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Accounting for Overheads Costs

Accurate overhead allocations are essential to understanding financial performance and making informed pricing decisions. Here’s guidance on how to estimate overhead rates to allocate these indirect costs to your products and how to adjust for variances that may occur.

What’s included in overhead?

Overhead costs are a part of every business. These accounts frequently serve as catch-alls for any expense that can’t be directly allocated to production, including:

  • Equipment maintenance and depreciation,
  • Factory and warehouse rent,
  • Building maintenance,
  • Administrative and executive salaries,
  • Taxes,
  • Insurance, and
  • Utilities.

Generally, such indirect costs of production are fixed, meaning they won’t change appreciably whether production increases or diminishes.

How are overhead rates calculated?

The challenge comes in deciding how to allocate these costs to products using an overhead rate. The rate is typically determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future period of time. Then you multiply the rate by the actual number of direct labor hours for each product (or batch of products) to establish the amount of overhead that should be applied.

In some organizations, the rate is applied companywide, across all products. This is particularly appropriate for organizations that make single, standard products — such as bricks — over long periods of time. If your product mix is more complex and customized, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate.

How do you handle variances from actual costs?

There’s one problem with accounting for overhead costs: Variances are almost certain. There are likely to be more variances if you use a simple companywide overhead rate, but even the most carefully thought-out multiple rates won’t always be 100% accurate.

The result? Large accounts that many managers don’t understand and that require constant adjustment. This situation creates opportunities for errors — and for dishonest people to commit fraud. Fortunately, you can reduce the chance of overhead anomalies with strong internal control procedures, such as:

  • Conducting independent reviews of all adjustments to overhead and inventory accounts,
  • Studying significant overhead adjustments over different periods of time to spot anomalies,
  • Discussing complaints about high product costs with nonaccounting managers, and
  • Evaluating your existing overhead allocation and making adjustments as necessary.

Allocating costs more accurately won’t guarantee that you make a profit. To do that, you have to make prudent pricing decisions — based on the production costs and market conditions — and then sell what you produce.

Need help?

Cost accounting can be complex, and indirect overhead costs can be difficult to trace. We can help you understand how to minimize the guesswork in accounting for overhead and identify when it’s time to adjust your allocation rates. Our accounting pros can also suggest ways to monitor cost allocations to prevent errors and mismanagement.

© 2018

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When Holiday Gifts and Parties are Deductible or Taxable

The holiday season is a great time for businesses to show their appreciation for employees and customers by giving them gifts or hosting holiday parties. Before you begin shopping or sending out invitations, though, it’s a good idea to find out whether the expense is tax deductible and whether it’s taxable to the recipient. Here’s a brief review of the rules.

Gifts to customers

When you make gifts to customers, the gifts are deductible up to $25 per recipient per year. For purposes of the $25 limit, you need not include “incidental” costs that don’t substantially add to the gift’s value, such as engraving, gift-wrapping, packaging or shipping. Also excluded from the $25 limit is branded marketing collateral — such as pens or stress balls imprinted with your company’s name and logo — provided they’re widely distributed and cost less than $4.

The $25 limit is for gifts to individuals. There’s no set limit on gifts to a company (a gift basket for all to share, for example) as long as they’re “reasonable.”

Gifts to employees

Generally anything of value that you transfer to an employee is included in the employee’s taxable income (and, therefore, subject to income and payroll taxes) and deductible by you. But there’s an exception for noncash gifts that constitute “de minimis fringe benefits.”

These are items so small in value and given so infrequently that it would be administratively impracticable to account for them. Common examples include holiday turkeys or hams, gift baskets, occasional sports or theater tickets (but not season tickets), and other low-cost merchandise.

De minimis fringe benefits are not included in an employee’s taxable income yet are still deductible by you. Unlike gifts to customers, there’s no specific dollar threshold for de minimis gifts. However, many businesses use an informal cutoff of $75.

Keep in mind that cash gifts — as well as cash equivalents, such as gift cards — are included in an employee’s income and subject to payroll tax withholding regardless of how small and infrequent.

Holiday parties

The Tax Cuts and Jobs Act reduced certain deductions for business-related meals and eliminated the deduction for business entertainment altogether. There’s an exception, however, for certain recreational activities, including holiday parties.

Holiday parties are fully deductible (and excludible from recipients’ income) provided they’re primarily for the benefit of non-highly-compensated employees and their families. If customers also attend, holiday parties may be partially deductible.

Gifts that give back

If you’re thinking about giving holiday gifts to employees or customers or throwing a holiday party, contact us. With a little tax planning, you may receive a gift of your own from Uncle Sam.

