What’s excluded from the balance sheet?

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Financial statements help investors and lenders monitor a company’s performance. However, financial statements may not provide a full picture of financial health. What’s undisclosed could be just as significant as the disclosures. Here’s how a CPA can help stakeholders identify unrecorded items either through external auditing procedures or by conducting agreed upon procedures (AUPs) that target specific accounts.

Start with assets

Revealing undisclosed liabilities and risks begins with assets. For each asset, it’s important to evaluate what could cause the account to diminish. For example, accounts receivable may include bad debts, or inventory may include damaged goods. In addition, some fixed assets may be broken or in desperate need of repairs and maintenance. These items may signal financial distress and affect financial ratios just as much as unreported liabilities do.

Some of these problems may be uncovered by touring the company’s facilities or reviewing asset schedules for slow-moving items. Benchmarking can also help. For example, if receivables are growing much faster than sales, it could be a sign of aging, uncollectible accounts.

Evaluate liabilities

Next, external accountants can assess liabilities to determine whether the amount reported for each item seems accurate and complete. For example, a company may forget to accrue liabilities for salary or vacation time.

Alternatively, management might underreport payables by holding checks for weeks (or months) to make the company appear healthier than it really is. This ploy preserves the checking account while giving the impression that supplier invoices are being paid. It also mismatches revenues and expenses, understates liabilities and artificially enhances profits. Delayed payments can hurt the company’s reputation and cause suppliers to restrict their credit terms.

Identify unrecorded items

Finally, CPAs can investigate what isn’t showing on the balance sheet. Examples include warranties, pending lawsuits, IRS investigations and an underfunded pension. Such risks appear on the balance sheet only when they’re “reasonably estimable” and “more than likely” to be incurred.

These are subjective standards. In-house accounting personnel may claim that liabilities are too unpredictable or remote to warrant disclosure. Footnotes, when available, may shed additional light on the nature and extent of these contingent liabilities.

Need help?

An external audit is your best line of defense against hidden risks and potential liabilities. Or, if funds are limited, an AUP engagement can target specific high-risk accounts or transactions. Contact our experienced CPAs to gain a clearer picture of your company’s financial well-being.

© 2018

Summer 2018 Auto Focus

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In this quarter’s issue of Auto Focus, the following be will discussed:

  • Insurance: Do you have adequate coverage?
  • Tax Credit could prompt more paid family and medical leave
  • Hiring a CFO or controller
  • Lease accounting Standard: Get Ready! Deadlines are fast approaching!

Click Here for the Summer 2018 Auto Focus Newsletter

The Big, Bad Kiddie Tax

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Once upon a time, some parents and grandparents would attempt to save tax by putting investments in the names of their young children or grandchildren in lower income tax brackets. To discourage such strategies, Congress created the “kiddie” tax back in 1986. Since then, this tax has gradually become more far-reaching. Now, under the Tax Cuts and Jobs Act (TCJA), the kiddie tax has become more dangerous than ever.

A short history

Years ago, the kiddie tax applied only to children under age 14 — which still provided families with ample opportunity to enjoy significant tax savings from income shifting. In 2006, the tax was expanded to children under age 18. And since 2008, the kiddie tax has generally applied to children under age 19 and to full-time students under age 24 (unless the students provide more than half of their own support from earned income).

What about the kiddie tax rate? Before the TCJA, for children subject to the kiddie tax, any unearned income beyond a certain amount ($2,100 for 2017) was taxed at their parents’ marginal rate (assuming it was higher), rather than their own likely low rate.

A fiercer kiddie tax

The TCJA doesn’t further expand who’s subject to the kiddie tax. But it will effectively increase the kiddie tax rate in many cases.

For 2018–2025, a child’s unearned income beyond the threshold ($2,100 again for 2018) will be taxed according to the tax brackets used for trusts and estates. For ordinary income (such as interest and short-term capital gains), trusts and estates are taxed at the highest marginal rate of 37% once 2018 taxable income exceeds $12,500. In contrast, for a married couple filing jointly, the highest rate doesn’t kick in until their 2018 taxable income tops $600,000.

Similarly, the 15% long-term capital gains rate takes effect at $77,201 for joint filers but at only $2,601 for trusts and estates. And the 20% rate kicks in at $479,001 and $12,701, respectively.

In other words, in many cases, children’s unearned income will be taxed at higher rates than their parents’ income. As a result, income shifting to children subject to the kiddie tax will not only not save tax, but it could actually increase a family’s overall tax liability.

The moral of the story

To avoid inadvertently increasing your family’s taxes, be sure to consider the big, bad kiddie tax before transferring income-producing or highly appreciated assets to a child or grandchild who’s a minor or college student. If you’d like to shift income and you have adult children or grandchildren who’re no longer subject to the kiddie tax but in a lower tax bracket, consider transferring such assets to them.

Please contact us for more information about the kiddie tax — or other TCJA changes that may affect your family.

© 2018

Family Limited Partnerships & Succession Planning

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One of the biggest concerns for family business owners is succession planning — transferring ownership and control of the company to the next generation. Often, the best time tax-wise to start transferring ownership is long before the owner is ready to give up control of the business.
A family limited partnership (FLP) can help owners enjoy the tax benefits of gradually transferring ownership yet allow them to retain control of the business.

How it works

To establish an FLP, you transfer your ownership interests to a partnership in exchange for both general and limited partnership interests. You then transfer limited partnership interests to your children.

You retain the general partnership interest, which may be as little as 1% of the assets. But as general partner, you can still run day-to-day operations and make business decisions.

Tax benefits

As you transfer the FLP interests, their value is removed from your taxable estate. What’s more, the future business income and asset appreciation associated with those interests move to the next generation.

