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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Lean Manufacturers: Reap the Benefits of Lean Accounting

Standard cost accounting doesn’t necessarily work for lean operations. Instead, lean accounting offers a simplified reporting alternative that generates more timely, relevant financial data. But it’s not right for every situation.

What’s lean manufacturing?

Lean manufacturers strive for continuous improvement and elimination of non-value-added activities. Rather than scheduling workflow from one functional department to another, these manufacturers organize their facilities into cross-functional work groups or cells.

Lean manufacturing is a “pull-demand” system, where customer orders jumpstart the production process. Lean companies view inventory not as an asset but as a waste of cash flow and storage space.

Why won’t traditional accounting methods work?

From a benchmarking standpoint, liquidity and profitability ratios tend to decline when traditional cost accounting methods are applied to newly improved operations. For example, to minimize inventory, companies transitioning from mass production to lean production must initially deplete in-stock inventories before producing more units. They also must write off obsolete items. As they implement lean principles, many companies learn that their inventories were overvalued due to obsolete items and inaccurate overhead allocation rates (traditionally based on direct labor hours).

During the transition phase, several costs — such as deferred compensation and overhead expense — transition from the balance sheet to the income statement. Accordingly, lean manufacturers may initially report higher costs and, therefore, reduced profits on their income statements. In addition, their balance sheets initially show lower inventory.

Alone, these financial statement trends will likely raise a red flag among investors and lenders — and possibly lead to erroneous business decisions.

How does lean accounting work?

Standard cost accounting is time consuming and transaction-driven. To estimate cost of goods sold, standard cost accounting uses complex variance accounts, such as purchase price variances, labor efficiency variances and overhead spending variances.

In contrast, lean accounting is relatively simple and flexible. Rather than lumping costs into overhead, lean accounting methods trace costs directly to the manufacturer’s cost of goods sold, typically dividing them into four value stream categories:

  1. Materials costs,
  2. Procurement costs,
  3. Conversion costs, such as factory wages and benefits, equipment depreciation and repairs, supplies, and scrap, and
  4. Occupancy costs.

These are easier to understand and evaluate than the variances used in standard cost accounting. In addition, box score reports are often used in lean accounting to supplement profit and loss statements. These reports list performance measures that traditional financial statements neglect, such as scrap rates, inventory turns, on-time delivery rates, customer satisfaction scores and sales per employee.

Should your company abandon standard cost accounting?

Most companies are required to use standard cost accounting methods for formal reporting purposes to comply with U.S. Generally Accepted Accounting Principles (GAAP). But lean manufacturers may benefit from comparing traditional and lean financial statements. Such comparisons may even highlight areas to target with future lean improvement initiatives. Contact us for more information.

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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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How Entrepreneurs Must Treat Expenses on Their Tax Returns

Have you recently started a new business? Or are you contemplating starting one? Launching a new venture is a hectic, exciting time. And as you know, before you even open the doors, you generally have to spend a lot of money. You may have to train workers and pay for rent, utilities, marketing and more.

Entrepreneurs are often unaware that many expenses incurred by start-ups can’t be deducted right away. You should be aware that the way you handle some of your initial expenses can make a large difference in your tax bill.

Key points on how expenses are handled

When starting or planning a new enterprise, keep these factors in mind:

  1. Start-up costs include those incurred or paid while creating an active trade or business — or investigating the creation or acquisition of one.
  2. Under the federal tax code, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs in the year the business begins. We don’t need to tell you that $5,000 doesn’t go far these days! And the $5,000 deduction is reduced dollar-for-dollar by the amount by which your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over 180 months on a straight-line basis.
  3. No deductions or amortization write-offs are allowed until the year when “active conduct” of your new business commences. That usually means the year when the enterprise has all the pieces in place to begin earning revenue. To determine if a taxpayer meets this test, the IRS and courts generally ask questions such as: Did the taxpayer undertake the activity intending to earn a profit? Was the taxpayer regularly and actively involved? Has the activity actually begun?

Examples of expenses

Start-up expenses generally include all expenses that are incurred to:

  • Investigate the creation or acquisition of a business,
  • Create a business, or
  • Engage in a for-profit activity in anticipation of that activity becoming an active business.

To be eligible for the election, an expense also must be one that would be deductible if it were incurred after a business began. One example would be the money you spend analyzing potential markets for a new product or service.

To qualify as an “organization expense,” the outlay must be related to the creation of a corporation or partnership. Some examples of organization expenses are legal and accounting fees for services related to organizing the new business and filing fees paid to the state of incorporation.

An important decision

Time may be of the essence if you have start-up expenses that you’d like to deduct this year. You need to decide whether to take the elections described above. Recordkeeping is important. Contact us about your business start-up plans. We can help with the tax and other aspects of your new venture.

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Put a QOE Report to Work for You

An independent quality of earnings (QOE) report can be a valuable tool in mergers and acquisitions. It’s important for both buyers and sellers to look beyond the quantitative information provided by the selling company’s financial statements.

Quality matters

There’s a lack of guidance from the American Institute of Certified Public Accountants (AICPA) regarding scope and format of a QOE report. As a result, these engagements may be customized to meet the needs of the party requesting the report.

Typically, QOE reports analyze the individual components of earnings (that is, revenue and expenses) on a month-to-month basis. The goals are twofold: 1) to determine whether earnings are sustainable, and 2) to identify potential risks and opportunities, both internal and external, that could affect the company’s ability to operate as a going concern.

Examples of issues that a QOE report might uncover include:

  • Deficient accounting policies and procedures,
  • Excessive concentration of revenue with one customer,
  • Transactions with undisclosed related parties,
  • Inaccurate period-end adjustments,
  • Unusual revenue or expense items,
  • Insufficient loss reserves, and
  • Overly optimistic prospective financial statements.

