M&A Transactions: Avoid Surprises From The IRS

If you’re considering buying or selling a business — or you’re in the process of a merger or acquisition — it’s important that both parties report the transaction to the IRS in the same way. Otherwise, you may increase your chances of being audited.

If a sale involves business assets (as opposed to stock or ownership interests), the buyer and the seller must generally report to the IRS the purchase price allocations that both use. This is done by attaching IRS Form 8594, “Asset Acquisition Statement,” to each of their respective federal income tax returns for the tax year that includes the transaction.

What’s reported?

When buying business assets in an M&A transaction, you must allocate the total purchase price to the specific assets that are acquired. The amount allocated to each asset then becomes its initial tax basis. For depreciable and amortizable assets, the initial tax basis of each asset determines the depreciation and amortization deductions for that asset after the acquisition. Depreciable and amortizable assets include:

  • Equipment,
  • Buildings and improvements,
  • Software,
  • Furniture, fixtures and
  • Intangibles (including customer lists, licenses, patents, copyrights and goodwill).

In addition to reporting the items above, you must also disclose on Form 8594 whether the parties entered into a noncompete agreement, management contract or similar agreement, as well as the monetary consideration paid under it.

IRS scrutiny

The IRS may inspect the forms that are filed to see if the buyer and the seller use different allocations. If the IRS finds that different allocations are used, auditors may dig deeper and the investigation could expand beyond just the transaction. So, it’s in your best interest to ensure that both parties use the same allocations. Consider including this requirement in your asset purchase agreement at the time of the sale.

The tax implications of buying or selling a business are complicated. Price allocations are important because they affect future tax benefits. Both the buyer and the seller need to report them to the IRS in an identical way to avoid unwanted attention. To lock in the best postacquisition results, consult with us before finalizing any transaction.

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Private Companies: Beware of SEC Scrutiny

The Securities and Exchange Commission (SEC) doesn’t monitor just publicly traded companies. It also looks at the dealings of some private companies, often to the surprise of their owners and executives.

Reasons for SEC scrutiny

The SEC’s mission is to protect the public as well as the integrity of the financial markets. That mission extends to not only public companies but also private ones that may be acquired by a public company or that are large enough to consider an initial public offering (IPO).

Ultimately, whether a private company attracts regulatory scrutiny depends on its disclosures regarding current and projected financial performance. Therefore, private companies must walk a fine line between 1) enticing would-be investors with attractive financial projections, and 2) painting an overly optimistic picture that’s unhinged from reality.

Interest in private company activities

Increasingly, the SEC has unleashed enforcement actions and investors have filed lawsuits related to allegedly misleading or erroneous statements made by private (or formerly private) companies. So, companies contemplating an IPO or a merger with a public company should begin developing their approach to SEC compliance as soon as possible.

The risk of attracting the attention of the SEC is particularly concerning if there’s a secondary market for your company’s pre-IPO shares. These are known as “security-based swaps” for purposes of SEC regulation. If the swaps are available to retail investors who don’t meet the criteria of an “eligible contract participant” under the Dodd-Frank Act, the securities must follow specific rules, including the existence of a registration statement and the ability to trade on a national securities exchange.

Additionally, the Financial Accounting Standards Board (FASB) recently proposed Accounting Standards Update No. 2019-600, Disclosure Improvements — Codification Amendments in Response to the SEC’s Disclosure Update and Simplification Initiative. The updated FASB guidance — which would apply to both public and private entities — would better sync U.S. Generally Accepted Accounting Principles (GAAP) with the SEC’s updated disclosure requirements.

Proactive compliance

It takes time to create and deploy an effective corporate governance program that complies with the SEC rules. Start the process by determining whether retail investors participate in trading that raises your company’s compliance risk. Pay close attention to every financial disclosure and the publicly available information that may affect trading. This effort should also include keeping track of material, nonpublic information available to insiders who may sell shares in the secondary market.

Next, create and deploy policies regarding how your company compiles its financial reports. Implement tools and procedures designed to prevent financial crime — such as internal fraud, bribery and corruption — and ensure compliance with SEC regulations. For example, you might consider setting up an anonymous whistleblower hotline for employees to report concerns regarding the company’s activities.

We can help

Companies on their way to becoming public represent a small, but growing, segment of the SEC’s enforcement activity. Protect your company against unwanted scrutiny by learning and complying with the SEC’s financial reporting rules and regulations.

