efficiently getting cash out of your business

Efficiently Getting Cash Out of Your Business

Sarah Anderson CPA, MSTBonnie Trochim CPA

Introductions

EisnerAmper, LLP

Participant What do you want out of class? What type of business do you own?

Course summary

Cash flow basics Business structures Accounting methods Timing of income and expenses Getting cash out by entity type / Basis Other ways to get cash out Self employment taxes and planning Special tax deductions Useful web resources

Cash-in minus cash-out does not equal profit

Important concepts: Cash-in minus Cash-out = Cash left-over Basics:

What counts as income? What counts as expenses? Taxability depends on:

Forms of businesses Accounting methods

What counts as income?

Cash-in normally = income

There are some exceptions – examples: Rebates or refunds for products reduce the

expense Deposits other people pay you Sales tax collected is a liability owed to the state Borrowed funds are liabilities Owner’s contributions

What counts as expense?

Cash-out normally = expenses

There are some exceptions: Capital Assets Deposits to others Partial/non-deductible expenses Loan re-payments Distributions to Owners

Cash flow vs. net income example

Description Amount

Receipts from Services 10,000

Loan from Bank 20,000

Business Insurance Payment 1,500

Loan Repayment 1,000 Principal 500 Interest

Cash flow vs. net income answer

Description Cash Flow Net Income

Receipts from Services 10,000 10,000

Loan from Bank 20,000 -0-

Business Insurance Payment (1,500) (1,500)

Loan Repayment (1,500) (500)

Total 27,000 8,000

Types of business structure

Sole Proprietorship/SMLLC – Schedule “C”

Partnership/LLC (& entities tax as partnership) Corporation:

C Corporation S Corporation (C-Corp with special election)

Types of business structure (continued)

Sole proprietors or SMLLC – Income reported on owner’s income tax return (Schedule C)

Partnerships (and LLCs) and S-corporations - Income reported on a business return and will flow through to the owner’s individual income tax return (via K-1)

C-corporations - Income taxed on the corporate return.

Where does income get reported?

Wages (from Corp)

Schedule C Income/(Loss)

S Corp / Partnership Income/(Loss)

Accounting methods

Selection required

Determines the timing of income and expenses

Chosen when you file your initial income tax return

Requires IRS approval to change your method

Accounting methods (continued)

Two basic types : Cash basis Accrual basis

Same method used for income and expenses Business with inventory require accrual.

(Exceptions) Gross receipts amounts can prohibit using the

cash method

Cash basis of accounting

Definition: Income - Payment received from customers

Expense - When paying vendor bills

NO AR, AP or Accruals.

Accrual basis of accounting

Definition: Income - When you bill a customer.

Expense - When you receive vendor bills.

Accounting records include AR, AP and Accruals.

Timing of income and expenses

Strategies to control tax liability for the cash basis taxpayer

Timing when income is recognized

Timing when deductible expenses are paid

Deferring your income taxes to increase your cash flow

Timing misconceptions

Receipt of payment via check is income when received not when deposited.

Expenses are recorded when mailed not when checks are cut and put in your drawer.

Credit cards are the exception

Timing example – cash basis

Description Cash Flow

Check received for services 12/30/10. Deposited 1/4/11.

15,000

Business insurance check cut and mailed 12/29/10. Cleared 1/5/11.

2,000

Mailed invoice to client 12/30/10. Check not received until 1/15/11.

5,000

Utility bill received 12/28/10. Payment made 1/3/11.

500

Timing example – cash basis answer

Description 2010 2011

Check received for services 12/30/10. Deposited 1/4/11.

15,000

Business insurance check cut and mailed 12/29/10. Cleared 1/5/11.

(2,000)

Mailed invoice to client 12/30/10. Check not received until 1/15/11.

5,000

Utility bill received 12/28/10. Payment made 1/3/11.