QOE analyses can be performed on financial statements that have been prepared in-house, as well as those that have been compiled, reviewed or audited by a CPA firm. Rather than focus on historical results and compliance with Generally Accepted Accounting Principles (GAAP), QOE reports focus on how much cash flow the company is likely to generate for investors in the future.

Beyond EBITDA

Earnings before interest, taxes, depreciation and amortization (EBITDA) for the trailing 12 months is often the starting point for assessing earnings quality. To reflect a more accurate picture of a company’s operations, EBITDA may need to be adjusted for such items as:

  • Nonrecurring items, such as a loss from a natural disaster or a gain from an asset sale,
  • Above- or below-market owners’ compensation,
  • Discretionary expenses, and
  • Differences in accounting methods used by the company compared to industry peers.

In addition, QOE reports usually entail detailed ratio and trend analysis to identify unusual activity. Additional procedures can help determine whether changes are positive or negative.

For example, an increase in accounts receivable could result from revenue growth (a positive indicator) or a buildup of uncollectible accounts (a negative indicator). If it’s the former, the gross margin on incremental revenue should be analyzed to determine if the new business is profitable — or if the revenue growth results from aggressive price cuts.   

We can help

Using an objective accounting professional to provide a QOE report can help the parties stay focused on financial matters during M&A discussions and add credibility to management’s historical and prospective financial statements. Contact us if you’re in the market to buy or sell a business.

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Deducting Business Meal Expenses Under Today’s Tax Rule

In the course of operating your business, you probably spend time and money “wining and dining” current or potential customers, vendors and employees. What can you deduct on your tax return for these expenses? The rules changed under the Tax Cuts and Jobs Act (TCJA), but you can still claim some valuable write-offs.

No more entertainment deductions

One of the biggest changes is that you can no longer deduct most business-related entertainment expenses. Beginning in 2018, the TCJA disallows deductions for entertainment expenses, including those for sports events, theater productions, golf outings and fishing trips.

Meal deductions still allowed

You can still deduct 50% of the cost of food and beverages for meals conducted with business associates. However, you need to follow three basic rules in order to prove that your expenses are business related:

  1. The expenses must be “ordinary and necessary” in carrying on your business. This means your food and beverage costs are customary and appropriate. They shouldn’t be lavish or extravagant.
  2. The expenses must be directly related or associated with your business. This means that you expect to receive a concrete business benefit from them. The principal purpose for the meal must be business. You can’t go out with a group of friends for the evening, discuss business with one of them for a few minutes, and then write off the check.
  3. You must be able to substantiate the expenses. There are requirements for proving that meal and beverage expenses qualify for a deduction. You must be able to establish the amount spent, the date and place where the meals took place, the business purpose and the business relationship of the people involved.

Set up detailed recordkeeping procedures to keep track of business meal costs. That way, you can prove them and the business connection in the event of an IRS audit.

Other considerations

What if you spend money on food and beverages at an entertainment event? The IRS clarified in guidance (Notice 2018-76) that taxpayers can still deduct 50% of food and drink expenses incurred at entertainment events, but only if business was conducted during the event or shortly before or after. The food-and-drink expenses should also be “stated separately from the cost of the entertainment on one or more bills, invoices or receipts,” according to the guidance.

Another related tax law change involves meals provided to employees on the business premises. Before the TCJA, these meals provided to an employee for the convenience of the employer were 100% deductible by the employer. Beginning in 2018, meals provided for the convenience of an employer in an on-premises cafeteria or elsewhere on the business property are only 50% deductible. After 2025, these meals won’t be deductible at all.

Plan ahead

As you can see, the treatment of meal and entertainment expenses became more complicated after the TCJA. Your tax advisor can keep you up to speed on the issues and suggest strategies to get the biggest tax-saving bang for your business meal bucks.

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Now or Later? When to Report Subsequent Events

Financial statements present a company’s financial position as of a specific date, typically the end of the year or quarter. But sometimes events happen shortly after the end of the period that have financial implications for the prior period or for the future. Here’s a look at what’s reportable and what’s not.

Classifying subsequent events

So-called “subsequent events” happen between the date of the financial statements and the date the financial statements are available to be issued. This lag usually lasts two or three months, because it takes time to record end-of-period journal entries, make estimates, draft footnotes and, if applicable, complete external compilation, review or audit procedures. The two types of subsequent events include:

Recognized. These events provide further evidence of conditions that existed on the financial statement date. For example, a major customer might file for bankruptcy. There was probably evidence of the customer’s financial distress in the prior period, such as a decrease in revenue or a buildup of receivables. The customer’s bankruptcy filing may trigger a write-off for bad debts to be recorded on the balance sheet in the prior period.

Nonrecognized. These subsequent events reflect unforeseeable conditions that didn’t exist at the end of the accounting period. Examples might include a change in foreign exchange rates, a fire or an unexpected natural disaster that severely damages the business.

Generally, the former must be recorded in the financial statements. The latter type of subsequent event isn’t required to be recorded but may have to be disclosed in the footnotes.

Disclosing subsequent events

Nonrecognized subsequent events must be disclosed in the footnotes only if failure to disclose the details would cause the financial statements to be misleading to investors and lenders. Subsequent event disclosures should include 1) a description of the nature of the event, and 2) an estimate of the financial effect (or, if not practical, a statement that an estimate can’t be made).

In some extreme cases, the effect of a subsequent event may be so pervasive that a company’s viability is questionable. This may cause the CPA to re-evaluate the going concern assumption that underlies its financial statements.

Footnotes add value

Subsequent events may not be reflected on a company’s balance sheet or income statement. But, when in doubt, companies typically disclose subsequent events to promote transparency in financial reporting. Contact us for more information about reporting and disclosing subsequent events.

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