© 2018

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Buy Business Assets Before Year End to Reduce Your 2018 Tax Liability

The Tax Cuts and Jobs Act (TCJA) has enhanced two depreciation-related breaks that are popular year-end tax planning tools for businesses. To take advantage of these breaks, you must purchase qualifying assets and place them in service by the end of the tax year. That means there’s still time to reduce your 2018 tax liability with these breaks, but you need to act soon.

Section 179 expensing

Sec. 179 expensing is valuable because it allows businesses to deduct up to 100% of the cost of qualifying assets in Year 1 instead of depreciating the cost over a number of years. Sec. 179 expensing can be used for assets such as equipment, furniture and software. Beginning in 2018, the TCJA expanded the list of qualifying assets to include qualified improvement property, certain property used primarily to furnish lodging and the following improvements to nonresidential real property: roofs, HVAC equipment, fire protection and alarm systems, and security systems.

The maximum Sec. 179 deduction for 2018 is $1 million, up from $510,000 for 2017. The deduction begins to phase out dollar-for-dollar for 2018 when total asset acquisitions for the tax year exceed $2.5 million, up from $2.03 million for 2017.

100% bonus depreciation

For qualified assets that your business places in service in 2018, the TCJA allows you to claim 100% first-year bonus depreciation — compared to 50% in 2017. This break is available when buying computer systems, software, machinery, equipment and office furniture. The TCJA has expanded eligible assets to include used assets; previously, only new assets were eligible.

However, due to a TCJA drafting error, qualified improvement property will be eligible only if a technical correction is issued. Also be aware that, under the TCJA, certain businesses aren’t eligible for bonus depreciation in 2018, such as real estate businesses that elect to deduct 100% of their business interest and auto dealerships with floor plan financing (if the dealership has average annual gross receipts of more than $25 million for the three previous tax years).

Traditional, powerful strategy

Keep in mind that Sec. 179 expensing and bonus depreciation can also be used for business vehicles. So purchasing vehicles before year end could reduce your 2018 tax liability. But, depending on the type of vehicle, additional limits may apply.

Investing in business assets is a traditional and powerful year-end tax planning strategy, and it might make even more sense in 2018 because of the TCJA enhancements to Sec. 179 expensing and bonus depreciation. If you have questions about these breaks or other ways to maximize your depreciation deductions, please contact us.

© 2018

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LIFO Lessons Learned

You have choices when it comes to reporting inventory costs. One popular technique — the last-in, first-out (LIFO) method — assumes that merchandise is sold in the reverse order it was acquired or produced. That is, it allocates the most recent costs to the cost of sales. Although this method is often preferred for tax purposes, internal accounting personnel may be hesitant to use it for various reasons.

Tax benefits

Assuming your inventory costs generally increase over time, LIFO offers a definite tax advantage over other inventory reporting methods. By allocating the most recent — and, therefore, higher — costs first, LIFO maximizes your cost of goods sold, which minimizes your taxable income.

In contrast, the first-in, first-out (FIFO) method assumes that merchandise is sold in the order it was acquired or produced. Thus, the cost of goods sold is based on older — and often lower — prices.

Financial reporting challenges

Before you jump headfirst into using LIFO, it’s important to recognize that it’s not permitted under International Financial Reporting Standards. The approach also involves sophisticated record keeping and calculations.

For example, the “LIFO conformity rule” generally requires you to use the same inventory accounting method for tax and financial statement purposes. Switching to LIFO may reduce your tax bill, but it could also depress your current earnings and reduce the value of inventories on your balance sheet, thus giving the appearance of a weaker financial position.

LIFO also can create a problem if your inventory levels are declining. As higher inventory costs are used up, you’ll need to start dipping into lower-cost “layers” of inventory, triggering taxes on “phantom income” that the LIFO method previously has allowed you to defer.

Moreover, if a C corporation elects S corporation status, the business must include a “LIFO recapture amount” in income for the C corporation’s last tax year. The recapture amount is the excess of your inventory’s value using FIFO over its value using LIFO. Fortunately, you can spread out the tax payments over four years in equal, interest-free installments.

One of the biggest challenges in using LIFO is the need to measure changes in inventory costs. If you currently use LIFO, you may be able to enjoy additional savings by electing to use the inventory price index computation method. It may enable you to reduce administrative costs — and it might even generate greater tax benefits — if you rely on government indexes to calculate LIFO values rather than developing an internal index.

Right for you?

If you’re contemplating a switch to LIFO, there are various issues to address and forms to complete. Contact us to help decide whether it’s right for your business.

© 2018

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Now’s the Time to Review Your Business Expenses

As we approach the end of the year, it’s a good idea to review your business’s expenses for deductibility. At the same time, consider whether your business would benefit from accelerating certain expenses into this year.

