Assessing the S corp

The S corporation business structure offers many advantages, including limited liability for owners and no double taxation (at least at the federal level). But not all businesses are eligible – and, with the new 21% flat income tax rate that now applies to C corporations, S corps may not be quite as attractive as they once were.

Tax comparison

The primary reason for electing S status is the combination of the limited liability of a corporation and the ability to pass corporate income, losses, deductions and credits through to shareholders. In other words, S corps generally avoid double taxation of corporate income — once at the corporate level and again when distributed to the shareholder. Instead, S corp tax items pass through to the shareholders’ personal returns and the shareholders pay tax at their individual income tax rates.

But now that the C corp rate is only 21% and the top rate on qualified dividends remains at 20%, while the top individual rate is 37%, double taxation might be less of a concern. On the other hand, S corp owners may be able to take advantage of the new qualified business income (QBI) deduction, which can be equal to as much as 20% of QBI.

You have to run the numbers with your tax advisor, factoring in state taxes, too, to determine which structure will be the most tax efficient for you and your business.

S eligibility requirements

If S corp status makes tax sense for your business, you need to make sure you qualify – and stay qualified. To be eligible to elect to be an S corp or to convert to S status, your business must:

  • Be a domestic corporation and have only one class of stock,
  • Have no more than 100 shareholders, and
  • Have only “allowable” shareholders, including individuals, certain trusts and estates. Shareholders can’t include partnerships, corporations and nonresident alien shareholders.

In addition, certain businesses are ineligible, such as insurance companies.

Reasonable compensation

Another important consideration when electing S status is shareholder compensation. The IRS is on the lookout for S corps that pay shareholder-employees an unreasonably low salary to avoid paying Social Security and Medicare taxes and then make distributions that aren’t subject to payroll taxes.

Compensation paid to a shareholder should be reasonable considering what a nonowner would be paid for a comparable position. If a shareholder’s compensation doesn’t reflect the fair market value of the services he or she provides, the IRS may reclassify a portion of distributions as unpaid wages. The company will then owe payroll taxes, interest and penalties on the reclassified wages.

Pros and cons

S corp status isn’t the best option for every business. To ensure that you’ve considered all the pros and cons, contact us. Assessing the tax differences can be tricky — especially with the tax law changes going into effect this year.

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Choosing the right accounting method for tax purposes

The Tax Cuts and Jobs Act (TCJA — check out our download on this) liberalized the eligibility rules for using the cash method of accounting, making this method — which is simpler than the accrual method — available to more businesses. Now the IRS has provided procedures a small business taxpayer can use to obtain automatic consent to change its method of accounting under the TCJA. If you have the option to use either accounting method, it pays to consider whether switching methods would be beneficial.

Cash vs. accrual

Generally, cash-basis businesses recognize income when it’s received and deduct expenses when they’re paid. Accrual-basis businesses, on the other hand, recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.

In most cases, a business is permitted to use the cash method of accounting for tax purposes unless it’s:

1. Expressly prohibited from using the cash method, or
2. Expressly required to use the accrual method.

Cash method advantages

The cash method offers several advantages, including:

Simplicity. It’s easier and cheaper to implement and maintain.

Tax-planning flexibility. It offers greater flexibility to control the timing of income and deductible expenses. For example, it allows you to defer income to next year by delaying invoices or to shift deductions into this year by accelerating the payment of expenses. An accrual-basis business doesn’t enjoy this flexibility. For example, to defer income, delaying invoices wouldn’t be enough; the business would have to put off shipping products or performing services.

Cash flow benefits. Because income is taxed in the year it’s received, the cash method does a better job of ensuring that a business has the funds it needs to pay its tax bill.

Accrual method advantages

In some cases, the accrual method may offer tax advantages. For example, accrual-basis businesses may be able to use certain tax-planning strategies that aren’t available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first 2½ months of the following year and deferring income on certain advance payments.

The accrual method also does a better job of matching income and expenses, so it provides a more accurate picture of a business’s financial performance. That’s why it’s required under Generally Accepted Accounting Principles (GAAP).

If your business prepares GAAP-compliant financial statements, you can still use the cash method for tax purposes. But weigh the cost of maintaining two sets of books against the potential tax benefits.

Making a change

Keep in mind that cash and accrual are the two primary tax accounting methods, but they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.

If your business is eligible for more than one method, we can help you determine whether switching methods would make sense and can execute the change for you if appropriate.