(500)

Net Income Impact 13,000 4,500

Timing example – planning

Description Year w/ High Income

Year w/ Low Income

Invoice customers / collection calls immediately

XDelay invoicing customers XPre-pay bills XDelay payment of bills X

Getting cash out – sole proprietor

Business is your alter ego, one and the same Cash can be freely taken out of and put into the

business. Owner does NOT take a salary. There are no loans to and from the company

with the owner Distributions are never taxable. **Need to keep a separate bank account** Don’t forget estimated tax payments

Unique to sole proprietorship

Sole proprietor can hire his or her minor child and not pay any payroll taxes

Additionally, the earned income of the minor child under 18 is not subject to federal income tax if the child earns less than his standard deduction ($5,700 for 2010)

A child may qualify to contribute $5,000 to a deductible IRA or nondeductible Roth for 2010

Deductible by business if: Child actually performs the work Payments are actually made

Tax consequences of owner withdrawal example

Description AmountReceipts from Services 10,000Loan from Bank 20,000Business Insurance Payment 1,500


Withdrawal by Owner 7,000

Tax consequences of owner withdrawal results






Withdrawal by Owner (7,000) -0-

Total 20,000 8,000

Tax consequences of owner withdrawal example

Description AmountReceipts from Services 10,000Loan from Bank 20,000Business Insurance Payment 1,500


Withdrawal by Owner 27,000

Tax consequences of owner withdrawal results






Withdrawal by Owner (27,000) -0-

Total -0- 8,000

Distributions

Distributions – S Corporations, partnerships and LLCs

Withdrawals from the business of cash or property

Generally are non-taxable since shareholders, partners & members are taxed on income when it is earned or received

Taxable in certain situations

Basis

What is “basis” and why is it important? Your cumulative investment in the business

Losses may be disallowed if you do not have sufficient “basis” in the S Corporation, partnership or LLC

Distributions may become taxable

Determination of the gain or loss on the sale of your business ownership interest

Basis (continued)

How is it computed? A shareholder or member’s basis is determined

as followed:

Original investment +- Contributions/Distributions +- Net income/ Loss +- Debt/Liabilities

Can never be less than zero

S corporation basis example year 1

Description AmountNet Income 100,000Capital Contributions from Owner 20,000Distributions to Owner 50,000

S corporation basis solution year 1

Description AmountNet Income 100,000Capital Contributions from Owner 20,000Distributions to Owner (50,000)

Basis at Year-end 70,000

Note: Taxable income is $100,000.

S corporation – basis example year 2

Description AmountBeginning Basis 70,000Net Income 20,000Distributions to Owner 100,000

S corporation basis solution year 2

Description AmountBeginning Basis 70,000Net Income 20,000Distributions to Owner (100,000)

Basis at Year-end Pre Gain (10,000)

Distributions in Excess of Basis – Capital Gain 10,000

Basis at Year-end -0-

Note: Taxable ordinary income is $20,000 and taxable capital gain income is 10,000.

Avoid distributions that may be taxable

Losses with limits – If only this were true

Make sure you consider the taxability of distributions from the business before the funds are withdrawn from the business

Basis – impact of debt

Impact of debt/liabilities on basis

A shareholder’s basis in a S-corporation is increased by the amount of monies the shareholder directly loaned to the corporation.

A partner or member’s basis in a partnership of LLC is increased for the amount of partnership or LLC’s loans it personally guarantees or is “at risk” for.

Shareholder, partner & member loans

S Corporations, partnership and LLCs

May borrow monies from their company. These loans should be properly documented

and should include the following:

Written promissory note Bear a AFR interest rate Have specific repayment terms or a schedule

Shareholder, partner & member loans (continued)

The IRS may reclassify the payment as a taxable dividend or compensation if it determines the arrangement is not a bona fide loan

Even with proper paperwork in place, if the payment has characteristics of compensation or a dividend payment, the IRS can re characterize it as a distribution to the shareholder (making it non-deductible)

S corporation basis example w/ debt

Description AmountNet Income/(Loss) (60,000)

Capital Contributions from Owner 100,000

Distributions to Owner 50,000

Loan to Corporation from Shareholder 15,000

Shareholder guaranteed bank debt 40,000

S corporation basis solution w/ debt



Distributions to Owner (50,000)



Note: The debt guarantee does NOT give the shareholder basis.