Contact us to get a comprehensive assessment of your private company’s corporate governance practices. Now’s the time to shore them up, rather than waiting for an IPO or a merger with a public company.

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The Pros and Cons of Interim Reporting

The Securities and Exchange Commission (SEC) requires certain public companies to publish quarterly financial statements to give investors insight into midyear performance. Though interim reporting generally isn’t required for private companies, stakeholders in smaller entities can benefit even more than those of public companies from this type of information. But it’s also important to understand the potential shortcomings.

Upsides

Interim financial statements cover periods of less than a year. They show how a company is doing each month or quarter.

If you think of annual financial statements as report cards for a business, interim reports would be like progress reports that may forewarn of troubles ahead — or reassure you that everything is going well. A lender or investor might request interim financial statements if a company:

  • Has implemented a turnaround plan to avert bankruptcy,
  • Has previously reported a major impairment loss,
  • Is in an industry that is experiencing a downturn, or
  • Is seeking new investors or applying for a loan.

These reports may provide peace of mind. Or they might signal impending financial turmoil due to, say, the loss of a major customer, significant uncollectible accounts receivable or pilfered inventory.

Early detection of such problems is critical for smaller businesses. While large public companies can often recover from a bad quarter or year, waiting until year end to discover these issues can be disastrous to a smaller business.

Downsides

Interim reports also have certain drawbacks and limitations. Unlike annual financial statements, interim financial statements are usually unaudited and condensed. So, when reviewing interim reports, revisiting last year’s complete annual financial statements may be helpful. Also check that accounting practices are consistent between the interim and year-end financial statements.

Specifically, interim numbers may omit estimates for bad-debt write-offs, accrued expenses, prepaid items, management bonuses or income taxes. And sometimes tedious bookkeeping procedures, such as physical inventory counts, updating depreciation schedules and composing detailed footnote disclosures, aren’t completed until year end. Instead, interim account balances often reflect last year’s amounts or may be based on historic gross margins.

For seasonal businesses, there are operating peaks and troughs. So you can’t multiply quarterly profits by four to reliably predict year end performance. Instead, you may need to benchmark current year-to-date numbers against last year’s monthly (or quarterly) results.

For more information

If interim statements reveal irregularities, you should consider digging deeper to find out what’s happening. Our accounting and auditing pros can help you address unresolved issues and determine an appropriate course of action.

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2019 Q3 Tax Calendar: Key Deadlines for Business and Other Employers

Here are some of the key tax-related deadlines affecting businesses and other employers during the third quarter of 2019. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.

July 31

  • Report income tax withholding and FICA taxes for the second quarter of 2019 (Form 941) and pay any tax due. (See the exception below, under “August 12.”)
  • File a 2018 calendar-year retirement plan report (Form 5500 or Form 5500-EZ) or request an extension.

August 12

  • Report income tax withholding and FICA taxes for the second quarter of 2019 (Form 941), if you deposited on time and in full all of the associated taxes due.

September 16

  • If a calendar-year C corporation, pay the third installment of 2019 estimated income taxes.
  • If a calendar-year S corporation or partnership that filed an automatic six-month extension:
    • File a 2018 income tax return (Form 1120S, Form 1065 or Form 1065-B) and pay any tax, interest and penalties due.
    • Make contributions for 2018 to certain employer-sponsored retirement plans.

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Measuring “Fair Value” for Financial Reporting Purposes

The standard for valuing certain assets and liabilities under U.S. Generally Accepted Accounting Principles (GAAP) is “fair value.” This differs from other valuation standards that may apply when valuing a security or business interest in a litigation or mergers and acquisitions (M&A) setting.

FASB guidance

The Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures , in 2006. It defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

The statement unified approximately 60 existing accounting pronouncements that used this term. Among the items currently reported at fair value (rather than historic cost) are asset retirement obligations, derivatives and intangible assets acquired in a business combination.

Valuation hierarchy

The statement also establishes a “fair value hierarchy” that emphasizes market-based valuation methods. In order of decreasing relevance, the following factors should be considered when measuring fair value:

  1. Quoted prices in active markets for identical assets or liabilities,
  2. Quoted prices in active markets for similar assets or liabilities, or other “observable” inputs, and
  3. Unobservable inputs, such as the reporting entity’s own data.

When the recession hit in 2008, the FASB advised companies to use internal assumptions, such as expected cash flows and appropriately risk-adjusted discount rates, to value securities when relevant market data is unavailable. FASB guidance said that, in times of “market dislocation,” market prices may not always be determinative of fair value. Rather, valuations “may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.”