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Contemplating compensation increases and pay for performance

As a business grows, one of many challenges it faces is identifying a competitive yet manageable compensation structure. After all, offer too little and you likely won’t have much success in hiring. Offer too much and you may compromise cash flow and profitability.

But the challenge doesn’t end there. Once you have a feasible compensation structure in place, your organization must then set its course for determining the best way for employees to progress through it. And this is when you must contemplate the nature and efficacy of linking pay to performance.

Issues in play

Some observers believe that companies shouldn’t use compensation to motivate employees because workers might stop focusing on quality of work and start focusing on money. Additionally, employees may feel that the merit — or “pay-for-performance” — model pits staff members against each other for the highest raises.

Thus, some businesses give uniform pay adjustments to everyone. In doing so, these companies hope to eliminate competition and ensure that all employees are working toward the same goal. But, if everyone gets the same raise, is there any motivation for employees to continually improve?

2 critical factors

Many businesses don’t think so and do use additional money to motivate employees, whether by bonuses, commissions or bigger raises. In its most basic form, a merit increase is the amount of additional compensation added to current base pay following an employee’s performance review. Two critical factors typically determine the increase:

1. The amount of money a company sets aside in its “merit” budget for performance-based increases — usually based on competitive market practice, and2. Employee performance as determined through a performance review process conducted by management.

Although pay-for-performance can achieve its original intent — recognizing employee performance and outstanding contributions to the company’s success — beware that your employees may perceive merit increases as an entitlement or even nothing more than an inflation adjustment. If they do, pay-for-performance may not be effective as a motivational tool.

Communication is the key

The ideal solution to both compensation structure and pay raises will vary based on factors such as the size of the business and typical compensation levels of its industry. Nonetheless, to avoid unintended ill effects of the pay-for-performance model, be sure to communicate clearly with employees. Be as specific as possible about what contributes to merit increases and ensure that your performance review process is transparent, interactive and understandable. Contact us to discuss this or other compensation-related issues further.

© 2018

Business deductions for meal, vehicle and travel expenses: Document, document, document


Meal, vehicle and travel expenses are common deductions for businesses. But if you don’t properly document these expenses, you could find your deductions denied by the IRS.

A critical requirement

Subject to various rules and limits, business meal (generally 50%), vehicle and travel expenses may be deductible, whether you pay for the expenses directly or reimburse employees for them. Deductibility depends on a variety of factors, but generally the expenses must be “ordinary and necessary” and directly related to the business.

Proper documentation, however, is one of the most critical requirements. And all too often, when the IRS scrutinizes these deductions, taxpayers don’t have the necessary documentation.

What you need to do

Following some simple steps can help ensure you have documentation that will pass muster with the IRS:

Keep receipts or similar documentation. You generally must have receipts, canceled checks or bills that show amounts and dates of business expenses. If you’re deducting vehicle expenses using the standard mileage rate (54.5 cents for 2018), log business miles driven.

Track business purposes. Be sure to record the business purpose of each expense. This is especially important if on the surface an expense could appear to be a personal one. If the business purpose of an expense is clear from the surrounding circumstances, the IRS might not require a written explanation — but it’s probably better to err on the side of caution and document the business purpose anyway.

Require employees to comply. If you reimburse employees for expenses, make sure they provide you with proper documentation. Also be aware that the reimbursements will be treated as taxable compensation to the employee (and subject to income tax and FICA withholding) unless you make them via an “accountable plan.”

Don’t re-create expense logs at year end or when you receive an IRS deficiency notice. Take a moment to record the details in a log or diary at the time of the event or soon after. The IRS considers timely kept records more reliable, plus it’s easier to track expenses as you go than try to re-create a log later. For expense reimbursements, require employees to submit monthly expense reports (which is also generally a requirement for an accountable plan).

Addressing uncertainty

You’ve probably heard that, under the Tax Cuts and Jobs Act, entertainment expenses are no longer deductible. There’s some debate as to whether this includes business meals with actual or prospective clients. Until there’s more certainty on that issue, it’s a good idea to document these expenses. That way you’ll have what you need to deduct them if Congress or the IRS provides clarification that these expenses are indeed still deductible.

For more information about what meal, vehicle and travel expenses are and aren’t deductible — and how to properly document deductible expenses — please contact us.

© 2018

Is your inventory getting the better of you?