Be sure to evaluate the impact of the Tax Cuts and Jobs Act (TCJA), which reduces or eliminates many deductions. In some cases, it may be necessary or desirable to change your expense and reimbursement policies.

What’s deductible, anyway?

There’s no master list of deductible business expenses in the Internal Revenue Code (IRC). Although some deductions are expressly authorized or excluded, most are governed by the general rule of IRC Sec. 162, which permits businesses to deduct their “ordinary and necessary” expenses.

An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your business. (It need not be indispensable.) Even if an expense is ordinary and necessary, it may not be deductible if the IRS considers it lavish or extravagant.

What did the TCJA change?

The TCJA contains many provisions that affect the deductibility of business expenses. Significant changes include these deductions:

Meals and entertainment. The act eliminates most deductions for entertainment expenses, but retains the 50% deduction for business meals. What about business meals provided in connection with nondeductible entertainment? In a recent notice, the IRS clarified that such meals continue to be 50% deductible, provided they’re purchased separately from the entertainment or their cost is separately stated on invoices or receipts.

Transportation. The act eliminates most deductions for qualified transportation fringe benefits, such as parking, vanpooling and transit passes. This change may lead some employers to discontinue these benefits, although others will continue to provide them because 1) they’re a valuable employee benefit (they’re still tax-free to employees) or 2) they’re required by local law.

Employee expenses. The act suspends employee deductions for unreimbursed job expenses — previously treated as miscellaneous itemized deductions — through 2025. Some businesses may want to implement a reimbursement plan for these expenses. So long as the plan meets IRS requirements, reimbursements are deductible by the business and tax-free to employees.

Need help?

The deductibility of certain expenses, such as employee wages or office supplies, is obvious. In other cases, it may be necessary to consult IRS rulings or court cases for guidance. For assistance, please contact us.

© 2018

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Audit Opinions: How Your Financial Statements Measure Up

Audit opinions differ depending on the information available, financial viability, errors discovered during audit procedures and other limiting factors. The type of opinion your auditor issues tells stakeholders whether you’re in compliance with accounting rules and likely to continue operating as a going concern.

The basics

To find out what type of audit opinion you’ve received, scan the first page of your financial statements. Known as the “audit opinion letter,” this is where your auditor states whether the financial statements are fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement. But the opinion doesn’t constitute an endorsement or evaluation of the company’s financial results.

Most audit opinion letters consist of three paragraphs. The introductory paragraph identifies the company, accounting period and auditor’s responsibilities. The second discusses the scope of work performed. The third paragraph contains the audit opinion.

In general, there are four types of audit opinions, ranked from most to least desirable.

1. Unqualified. A clean “unqualified” opinion is the most common (and desirable). Here the auditor states that the company’s financial condition, position and operations are fairly presented in the financial statements.

2. Qualified. The auditor expresses a qualified opinion if the financial statements appear to contain a small deviation from GAAP, but are otherwise fairly presented. To illustrate: An auditor will “qualify” his or her opinion if a borrower incorrectly estimates warranty expense, but the exception doesn’t affect the rest of the financial statements.

Qualified opinions are also given if the company’s management limits the scope of audit procedures. For example, a qualified opinion may result if you deny the auditor access to a warehouse to observe year-end inventory counts.

3. Adverse. When an auditor issues an adverse opinion, there are material exceptions to GAAP that affect the financial statements as a whole. Here the auditor indicates that the financial statements aren’t presented fairly. Typically, an adverse opinion letter contains a fourth paragraph that outlines these exceptions.

4. Disclaimer. Even more alarming to lenders and investors is a disclaimer opinion. Disclaimers occur when an auditor gives up midaudit. Reasons for disclaimers may include significant scope limitations, material doubt about the company’s going-concern status and uncertainties within the subject company itself. A disclaimer opinion letter briefly outlines the auditor’s reasons for throwing in the towel.

Ready, set, audit

Before fieldwork starts for the audit of your 2018 financial statements, let’s discuss any foreseeable scope limitations and possible deviations from GAAP. Depending on the situation, we may be able to recommend corrective actions and help you proactively communicate with stakeholders about the reasons for a less-than-perfect audit opinion.

© 2018

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How to Reduce the Tax Risk of Using Independent Contractors

Classifying a worker as an independent contractor frees a business from payroll tax liability and allows it to forgo providing overtime pay, unemployment compensation and other employee benefits. It also frees the business from responsibility for withholding income taxes and the worker’s share of payroll taxes.

For these reasons, the federal government views misclassifying a bona fide employee as an independent contractor unfavorably. If the IRS reclassifies a worker as an employee, your business could be hit with back taxes, interest and penalties.