Different purposes, different standards

Though it may be tempting to “recycle” valuations prepared for litigation or M&A purposes for use in financial reporting (or vice versa), the values may not be equivalent. That’s because different standards sometimes apply, depending on the purpose of the valuation.

For example, “fair value” in an oppressed shareholder or divorce case may be statutorily defined and based on relevant case law. Likewise, “strategic value,” which is commonly used in M&As, may include buyer-specific synergies and, therefore, warrant a premium above the price others in the marketplace would pay.

In addition, the FASB specifically avoided using the term “fair market value” in ASC 820. This term applies to valuations prepared for federal tax purposes. The rationale was that the FASB wanted to separate its guidance from the extensive body of IRS guidance and Tax Court precedent. The term “fair value” has less baggage tied to it and allowed the FASB to start with a clean slate.

Use valuation experts

Estimating fair value, like any valuation assignment, generally requires the use of specialists who are independent of your audit team. Contact us for more information about fair value measurements.

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Consider a Roth 401(k) Plan – And Make Sure Employees Use It

Roth 401(k) accounts have been around for 13 years now. Studies show that more employers are offering them each year. A recent study by the Plan Sponsor Council of America (PSCA) found that Roth 401(k)s are now available at 70% of employer plans, up from 55.6% of plans in 2016.

However, despite the prevalence of employers offering Roth 401(k)s, most employees aren’t choosing to contribute to them. The PSCA found that only 20% of participants who have access to a Roth 401(k) made contributions to one in 2017. Perhaps it’s because they don’t understand them.

If you offer a Roth 401(k) or you’re considering one, educate your employees about the accounts to boost participation.

A 401(k) with a twist

As the name implies, these plans are a hybrid — taking some characteristics from Roth IRAs and some from employer-sponsored 401(k)s.

An employer with a 401(k), 403(b) or governmental 457(b) plan can offer designated Roth 401(k) accounts.

As with traditional 401(k)s, eligible employees can elect to defer part of their salaries to Roth 401(k)s, subject to annual limits. The employer may choose to provide matching contributions. For 2019, a participating employee can contribute up to $19,000 ($25,000 if he or she is age 50 or older) to a Roth 401(k). The most you can contribute to a Roth IRA for 2019 is $6,000 ($7,000 for those age 50 or older).

Note: The ability to contribute to a Roth IRA is phased out for upper-income taxpayers, but there’s no such restriction for a Roth 401(k).

The pros and cons

Unlike with traditional 401(k)s, contributions to employees’ accounts are made with after-tax dollars, instead of pretax dollars. Therefore, employees forfeit a key 401(k) tax benefit. On the plus side, after an initial period of five years, “qualified distributions” are 100% exempt from federal income tax, just like qualified distributions from a Roth IRA. In contrast, regular 401(k) distributions are taxed at ordinary-income rates, which are currently up to 37%.

In general, qualified distributions are those:

  • Made after a participant reaches age 59½, or
  • Made due to death or disability.

Therefore, you can take qualified Roth 401(k) distributions in retirement after age 59½ and pay no tax, as opposed to the hefty tax bill that may be due from traditional 401(k) payouts. And unlike traditional 401(k)s, which currently require retirees to begin taking required minimum distributions after age 70½, Roth 401(k)s have no mandate to take withdrawals.

Not for everyone

A Roth 401(k) is more beneficial than a traditional 401(k) for some participants, but not all. For example, it may be valuable for employees who expect to be in higher federal and state tax brackets in retirement. Contact us if you have questions about adding a Roth 401(k) to your benefits lineup.

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Comparing Internal and External Audits

Businesses use two types of audits to gauge financial results: internal and external. Here’s a closer look at how they measure up.

Focus

Internal auditors go beyond traditional financial reporting. They focus on a company’s internal controls, accounting processes and ability to mitigate risk. Internal auditors also evaluate whether the company’s activities comply with its strategy, and they may consult on a variety of financial issues as they arise within the company.

In contrast, external auditors focus solely on the financial statements. Specifically, external auditors evaluate the statements’ accuracy and completeness, whether they comply with applicable accounting standards and practices, and whether they present a true and accurate presentation of the company’s financial performance. Accounting rules prohibit external audit firms from providing their audit clients with ancillary services that extend beyond the scope of the audit.

The audit “client”

Internal auditors are employees of the company they audit. They report to the chief audit executive and issue reports for management to use internally.