On one level, every company’s inventory is a carefully curated collection of inanimate objects ready for sale. But, on another, it can be a confounding, slippery and unpredictable creature that can shrink too small or grow too big — despite your best efforts to keep it contained. If your inventory has been getting the better of you lately, don’t give up on showing it who’s boss.

Check your math

Getting the upper hand on inventory is essentially one part mathematics and another part strategic planning. You need to have accurate inventory counts as well as the controls in place to regulate quality and keep things moving.

As is true for so much in business, timing is everything. Companies need raw materials and key components in place before starting a production run, but they don’t want to bring them in too soon and suffer excess costs. The same holds true for finished products — you need enough on hand to fulfill sales without over- or understocking.

If you’re struggling in this area, re-evaluate your counting process. One alternative to consider is cycle counting. This process involves taking a weekly or monthly physical count of part of your warehoused inventory. These physical counts are then compared against the levels shown on your inventory management system.

The goal is to pinpoint as many inventory discrepancies as possible. By identifying the source of accuracy problems, you can figure out the best solutions. Of course, you can’t conduct cycle counting once and expect a cure-all. You’ll need to use it regularly.

Use technology

With all this data flying around, you need the right tools to gather, process and store it. So, investing in a good inventory software system (or upgrading the one you have) is key. As the saying goes, “garbage in, garbage out” — imprecise information coming from your current system could be leading to all those write-offs, inflated costs, missed sales and lost profits.

As always, you get what you pay for: Investing in a new software system and then paying ongoing maintenance fees (which are usually recommended to keep it running smoothly) could seem like a bitter pill to swallow. But, in the long run, strong inventory management can pay for itself.

Another way to use technology for inventory purposes is as a communication tool. Knowing which products are hot and which are not will go a long way toward developing correct purchasing and stocking levels. Consider using online surveys, email contests and even social networking (such as a Facebook page) to keep in touch with customers and gather this info.

Show some tough love

In an ideal world, every company’s inventory would be its best friend. But don’t be surprised if you have to regularly show yours some tough love to keep it from making a mess of your bottom line. Let us help you identify the best metrics and methods for managing your inventory.

© 2018

Does your business have to begin collecting sales tax on all out-of-state online sales?


You’ve probably heard about the recent U.S. Supreme Court decision allowing state and local governments to impose sales taxes on more out-of-state online sales. The ruling in South Dakota v. Wayfair, Inc. is welcome news for brick-and-mortar retailers, who felt previous rulings gave an unfair advantage to their online competitors. And state and local governments are pleased to potentially be able to collect more sales tax.

But for businesses with out-of-state online sales that haven’t had to collect sales tax from out-of-state customers in the past, the decision brings many questions and concerns.

What the requirements used to be

Even before Wayfair, a state could require an out-of-state business to collect sales tax from its residents on online sales if the business had a “substantial nexus” — or connection — with the state. The nexus requirement is part of the Commerce Clause of the U.S. Constitution.

Previous Supreme Court rulings had found that a physical presence in a state (such as retail outlets, employees or property) was necessary to establish substantial nexus. As a result, some online retailers have already been collecting tax from out-of-state customers, while others have not had to.

What has changed

In Wayfair, South Dakota had enacted a law requiring out-of-state retailers that made at least 200 sales or sales totaling at least $100,000 in the state to collect and remit sales tax. The Supreme Court found that the physical presence rule is “unsound and incorrect,” and that the South Dakota tax satisfies the substantial nexus requirement.

The Court said that the physical presence rule puts businesses with a physical presence at a competitive disadvantage compared with remote sellers that needn’t charge customers for taxes.

In addition, the Court found that the physical presence rule treats sellers differently for arbitrary reasons. A business with a few items of inventory in a small warehouse in a state is subject to sales tax on all of its sales in the state, while a business with a pervasive online presence but no physical presence isn’t subject to the same tax for the sales of the same items.

What the decision means

Wayfair doesn’t necessarily mean that you must immediately begin collecting sales tax on online sales to all of your out-of-state customers. You’ll be required to collect such taxes only if the particular state requires it. Some states already have laws on the books similar to South Dakota’s, but many states will need to revise or enact legislation.

Also keep in mind that the substantial nexus requirement isn’t the only principle in the Commerce Clause doctrine that can invalidate a state tax. The others weren’t argued in Wayfair, but the Court observed that South Dakota’s tax system included several features that seem designed to prevent discrimination against or undue burdens on interstate commerce, such as a prohibition against retroactive application and a safe harbor for taxpayers who do only limited business in the state.