Because your children hold limited partnership interests, they have no control over the FLP, and thus no control over the business. They also can’t sell their interests without your consent or force the FLP’s liquidation.

The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount — so greater portions of the business can be transferred before triggering gift tax. For example, if the discount is 25%, in 2018 you could gift an FLP interest equal to as much as $20,000 tax-free because the discounted value wouldn’t exceed the $15,000 annual gift tax exclusion.

To transfer interests in excess of the annual exclusion, you can apply your lifetime gift tax exemption. And 2018 may be a particularly good year to do so, because the Tax Cuts and Jobs Act raised it to a record-high $11.18 million. The exemption is scheduled to be indexed for inflation through 2025 and then drop back down to an inflation-adjusted $5 million in 2026. While Congress could extend the higher exemption, using as much of it as possible now may be tax-smart.

There also may be income tax benefits. The FLP’s income will flow through to the partners for income tax purposes. Your children may be in a lower tax bracket, potentially reducing the amount of income tax paid overall by the family.

FLP risks

Perhaps the biggest downside is that the IRS scrutinizes FLPs. If it determines that discounts were excessive or that your FLP had no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.

The IRS pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for example, can indicate that an FLP was set up solely as a tax-reduction strategy.

Right for you?

An FLP can be an effective succession and estate planning tool, but it isn’t risk free. Please contact us for help determining whether an FLP is right for you.

© 2018

Do you qualify for the home-office deduction?

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Under the Tax Cuts and Jobs Act, employees can no longer claim the home office deduction. If, however, you run a business from your home or are otherwise self-employed and use part of your home for business purposes, the home office deduction may still be available to you.

Home-related expenses

Homeowners know that they can claim itemized deductions for property tax and mortgage interest on their principal residences, subject to certain limits. Most other home-related expenses, such as utilities, insurance and repairs, aren’t deductible.

But if you use part of your home for business purposes, you may be entitled to deduct a portion of these expenses, as well as depreciation. Or you might be able to claim the simplified home office deduction of $5 per square foot, up to 300 square feet ($1,500).

Regular and exclusive use

You might qualify for the home office deduction if part of your home is used as your principal place of business “regularly and exclusively,” defined as follows:

1. Regular use. You use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use.

2. Exclusive use. You use the specific area of your home only for business. It’s not necessary for the space to be physically partitioned off. But, you don’t meet the requirements if the area is used both for business and personal purposes, such as a home office that also serves as a guest bedroom.

Regular and exclusive business use of the space aren’t, however, the only criteria.

Principal place of business

Your home office will qualify as your principal place of business if you 1) use the space exclusively and regularly for administrative or management activities of your business, and 2) don’t have another fixed location where you conduct substantial administrative or management activities.

Examples of activities that are administrative or managerial in nature include:

  • Billing customers, clients or patients,
  • Keeping books and records,
  • Ordering supplies,
  • Setting up appointments, and
  • Forwarding orders or writing reports.

Meetings or storage

If your home isn’t your principal place of business, you may still be able to deduct home office expenses if you physically meet with patients, clients or customers on your premises. The use of your home must be substantial and integral to the business conducted.

Alternatively, you may be able to claim the home office deduction if you have a storage area in your home — or in a separate free-standing structure (such as a studio, workshop, garage or barn) — that’s used exclusively and regularly for your business.

Valuable tax-savings

The home office deduction can provide a valuable tax-saving opportunity for business owners and other self-employed taxpayers who work from home. If you’re not sure whether you qualify or if you have other questions, please contact us.

© 2018

401(k) Hardship Withdrawals

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Many employers sponsor 401(k) plans to help employees save for retirement, but sometimes those employees need access to plan funds well before they retire. In such cases, if the plan allows it, participants can make a hardship withdrawal.

If your organization sponsors a 401(k) with this option, you should know that there are important changes on the way next year.

What will be different

Right now, 401(k) hardship withdrawals are limited to only funds an employee has contributed, and the employee must first take out a plan loan from the account. The employee also cannot participate in the plan for six months after a hardship withdrawal.

However, important changes take effect in 2019 under the Bipartisan Budget Act of 2018 (BBA). First, employees’ withdrawal limits will include not only their own contributed amounts, but also accumulated employer matching contributions plus earnings on contributions. If an employee has been participating in your 401(k) for several years, this could add substantially to the amount of funds available for withdrawal in the event of a legitimate hardship.

In addition, the BBA eliminates the current six-month ban on employee participation in the 401(k) plan following a hardship withdrawal. This means employees can stay in the plan and keep contributing, which allows them to begin recouping withdrawn amounts right away. And, for you, the plan sponsor, it means no longer having to re-enroll employees in the 401(k) after the six-month hiatus.

What remains the same

Some things haven’t changed. Hardship withdrawals are still subject to a 10% tax penalty, along with regular income tax. This combination could take a substantial bite out of the amount withdrawn, effectively forcing account holders to take out more dollars than they otherwise would have to, so as to wind up with the same net amount.

The BBA also didn’t change the reasons for which hardship withdrawals can be made. According to the IRS, such a withdrawal “must be made because of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need.” This can include the need of an employee’s spouse or dependent, as well as that of a nonspouse, nondependent beneficiary.

The agency has said that the meaning of “immediate and heavy” depends on the facts of the situation and assumes the employee doesn’t have any other way to meet the need.

Examples offered by the IRS include:

  • Qualified medical expenses
  • Tuition and related educational fees and expenses
  • Burial or funeral expenses

The agency has also cited costs related to a principal residence as usually qualifying. These include expenses related to the purchase of a principal residence, its repair after significant damage, and costs necessary to prevent eviction or foreclosure.

Further guidance

If your organization sponsors a 401(k) plan that permits hardship withdrawals, be sure to read up on all the details related to the BBA’s changes. Our firm can provide more information and further guidance.

© 2018