External auditors work for an independent accounting firm. The company’s shareholders or board of directors hires a third-party auditing firm to serve as its external auditor. The external audit team delivers reports directly to the company’s shareholders or audit committee, not to management

Qualifications

Internal auditors don’t need to be certified public accountants (CPAs), although many have earned this qualification. Often, internal auditors earn a certified internal auditor (CIA) qualification, which requires them to follow standards issued by the Institute of Internal Auditors (IIA).

Conversely, the partner directing an external audit must be a CPA. Most midlevel and senior auditors earn their CPA license at some point in their career. External auditors must follow U.S. Generally Accepted Auditing Standards (GAAS), which are issued by the American Institute of Certified Public Accountants (AICPA).

Reporting format

Internal auditors issue reports throughout the year. The format may vary depending on the preferences of management or the internal audit team.

External auditors issue financial statements quarterly for most public companies and at least annually for private ones. In general, external audit reports must conform to U.S. Generally Accepted Accounting Principles (GAAP) or another basis of accounting (such as tax or cash basis reporting). If needed, external auditing procedures may be performed more frequently. For example, a lender may require a private company that fails to meet its loan covenants at year end to undergo a midyear audit by an external audit firm.

Common ground

Sometimes the work of internal and external auditors overlaps. Though internal auditors have a broader focus, both teams have the same goal: to help the company report financial data that people can count on. So, it makes sense for internal and external auditors to meet frequently to understand the other team’s focus and avoid duplication of effort. Contact us to map out an auditing strategy that fits the needs of your company.

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What Type of Expenses Can’t Be Written Off By Your Business?

If you read the Internal Revenue Code (and you probably don’t want to!), you may be surprised to find that most business deductions aren’t specifically listed. It doesn’t explicitly state that you can deduct office supplies and certain other expenses.

Some expenses are detailed in the tax code, but the general rule is contained in the first sentence of Section 162, which states you can write off “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

Basic definitions

In general, an expense is ordinary if it’s considered common or customary in the particular trade or business. For example, insurance premiums to protect a store would be an ordinary business expense in the retail industry.

A necessary expense is defined as one that’s helpful or appropriate. For example, let’s say a car dealership purchases an automatic defibrillator. It may not be necessary for the operation of the business, but it might be helpful and appropriate if an employee or customer suffers a heart attack.

It’s possible for an ordinary expense to be unnecessary — but, in order to be deductible, an expense must be ordinary and necessary.

In addition, a deductible amount must be reasonable in relation to the benefit expected. For example, if you’re attempting to land a $3,000 deal, a $65 lunch with a potential client should be OK with the IRS. (Keep in mind that the Tax Cuts and Jobs Act eliminated most deductions for entertainment expenses but retains the 50% deduction for business meals.)

Examples of not ordinary and unnecessary

Not surprisingly, the IRS and courts don’t always agree with taxpayers about what qualifies as ordinary and necessary expenditures.

In one case, a man engaged in a business with his brother was denied deductions for his private airplane expenses. The U.S. Tax Court noted that the taxpayer had failed to prove the expenses were ordinary and necessary to the business. In addition, only one brother used the plane and the flights were to places that the taxpayer could have driven to or flown to on a commercial airline. And, in any event, the stated expenses including depreciation expenses, weren’t adequately substantiated, the court added. (TC Memo 2018-108)

In another case, the Tax Court ruled that a business owner wasn’t entitled to deduct legal and professional fees he’d incurred in divorce proceedings defending his ex-wife’s claims to his interest in, or portion of, distributions he received from his LLC. The IRS and the court ruled the divorce legal fees were nondeductible personal expenses and weren’t ordinary and necessary. (TC Memo 2018-80)

Proceed with caution

The deductibility of some expenses is clear. But for other expenses, it can get more complicated. Generally, if an expense seems like it’s not normal in your industry — or if it could be considered fun, personal or extravagant in nature — you should proceed with caution. And keep records to substantiate the expenses you’re deducting. Consult with us for guidance.

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Employee vs. Independent Contractor: How Should You Handle Worker Classification?

Many employers prefer to classify workers as independent contractors to lower costs, even if it means having less control over a worker’s day-to-day activities. But the government is on the lookout for businesses that classify workers as independent contractors simply to reduce taxes or avoid their employee benefit obligations.

Why it matters

When your business classifies a worker as an employee, you generally must withhold federal income tax and the employee’s share of Social Security and Medicare taxes from his or her wages. Your business must then pay the employer’s share of these taxes, pay federal unemployment tax, file federal payroll tax returns and follow other burdensome IRS and U.S. Department of Labor rules.