Partnership basis example w/ debt



Distributions to Owner 50,000


Shareholder guaranteed bank debt 40,000

Partnership basis solution w/ debt



Distributions to Owner (50,000)

Loan to Corporation from Partner 15,000

Partner guaranteed bank debt 40,000


Basis planning opportunities

If the business has losses Make the contribution before year-end Plan withdrawals after year-end

If a partnership or LLC will be borrowing soon, consider having them obtain the new loan before year-end.

Getting cash out - S corporation

Salary Shareholders that perform services.

Can take a salary from the corporation. Salary is a deduction for the corporation and is ordinary

income for the shareholder. The wages are subject to the normal payroll taxes.

Compensation from the corporation – it must be reasonable

• The character & financial condition of the corporation• The role of the shareholder-employee • The corporations compensation policy/history• Comparison to similar companies• Independent investor view.

Getting cash out - S corporation (continued)

Distributions Must be pro-rata based on shareholder ownership

interest Can trigger capital gain income to shareholder if

there isn’t sufficient basis.

Getting cash out – C corporation

Salary (same as S Corporation) Shareholders that perform services.

Can take a salary from the corporation. Salary is a deduction for the corporation and is ordinary

income for the shareholder. The wages are subject to the normal payroll taxes.

Compensation from the corporation – it must be reasonable

The character & financial condition of the corporation The role of the shareholder-employee The corporations compensation policy/history Comparison to similar companies Independent investor view.

Getting cash out – C corporation (continued)

Dividends Taxed at 15% (for US Corporations & certain foreign

corporations) Double taxed income

No distributions like S corporation and Partnerships

Getting cash out – partnership/LLC

Guaranteed Payments Payments for services (a partnership’s version of

salary) The partnership gets a deduction for the total

guaranteed payments. The payments are specifically allocated as income

to the partner or member to which it was paid. Subject to self-employment taxes Reported on K-1, not W-2

Getting cash out – partnership/LLC (continued)

Distributions Do NOT need to be made pro-rata. They are

based upon partnership agreement Can trigger capital gain income to partner/member

if there isn’t sufficient basis. In certain situations distributing property from a

partnership may be beneficial though the basis in the property distributed will never be higher than the basis in the partnership

Other ways to get cash out

Rents between related entities

Fringe-benefits

Retirement plans

Rents between related entities

Forming a entity with rental property/equipment/intangibles.

The operating entity realizes tax deduction for the rent paid, and owner avoids the payroll tax liability

The owner reports the rental income and expenses on personal income tax return

Liability shield for operating entity. Isolates a valuable asset

Rents between related parties

Deductibility of rents between related parties is cash basis

Additional factors to consider: Rents should be reasonable – document the

commercial practices of rents paid for similar properties in the area at the time the lease is entered into

Lease should be in writing Rents should be paid on time

Fringe benefits

Fringe benefits such as

health insurance medical reimbursement travel, education group term life insurance

Costs that would otherwise be non-deductible personal expenses can be converted into tax deductions

Fringe benefits (continued)

Employer sponsored educational assistance programs can deliver up to $5,250 in annual tax-free reimbursements to each eligible employee

Can benefit S or C corporation, partnership, sole proprietorship or LLC

The education need not be job related Graduate-level courses qualify Program must be set up under a written plan

of the employer for the exclusive benefit of employees (Sec. 127(b)(1))

Fringe benefits (continued)

There is a benefit for any child who is: Age 21 or older and a legitimate employee of

the parent’s business;

Not a more-than-5% owner of the business in his own right; and

Not a dependent of the parent (business owner)

Qualified retirement plans

Tax advantages of qualified retirement plans

Immediate tax deduction/defer payment

Income earned within the plan fund is tax deferred

Employees incur no tax liability until amounts are distributed

Qualified distributions can be rolled over tax free

Qualified retirement plans (continued)

One of the best tools for tax savings

Qualified retirement plans fall into two basic categories

Defined-contribution plans

Defined benefit plans

Defined contribution plans

• Based on the amount contributed to an employee’s individual account plus an earnings or forfeitures of other employees that are allocated to that account.