Please contact us with any questions you have about sales tax collection requirements.

© 2018

Choosing the best business entity structure post-TCJA


For tax years beginning in 2018 and beyond, the Tax Cuts and Jobs Act (TCJA) created a flat 21% federal income tax rate for C corporations. Under prior law, C corporations were taxed at rates as high as 35%. The TCJA also reduced individual income tax rates, which apply to sole proprietorships and pass-through entities, including partnerships, S corporations, and, typically, limited liability companies (LLCs). The top rate, however, dropped only slightly, from 39.6% to 37%.

On the surface, that may make choosing C corporation structure seem like a no-brainer. But there are many other considerations involved.

Conventional wisdom

Under prior tax law, conventional wisdom was that most small businesses should be set up as sole proprietorships or pass-through entities to avoid the double taxation of C corporations: A C corporation pays entity-level income tax and then shareholders pay tax on dividends — and on capital gains when they sell the stock. For pass-through entities, there’s no federal income tax at the entity level.

Although C corporations are still potentially subject to double taxation under the TCJA, their new 21% tax rate helps make up for it. This issue is further complicated, however, by another provision of the TCJA that allows noncorporate owners of pass-through entities to take a deduction equal to as much as 20% of qualified business income (QBI), subject to various limits. But, unless Congress extends it, the break is available only for tax years beginning in 2018 through 2025.

There’s no one-size-fits-all answer when deciding how to structure a business. The best choice depends on your business’s unique situation and your situation as an owner.

3 common scenarios

Here are three common scenarios and the entity-choice implications:

1. Business generates tax losses. For a business that consistently generates losses, there’s no tax advantage to operating as a C corporation. Losses from C corporations can’t be deducted by their owners. A pass-through entity will generally make more sense because losses pass through to the owners’ personal tax returns.

2. Business distributes all profits to owners. For a profitable business that pays out all income to the owners, operating as a pass-through entity generally will be better if significant QBI deductions are available. If not, it’s probably a toss-up in terms of tax liability.

3. Business retains all profits to finance growth. For a business that’s profitable but holds on to its profits to fund future growth strategies, operating as a C corporation generally will be advantageous if the corporation is a qualified small business (QSB). Why? A 100% gain exclusion may be available for QSB stock sale gains. If QSB status is unavailable, operating as a C corporation is still probably preferred — unless significant QBI deductions would be available at the owner level.

Many considerations

These are only some of the issues to consider when making the C corporation vs. pass-through entity choice. We can help you evaluate your options.

© 2018

Run the numbers before you extend customer credit


Funny thing about customers: They can keep you in business — but they can also put you out of it. The latter circumstance often arises when a company overly relies on a few customers that abuse their credit to the point where the company’s cash flow is dramatically impacted.

To guard against this, you need to diligently assess every customer’s creditworthiness before getting too deeply involved. And this includes running the numbers on entities you do business with, just as lenders and investors do with you.

Information, please

A first step is to ask new customers to complete a credit application. The application should request the company’s:

• Name, address, phone number and website address,
• Tax identification number,
• General history (number of years in existence),
• Legal entity type and parent company (if one exists), and
• A bank reference and several trade references.

Depending on which industry or industries you serve, there may be other important data points to gather, as well. If you haven’t updated your credit application form in a while, consider doing so — especially if you’ve gotten burned on the same type of credit failure multiple times.

Financial data

When dealing with private companies, consider asking for an income statement and balance sheet. You’ll want to analyze financial data such as profit margin, or net income divided by net sales. Ideally, this will have remained steady or increased during the past few years. The profit margin also should be like those of other companies in the customer’s industry.

From the balance sheet, you can calculate the current ratio, or the customer’s current assets divided by its current liabilities. The higher this is, the more likely the customer will be able to cover its bills. Generally, a current ratio of 2:1 is considered acceptable. Again, there may be other metrics that are particularly important for the types of businesses you work with.

An evolving challenge

Reviewing financials is only one key step in determining whether a customer is creditworthy. It’s also important to contact the references the customer provided, and you may want to purchase a credit report. Finally, be sure to look at coverage of the customer both by traditional media and on social media. Doing so could reveal information that will impact your decision on whether to extend credit.

When competing to win and keep customers, it’s easy to get carried away with credit. Approach this task carefully and bear in mind that, for most businesses, extending customer credit is a learning process and an evolving challenge. For further help and info on assessing customers’ creditworthiness, please contact our firm.