You may also have to pay state and local unemployment and workers’ compensation taxes and comply with more rules. Dealing with all this can cost a bundle each year.

On the other hand, with independent contractor status, you don’t have to worry about employment tax issues. You also don’t have to provide fringe benefits like health insurance, retirement plans and paid vacations. If you pay $600 or more to an independent contractor during the year, you must file a Form 1099-MISC with the IRS and send a copy to the worker to report what you paid. That’s basically the extent of your bureaucratic responsibilities.

But if you incorrectly treat a worker as an independent contractor — and the IRS decides the worker is actually an employee — your business could be assessed unpaid payroll taxes plus interest and penalties. You also could be liable for employee benefits that should have been provided but weren’t, including penalties under federal laws.

Filing an IRS form

To find out if a worker is an employee or an independent contractor, you can file optional IRS Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Then, the IRS will let you know how to classify a worker. However, be aware that the IRS has a history of classifying workers as employees rather than independent contractors.

Businesses should consult with us before filing Form SS-8 because it may alert the IRS that your business has worker classification issues — and inadvertently trigger an employment tax audit.

It can be better to simply treat independent contractors so the relationships comply with the tax rules. This generally includes not controlling how the workers perform their duties, ensuring that you’re not the workers’ only customer, providing annual Forms 1099 and, basically, not treating the workers like employees.

Workers can also ask for a determination

Workers who want an official determination of their status can also file Form SS-8. Disgruntled independent contractors may do so because they feel entitled to employee benefits and want to eliminate self-employment tax liabilities.

If a worker files Form SS-8, the IRS will send a letter to the business. It identifies the worker and includes a blank Form SS-8. The business is asked to complete and return the form to the IRS, which will render a classification decision.

Defending your position

If your business properly handles independent contractors, don’t panic if a worker files a Form SS-8. Contact us before replying to the IRS. With a proper response, you may be able to continue to classify the worker as a contractor. We also can assist you in setting up independent contractor relationships that stand up to IRS scrutiny.

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Close-Up on Professional Standards for CPAs

The accounting profession is largely self-regulated by the American Institute of Certified Public Accountants (AICPA). Part of its mission involves the development and enforcement of a broad range of standards for the profession.

Why do these standards matter to you? By having a little familiarity with the guidance that accountants and auditors follow, business owners and managers are better able to take advantage of the services offered by CPAs.

Existing standards

The AICPA requires CPAs to adhere to overarching ethical guidance contained in its code of professional conduct. Additional guidance is contained in standards for the following types of services:

Audit and attest. These standards must be followed when conducting, planning, and reporting audit and attestation engagements — such as compilations, reviews and agreed-upon procedures — of nonpublic companies.

Preparation, compilation and review. This guidance specifically governs such engagements for nonpublic companies.

Tax. These rules apply regardless of where the CPA practices or the types of tax services provided.

Personal financial planning. These standards cover such services as estate, retirement, investments, risk management, insurance and tax planning for individuals.

Consulting services. This guidance applies to CPAs who provide consulting services related to technology or industry-specific expertise, as well as management and financial skills.

Valuation services. Business valuations may be performed for a variety of reasons, including tax and accounting compliance, mergers and acquisitions, and litigation.

The AICPA also has standards governing the administration of continuing professional education programs and peer review of the work performed by other CPAs.

New Forensic Accounting Standard

Similar to the need for valuation services, demand for forensic accounting services has grown significantly in recent years. So, the AICPA recently added a standard for forensic services. This newly approved guidance covers investigations and litigation engagements involving forensic accountants. It goes into effect on January 1, 2020.

Beware: Statement on Standards for Forensic Services No. 1 places several limitations on forensic accountants, including prohibitions on charging contingent fees and providing legal opinions or the “ultimate conclusion” regarding fraud. Instead, it’s up to the trier-of-fact (generally a judge or jury) to determine innocence or guilt regarding fraud allegations. However, a CPA can express opinions regarding whether the evidence is “consistent with certain elements of fraud” and other laws based on their objective evaluation.

Bottom line

For any given assignment, a CPA may be required to follow multiple professional standards. In addition, CPAs adhere to general standards of the accounting profession, including competence, due professional care, and the use of sufficient, relevant data. These extensive rules and restrictions are good news for you — they promote the highest levels of quality and consistency when you receive services from a CPA.

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