going concern assumption, he or she may adjust balance sheet values to liquidation values, instead of historic costs. Footnotes can also report going concern issues. Moreover, the auditor’s opinion letter (which serves as a cover letter to the financial statements) could be downgraded when uncertainties arise.

Understanding an Audit Opinion

An audit opinion can vary depending on available information, errors discovered during audit procedures, financial viability and other limiting factors. The cleanest and most desirable type of audit opinion is known as an “unqualified” one. With this type, the auditor states that the business’s financial condition, operations and position are fairly presented in the financial statements.

If there are any uncertainties regarding the going concern assumption, the auditor will likely issue a “qualified” opinion and disclose the nature of the uncertainties in the footnotes. An auditor may also choose to issue a qualified opinion if the financial statements seem to contain a small deviation from Generally Accepted Accounting Principles (GAAP), but they’re otherwise fairly presented — or if the borrower limits the scope of audit procedures.

But there are much less desirable opinions, known as “adverse opinions.” They indicate that there are material exceptions to GAAP that will affect the financial statements as a whole.

But by far the most alarming opinion is a disclaimer. It occurs when the auditor gives up mid-audit. Reasons for a disclaimer may include significant uncertainties and scope limitations within the subject company itself. Many lenders won’t accept financial statements that have this designation. In addition, lenders are likely to call the loan unless the borrower takes corrective action.

Unexpected change of auditors

Some auditors will pull the plug on long-term audit clients before they even start fieldwork if they believe there’s a need to issue a disclaimer or an adverse opinion. Sometimes the client replaces their auditors if they question long-term viability.

No matter who initiated the switch, a sudden, unexpected change of auditors could lead to going concern issues.

The future of going concern assessments

As of now, an auditor will assess a period of one year beyond the financial statement date when evaluating the going concern assumption. But last summer, the Financial Accounting Standards Board (FASB) proposed a rather controversial change to GAAP that would mandate more frequent going concern assessments and require a longer assessment period.

Under the proposal, a client’s footnotes would discuss when it’s “more likely than not” that a business won’t meet its obligations within a year without taking action outside the normal course of business — or if it’s “known or probable” that it won’t meet these obligations within two years.

Over the last five years, businesses, regulators, auditors and other stakeholders have tried to determine how to reduce diversity in financial reporting about going concern issues. A final amendment to these rules isn’t expected until FASB can work out the problems in its latest proposal.

Monitoring viability

So, what’s the bottom line? Lenders should pay attention to audit opinion letters. The type of opinion expressed can have serious implications about your client’s ability to operate as a going concern. And downgraded opinions warrant your immediate attention.

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asset based lendingFreed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can  help you reduce the risk of lending or assist your clients with our business advisory, audit, fraud detection and prevention, and tax services.

For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.

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Corporate Tax Reform Update

 

On March 31, 2014, New York State enacted comprehensive corporate franchise tax reform with the passage of the 2014-2015 NY budget legislation. This legislation includes new rate structures, new rules for banks, changes the economic nexus rules, changes the rules on combined reporting, revises the net operating loss provisions, and changes sourcing of income and apportionment.  

The changes take effect over multiple years and this legislation will result in planning for the most advantageous entity structure for N.Y. State purposes for both existing and new businesses. 

Unfortunately, these changes will negatively impact utilization of non-refundable N.Y. State income tax credits by qualified NY manufacturers. 

Check out our educational alert, providing an overview of the corporate franchise tax reform. 

If you have additional questions, or need assistance with N.Y. State entity structuring to maximize utilization of tax incentives under the new corporate tax regime, CONTACT US today.

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3 Places Where Asset Based Lenders Can Hunt Down Borrower’s Hidden Risks and Liabilities

 

Author: Paul Muldoon

Beware of bloated assets, understated liabilities, and unrecorded items.

reducing the risk of lendingMany liabilities may be out of sight, but never out of a lender’s mind. For instance, a client’s balance sheet doesn’t list pending claims, contingent costs or underfunded accounts. A proactive lender will search for undisclosed risks in order to get a complete view of their borrowers’ financial health.

Beware of Bloated Assets

The search for risks and undisclosed liabilities begins with assets. For each asset, ask yourself what could cause the account to diminish. For instance:

  • Inventory may include damaged goods. 
  • Accounts receivable may include bad debts.
  • Some fixed assets may be broken or in desperate need of repairs and maintenance.

As you can imagine, such items compromise a client’s credit standing and affect its financial ratios just as much as unreported liabilities do.

Some problems may be uncovered simply by touring the business’s facilities or reviewing asset registers for slow-moving items. And benchmarking can help.

For instance, if a borrower’s receivables are growing faster than sales, it may be a sign of aging, uncollectible accounts. Or, if a client’s repairs and maintenance expense seems low when compared to historic levels or industry norms, it might signal neglected upkeep on assets, which can be a huge gamble over the long run.

Look for Understated Liabilities

Next take a look at the borrower’s liabilities on the balance sheet and ask if the amount reported for each item is complete and accurate. A business may try to understate its liabilities in order to appear stronger or to comply with its loan covenants.

For instance, borrowers may forget to accrue liabilities for vacation time or salaries. Some might even underreport payables by holding checks for weeks (or even months). This tactic preserves the checking account while giving a lender the impression that supplier invoices are actually being paid.

Other clients might hide bills in a drawer at year end in order to avoid recording the payable and the expense. This “scam” mismatches expenses and revenues, artificially enhances profits, and understates liabilities. Moreover, delayed payments can hurt the business’s credit score and even cause suppliers to restrict their credit terms.

Uncover unrecorded items

Make sure you investigate what isn’t showing up on the balance sheet. Examples include pending lawsuits, warranties, an IRS investigation or an underfunded pension. When available, look at the balance sheet footnotes. They may shed additional light on the extent and nature of these contingent liabilities.