©2018

What businesses need to know about the tax treatment of bitcoin and other virtual currencies


Over the last several years, virtual currency has become increasingly popular. Bitcoin is the most widely recognized form of virtual currency, also commonly referred to as digital, electronic or crypto currency.

While most smaller businesses aren’t yet accepting bitcoin or other virtual currency payments from their customers, more and more larger businesses are. And the trend may trickle down to smaller businesses. Businesses also can pay employees or independent contractors with virtual currency. But what are the tax consequences of these transactions?

Bitcoin 101

Bitcoin has an equivalent value in real currency and can be digitally traded between users. It also can be purchased with real currencies or exchanged for real currencies. Bitcoin is most commonly obtained through virtual currency ATMs or online exchanges.

Goods or services can be paid for using “bitcoin wallet” software. When a purchase is made, the software digitally posts the transaction to a global public ledger. This prevents the same unit of virtual currency from being used multiple times.

Tax impact

Questions about the tax impact of virtual currency abound. And the IRS has yet to offer much guidance.

The IRS did establish in a 2014 ruling that bitcoin and other convertible virtual currency should be treated as property, not currency, for federal income tax purposes. This means that businesses accepting bitcoin payments for goods and services must report gross income based on the fair market value of the virtual currency when it was received, measured in equivalent U.S. dollars.

When a business uses virtual currency to pay wages, the wages are taxable to the employees to the extent any other wage payment would be. You must, for example, report such wages on your employees’ W-2 forms. And they’re subject to federal income tax withholding and payroll taxes, based on the fair market value of the virtual currency on the date received by the employee.

When a business uses virtual currency to pay independent contractors or other service providers, those payments are also taxable to the recipient. The self-employment tax rules generally apply, based on the fair market value of the virtual currency on the date received. Payers generally must issue 1099-MISC forms to recipients.

Finally, payments made with virtual currency are subject to information reporting to the same extent as any other payment made in property.

Deciding whether to go virtual

Accepting bitcoin can be beneficial because it may avoid transaction fees charged by credit card companies and online payment providers (such as PayPal) and attract customers who want to use virtual currency. But the IRS is targeting virtual currency transactions in an effort to raise tax revenue, and it hasn’t issued much guidance on the tax treatment or reporting requirements. So bitcoin can also be a bit risky from a tax perspective.

To learn more about tax considerations when deciding whether your business should accept bitcoin or other virtual currencies — or use them to pay employees, independent contractors or other service providers — contact us.

© 2018

4 ways to encourage innovation in customer service


When business people speak of innovation, the focus is usually on a pioneering product or state-of-the-art service that will “revolutionize the industry.” But innovation can apply to any aspect of your company — including customer service.

Many business owners perceive customer service as a fairly cut-and-dried affair. Customers call, you answer their questions or solve their problems ― and life goes on. Yet there are ways to transform this function and, when companies do, word gets around. People want to do business with organizations that are easy to interact with.

Here are four ways to encourage innovation in your customer service department:

1. Welcome failure. Providing world-class customer service involves risk, and inevitably you’ll sometimes fail. For example, many businesses have jumped at the chance to use “big data” to develop automated systems to direct customers to answers and solutions. But the impersonality of these systems can frustrate the buying public until you establish the right balance of machine and human interaction. Remember, every failure opens the door to better strategies for serving your customers.

2. Link compensation to employees’ contributions. Companies that fail to reward innovation aren’t likely to retain their best customers or establish a good reputation. Because customer service employees tend to be paid hourly or relatively nominal salaries, consider a cash bonus program for the “most innovative idea of the year.” Or you could hold semiannual or even quarterly innovation challenges with prizes such as gift cards or additional time off.

3. Praise the groundbreakers. Employees who challenge customer-service tradition may find themselves at odds with management. But don’t be too quick to reprimand those with new ideas or methods. Fresh language and modes of communication enter the public consciousness regularly. Give companywide recognition to those who find ways to adapt — even if their initial efforts bend the rules a bit.

4. Be the customer. Among the most simple and practical ways to innovate your customer service is to simply pretend you’re a customer to get a firsthand view on how your employees treat those who contact your business. Business owners can make these calls themselves or, if your voice is too recognizable, find someone who’s less familiar but capable of taking detailed notes of the interaction.

Finding new ways to improve your company’s customer service isn’t easy. But innovations are always just one bright idea away. If you’d like more information and ideas about building your bottom line, contact our firm.

© 2018