• Plan contributions are determined by a formula and not by actuarial requirements

Defined contribution plans (continued)

Types of plans: Profit sharing plan (discretionary contribution) Savings incentive match plans for employees

(SIMPLE) 401(k) / Solo 401(k) Simplified Employee Pensions (SEPs) Individual Retirement Arrangements (IRAs)

Defined benefit plans

Any qualified retirement plan that is not considered a defined-contribution plan.

Contribution actuarially computed.

Useful for business owners in their 50s who are looking to retire over the next 10 to 15 years but have not saved much towards retirement

Guarantees the business owner a specific retirement plan based on age, years of service and pay

Retirement plans – useful link

http://www.retirementplans.irs.gov/

http://www.retirementplans.irs.gov/

Reduce self-employment taxes

Taxable income passed through by an S corporation (via K-1) to its shareholder-employee is not self-employment income for SE tax purposes

This has led to the tax planning idea of minimizing SE taxes by characterizing a small portion of S corporation income as salary, and a large portion as distributions.

IRS can recharacterize the distributions as “disguised wages” subject to SE tax


SMLLC vs. S Corporation T owns an existing sole proprietorship. She is

considering contributing the business to a newly formed SMLLC or S corporation.

Taxable income is expected to be $100,000. T expects to contribute $10,000 to a SEP. T expects to pay $5,000 for medical insurance

premiums. T is the only employee. T will have sufficient basis in S corporation

stock and take a $35,000 distribution.

.

Results with SMLLC

It will be treated as a sole proprietorship for tax purposes.

No change on reporting on tax return. T’s SE income is $92,350 ($100,000 x 0.9235). SE tax liability is $14,130 (15.3% of $92,350).

Results with S corporation

T pays herself a “reasonable salary of $50,000. The corporation will make contributions of

$10,000 to the company retirement plan. The corporation will pay medical insurance

premiums of $5,000. FICA taxes are due only on the salary of

$50,000. The medical premiums are taxable, but not

subject to FICA tax. FICA tax liability is $7,650 (15.3% of $50,000).


Partnership vs. S Corporation S & B are forming a new business as 50/50 co-

owners. It can be operated as either an partnership or S corporation.

Taxable income is expected to be $200,000. Retirement contributions will be $10,000 for

both S & B. Medical insurance premiums will be $5,000 for

both S & B. S & B will have sufficient basis in S corporation

stock and take a $35,000 distribution each.

Results with partnership

Each owner’s SE income is $92,350 ($100,000 x 0.9235.

SE tax liability for both S & B is $14,130 (15.3% of $92,350).

Results with S corporation

S & B pay themselves a “reasonable salary of $50,000 to each.

The corporation will make contributions of $10,000 to the company retirement plan for each owner.

The corporation will pay medical insurance premiums of $5,000 for each owner.

FICA taxes are due only on the salary of $50,000.

The medical premiums are taxable, but not subject to FICA tax.

FICA tax liability is $7,650 (15.3% of $50,000).

Special tax deductions

Automobile expenses

Home office deduction

Self-employed health premiums

Depreciation

Start-up expenses

Special tax deductions (continued)

Automobile Expenses Deductible auto expenses for a business can

be accounted for by using one of two methods:

Standard mileage method Actual expense method

Taxpayers that qualify for both methods may choose the most beneficial method.


Automobile Expenses - actual

Percentage related to business use

Track business miles/total miles

Keep complete and accurate mileage records Deduction disallowed if unable to produce

contemporaneous records


Standard mileage method – company deducts a standard rate for each business mile driven

50 cents per mile for 2010

Additional expenses allowed for deduction that are not included in the standard mileage rate include

Business parking fees and tolls Local transportation such as bus, cab, train


Election to use the Standard Method made in the year the car is placed in service

In a later year, you can switch to the actual method Straight-line depreciation required

Leased vehicles elections to use standard mileage method must be

used for the entire lease period.


Home Office Deduction

To qualify for the deduction a portion of the home must be used EXCLUSIVELY on a regular basis as:

The principal place of any business

A place of business that is used by clients or customers in meeting or dealing with the taxpayer in the normal course of business.