Key factors

When assessing worker classification, the IRS typically looks at the:

Level of behavioral control. This means the extent to which the company instructs a worker on when and where to do the work, what tools or equipment to use, whom to hire, where to purchase supplies and so on. Also, control typically involves providing training and evaluating the worker’s performance. The more control the company exercises, the more likely the worker is an employee.

Level of financial control. Independent contractors are more likely to invest in their own equipment or facilities, incur unreimbursed business expenses, and market their services to other customers. Employees are more likely to be paid by the hour or week or some other time period; independent contractors are more likely to receive a flat fee.

Relationship of the parties. Independent contractors are often engaged for a discrete project, while employees are typically hired permanently (or at least for an indefinite period). Also, workers who serve a key business function are more likely to be classified as employees.

The IRS examines a variety of factors within each category. You need to consider all of the facts and circumstances surrounding each worker relationship.

Protective measures

Once you’ve completed your review, there are several strategies you can use to minimize your exposure. When in doubt, reclassify questionable independent contractors as employees. This may increase your tax and benefit costs, but it will eliminate reclassification risk.

From there, modify your relationships with independent contractors to better ensure compliance. For example, you might exercise less behavioral control by reducing your level of supervision or allowing workers to set their own hours or work from home.

Also, consider using an employee-leasing company. Workers leased from these firms are employees of the leasing company, which is responsible for taxes, benefits and other employer obligations.

Handle with care

Keep in mind that taxes, interest and penalties aren’t the only possible negative consequences of a worker being reclassified as an employee. In addition, your business could be liable for employee benefits that should have been provided but weren’t. Fortunately, careful handling of contractors can help ensure that independent contractor status will pass IRS scrutiny. Contact us if you have questions about worker classification.

© 2018

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Choosing the Right Accounting Method for Tax Purposes

The Tax Cuts and Jobs Act (TCJA) 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.

© 2018

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Close-Up on the New QBI Deduction’s Wage Limit

The Tax Cuts and Jobs Act (TCJA) provides a valuable new tax break to noncorporate owners of pass-through entities: a deduction for a portion of qualified business income (QBI). The deduction generally applies to income from sole proprietorships, partnerships, S corporations and, typically, limited liability companies (LLCs). It can equal as much as 20% of QBI. But once taxable income exceeds $315,000 for married couples filing jointly or $157,500 for other filers, a wage limit begins to phase in.

Full vs. partial phase-in

When the wage limit is fully phased in, at $415,000 for joint filers and $207,500 for other filers, the QBI deduction generally can’t exceed the greater of the owner’s share of:

  • 50% of the amount of W-2 wages paid to employees during the tax year, or
  • The sum of 25% of W-2 wages plus 2.5% of the cost of qualified business property (QBP).

When the wage limit applies but isn’t yet fully phased in, the amount of the limit is reduced and the final deduction is calculated as follows:

1. The difference between taxable income and the applicable threshold is divided by $100,000 for joint filers or $50,000 for other filers.
2. The resulting percentage is multiplied by the difference between the gross deduction and the fully wage-limited deduction.
3. The result is subtracted from the gross deduction to determine the final deduction.

Some examples

Let’s say Chris and Leslie have taxable income of $600,000. This includes $300,000 of QBI from Chris’s pass-through business, which pays $100,000 in wages and has $200,000 of QBP. The gross deduction would be $60,000 (20% of $300,000), but the wage limit applies in full because the married couple’s taxable income exceeds the $415,000 top of the phase-in range for joint filers. Computing the deduction is fairly straightforward in this situation.

The first option for the wage limit calculation is $50,000 (50% of $100,000). The second option is $30,000 (25% of $100,000 + 2.5% of $200,000). So the wage limit — and the deduction — is $50,000.

What if Chris and Leslie’s taxable income falls within the phase-in range? The calculation is a bit more complicated. Let’s say their taxable income is $400,000. The full wage limit is still $50,000, but only 85% of the full limit applies:

($400,000 taxable income – $315,000 threshold)/$100,000 = 85%

To calculate the amount of their deduction, the couple must first calculate 85% of the difference between the gross deduction of $60,000 and the fully wage-limited deduction of $50,000:

($60,000 – $50,000) × 85% = $8,500

That amount is subtracted from the $60,000 gross deduction for a final deduction of $51,500.

That’s not all

Be aware that another restriction may apply: For income from “specified service businesses,” the QBI deduction is reduced if an owner’s taxable income falls within the applicable income range and eliminated if income exceeds it. Please contact us to learn whether your business is a specified service business or if you have other questions about the QBI deduction.

© 2018

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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