These risks appear on the balance sheet only when they’re “more than likely” to be incurred and “reasonably estimable.” They are subjective standards. Some borrowers may claim that liabilities are too unpredictable or remote to warrant disclosure.

Lenders should also consider the goodwill (or badwill) that’s attributable to the company’s owners and top managers. For instance, certain “key” people may be so critical to the company’s success that their unexpected departures might expose the entity to financial hardship. On the other hand, people who are exceptionally tax averse, risk-seeking or unethical can put the company at risk for IRS inquiry, lawsuits, and insurance and warranty claims.

Work with a pro

If a business’s financial statements are audited, the auditor will automatically test for these hidden risks and liabilities. They also watch for any exaggerated asset balances. Keep in mind that compiled or reviewed statements aren’t subject to the same level of scrutiny.

For added assurance from any questionable borrowers, ask for an agreed-upon-procedures engagement that can target high-risk areas and anomalies. If a ratio analysis reveals unusual trends based on the client’s track record or industry benchmarks, you may want to meet with the borrower and its accountant in order to hunt for any hidden liabilities and risks.

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reducing the risk of lendingFreed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can help you reduce the risk of lending or assist your clients with our business advisory, audit, fraud detection and prevention, and tax services.

For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.

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Asset Based Lenders Need to Understand the New GAAP Exceptions

 

Author: John Costello

FASB releases new ASUs regarding alternate reporting methods but don’t worry – it’s good news for Asset Based Lenders!

For a number of years, small businesses and their accountants have complained about the growing complexity and costs of complying with Generally Accepted Accounting Principles (GAAP). That led the Financial Accounting Standards Board (FASB) to solicit feedback from private company lenders and other stakeholders about the usefulness of certain complex accounting rules.

Accounting standard updatesThe feedback showed that many lenders are disregarding complicated accounting measures — including the subsequent reporting of impairment losses, goodwill following business combinations, and simple interest rate swaps — when evaluating a business’s financial condition and operating performance.

In January 2014, FASB released a couple of Accounting Standards Updates (ASUs) that offer private companies some alternate reporting methods. It’s critical for lenders to understand the new GAAP exceptions, which will go into effect for most private businesses at the end of 2014. Early adoption is permitted, as well.

Reporting Goodwill After a Merger or Acquisition

The first GAAP exception for private businesses applies to those that report goodwill following an acquisition or a merger. According to FASB Accounting Standards Codification Topic 350, Intangibles Goodwill and Other, goodwill is “a residual asset calculated after recognizing other (tangible and intangible) assets and liabilities acquired in a business combination.”

But, put another way, goodwill is the portion of the purchase price that’s left over after a buyer allocates fair value to all identifiable liabilities and assets. Goodwill can actually be a valuable asset. It’s commonly associated with professional practices, but retailers, manufacturers and even contractors can possess certain elements of goodwill that are transferable in a business combination.

The fair value of goodwill can decrease over time, particularly if a deal doesn’t live up to the buyer’s expectations. So GAAP requires that companies test for impairment. This occurs when the carrying value of goodwill exceeds its fair value. Nonprofits and public companies must test for impairment at least annually. And if triggering events occur, impairment testing should be even more frequent. (See the sidebar “Watch out for triggering events.”)

ASU 2014-02, Intangibles — Goodwill and Other (Topic 350): Accounting for Goodwill, offers a different method for private companies that acquired goodwill in a business combination. Instead of testing for impairment each year, private companies can elect to amortize goodwill straight-line over 10 years (or fewer, if they can justify a shorter useful life). Private businesses still need to test for impairment whenever a triggering event occurs. But they must compute impairment at only the entity level.

So, here’s what lenders must know about the goodwill exception’s alternate method: Smaller numbers of private borrowers will incur impairment losses, because amortization will automatically lower the carrying value of any goodwill over time. Moreover, the alternate method also reduces the need for valuations and makes reporting more predictable.

Understand that, because impairment is tested at the entity level, strong business segments may temporarily hide any “underperforming” acquisitions. So if a private borrower reports impairment under the alternate method, you should take it seriously.

An Easier Method for Interest Rate Swaps

The second GAAP exception applies to normal interest rate swaps. Following the recent financial crisis, certain borrowers could get only variable rate loans. So, they used simple interest rate swaps to get the consistency of fixed-rate payments. However, this strategy inadvertently opened up a can of worms of complex, and costly, accounting requirements that many private businesses weren’t prepared to handle.

Under GAAP, swaps are usually considered derivatives that must be reported at fair value. ASU 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps — Simplified Hedge Accounting Approach, offers another method. It allows a private company to measure qualifying swaps at settlement value, rather than fair value. That means interest expense is pretty much the same as if the borrower had entered into a fixed-rate loan directly.

Private borrowers can choose the alternate method on a swap-by-swap basis. New and existing swaps alike may qualify for the simplified treatment.

FASB is hoping that the alternate method will make financial statements much easier to understand and a lot less costly to prepare for small businesses. And lenders can expect to see fewer confusing earnings fluctuations that used to result from changes in the fair value of borrowers’ simple interest rate swaps.

A Welcome Change

Certain accounting rules were originally drafted with public companies in mind. Small businesses tend to operate more simply, though, so FASB’s move to allow exceptions for private companies is highly lauded by many small companies and their constituents.

Even if there are no impairment losses recorded when a triggering event occurs, that event can still compromise debt service and disrupt operations. If you notice one or more of these events when monitoring your clients, ask about how management plans to mitigate its adverse effects.

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Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can help you reduce the risk of lending or assist your clients with our business advisory, audit, fraud detection and prevention, and tax services.

For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.

If you enjoyed this article, get more delivered right to your inbox by subscribing to our blog.

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