If these tests are met than the taxpayer needs to determine what percentage of the home is used for business.

Take the square footage of the business use section over the total square footage of the home.

Multiply this percentage by the qualifying indirect expenses to come up with the home office deduction.


Examples of qualifying expenses subject to allocation are

Real estate taxes Mortgage interest Rent Utilities Repairs & maintenance Depreciation, etc.

Direct expenses are 100% deductible


Sale of a residence with home office Attached home offices

Do not need to allocate the gain on sale “Recapture” of depreciation allowed or allowable on

the home office after May 6, 1997 Designed to prevent a double benefit

Detached home offices Allocate gain and treat as two separate properties


Example T sold his home in 2009 at a $30,000 gain. T used part of the home as a business office in

2008 and claimed $500 depreciation. Because the business office was part of his

home (not separate) T does not have to allocate gain. T also does not have to report any gain on Form 4797. However, T must recognize the $500 of the gain as unrecaptured 1250 gain. He reports his gain, exclusion, and taxable gain of $500 on Schedule D.


Self Employed Health Insurance Premiums

SEHIP are not subject to the normal medical expense limitations – However, watch income limitations

‘S’ Shareholders and partners are considered self employed for this purpose


Tax year 2010

100% of SEHIP is deducted on page 1 of the 1040 with no limitation.

The Small Business Jobs Bill allows self-employed individuals to take the health insurance deduction into account in calculating net earnings from self-employment


Depreciation

Depreciation is allocation of cost, not loss of value

Total cost divided by estimated useful life equals yearly depreciation

Non-cash expense Depreciation creates difference between cash

flow and profit/loss statement


Small Business Jobs Act of 2010 raised maximum Section 179 expensing limit for tax years beginning in 2010 and 2011 to $500,000 (formerly $250,000)

Maximum expensing amounts (beginning of phase-out amount) s raised $2,000,000 (from $800,000)

Needs to be placed in service Can be new or used property Includes qualified real property expensing

(qualified leasehold improvement, restaurant property and retail improvement property)


Bonus first-year depreciation extended through 2010

In 2010, Bonus Depreciation – 50% of cost after any Section 179 Depreciation. Available for new property only. Extended under Small Business Tax Relief

Portion after 179 and Bonus, subject to regular depreciation


Start-up expenses Must be capitalized unless election made Includes investigation, acquisition, or

establishment of a trade or business Immediate write-off of certain amounts incurred The Small Business Jobs Act increases the

Section 195 deduction for trade or business startup expenses from $5,000 to $10,000 for tax years beginning 2010 & 2011

The start of the limitation on the deduction is increased from $50,000 to $60,000


Net operating loss carry-back

Small business with deductions exceeding their income in 2008 and 2009 can use a new net operating loss tax provision to get a refund of taxes paid over the past five years instead of the usual two

Examine your earlier returns to see if you had income that could be offset by a loss carry back. This could result in a tax refund to you

Some useful websites

Internal Revenue Service www.irs.gov www.sbrg.irs.gov

United States Government www.business.gov

New Jersey http://www.state.nj.us/treasury/taxation/ http://www.state.nj.us/nj/business/

http://www.irs.gov/

http://www.sbrg.irs.gov/

http://www.business.gov/

http://www.state.nj.us/treasury/taxation/

http://www.state.nj.us/nj/business/

QUESTIONS?Thank you for coming!

Contact information

Sarah Anderson CPA, MSTEisnerAmper LLP750 Route 202 South, Suite 500Bridgewater, NJ 08807908-218-5002 ext [email protected]

Bonnie Trochim CPAEisnerAmper LLP750 Route 202 South, Suite 500Bridgewater, NJ 08807908-218-5002 ext [email protected]

mailto:[email protected]

mailto:[email protected]

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.

EisnerAmper LLP is an independent member firm of PKF International Limited

efficiently getting cash out of your business

Documents

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debtdescriptionamountnet

special tax

se tax liability

medical insurance

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fica tax liability

payment made