As year end approaches, it’s a good idea for calendar-year entities to review the guidelines for recognizing revenue and expenses. There are specific rules regarding accounting cutoffs under U.S. Generally Accepted Accounting Principles (GAAP). Strict observance of these rules is generally the safest game plan.

The basics

Companies that follow GAAP must use the accrual method of accounting, not the cash method. That means revenues and expenses must be matched to the periods in which they were earned or incurred. The end of the period serves as a “cutoff” for recognizing revenue and expenses. For a calendar-year business, the cutoff is December 31.

However, some companies may be tempted to play timing games to lower taxes or boost financial results. The temptation might be especially high in 2020, as many companies struggle during the COVID-19 pandemic.

Now or later

Test your understanding of the cutoff rules with these two hypothetical situations:

1. As of December 31, a calendar-year, accrual-basis auto dealership has verbally negotiated a deal on an SUV. But the customer hasn’t yet signed all the paperwork. Should the sale be reported in 2020 or 2021?
2. On December 30, a calendar-year, accrual-basis retailer pays its rent bill for January. Rent is due on the first day of the month. Can the store deduct the extra month’s rent in 2020 to help lower its tax bill?

In both examples, the transactions should be reported in 2021, not 2020. In the first example, even if the customer takes the car home for the weekend, it doesn’t matter; there’s still the possibility the customer could back out of the deal. The dealership can’t report the transaction in 2020 revenue until the customer has signed the paperwork and paid for the vehicle with cash or financing.

Audit procedures

If your financial statements are audited, your CPA will enforce strict cutoff rules — and likely reverse any items that were reported inaccurately. Audit procedures may include reviewing customer contracts and returns reported near year end. Auditors also may compare expenses as a percentage of revenues from period to period to identify timing errors. And they may vouch expenses to invoices and contracts for accuracy.

It never reflects favorably — in the eyes of investor or lenders — when auditors adjust year-end financial statements for inaccurate observation of cutoffs. Don’t give cause for others to wonder about your operations.

Timing is critical

Contact us if you need help understanding the rules on when to record revenue or expenses. We can help you comply with the rules and minimize financial statement adjustments during your audit.

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Owners of closely held corporations are often interested in easily withdrawing money from their businesses at the lowest possible tax cost. The simplest way is to distribute cash as a dividend. However, a dividend distribution isn’t tax-efficient, since it’s taxable to you to the extent of your corporation’s “earnings and profits.” And it’s not deductible by the corporation.

Other strategies

Fortunately, there are several alternative methods that may allow you to withdraw cash from a corporation while avoiding dividend treatment. Here are five strategies to consider:

• Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts that you’ve advanced to the business, the corporation can repay the debt without the repayment being treated as a dividend. Additionally, interest paid on the debt can be deducted by the corporation. This assumes that the debt has been properly documented with terms that characterize debt and that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, the “debt” repayment may be taxed as a dividend. If you make future cash contributions to the corporation, consider structuring them as debt to facilitate later withdrawals on a tax-advantaged basis.
• Compensation. Reasonable compensation that you, or family members, receive for services rendered to the corporation is deductible by the business. However, it’s also taxable to the recipient(s). This same rule applies to any compensation (in the form of rent) that you receive from the corporation for the use of property. In both cases, the compensation amount must be reasonable in terms of the services rendered or the value of the property provided. If it’s considered excessive, the excess will be a nondeductible corporate distribution.
• Loans. You can withdraw cash tax free from the corporation by borrowing money from it. However, to prevent having the loan characterized as a corporate distribution, it should be properly documented in a loan agreement or note. It should also be made on terms that are comparable to those in which an unrelated third party would lend money to you, including a provision for interest and principal. Also, consider what the corporation’s receipt of interest income will mean.
• Fringe benefits. You may want to obtain the equivalent of a cash withdrawal in fringe benefits, which aren’t taxable to you and are deductible by the corporation. Examples include life insurance, certain medical benefits, disability insurance and dependent care. Most of these benefits are tax-free only if provided on a nondiscriminatory basis to other corporation employees. You can also establish a salary reduction plan that allows you (and other employees) to take a portion of your compensation as nontaxable benefits, rather than as taxable compensation.
• Property sales. You can withdraw cash from the corporation by selling property to it. However, certain sales should be avoided. For example, you shouldn’t sell property to a more than 50%-owned corporation at a loss, since the loss will be disallowed. And you shouldn’t sell depreciable property to a more than 50%-owned corporation at a gain, since the gain will be treated as ordinary income, rather than capital gain. A sale should be on terms that are comparable to those in which an unrelated third party would purchase the property. You may need to obtain an independent appraisal to establish the property’s value.

Minimize taxes

If you’re interested in discussing any of these ideas, contact us. We can help you get the most out of your corporation at the lowest tax cost.

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Unfortunately, the COVID-19 pandemic has forced many businesses to shut down. If this is your situation, we’re here to assist you in any way we can, including taking care of the various tax obligations that must be met.

Of course, a business must file a final income tax return and some other related forms for the year it closes. The type of return to be filed depends on the type of business you have. Here’s a rundown of the basic requirements.

Sole Proprietorships. You’ll need to file the usual Schedule C, “Profit or Loss from Business,” with your individual return for the year you close the business. You may also need to report self-employment tax. 

Partnerships. A partnership must file Form 1065, “U.S. Return of Partnership Income,” for the year it closes. You also must report capital gains and losses on Schedule D. Indicate that this is the final return and do the same on Schedules K-1, “Partner’s Share of Income, Deductions, Credits, Etc.”

All Corporations. Form 966, “Corporate Dissolution or Liquidation,” must be filed if you adopt a resolution or plan to dissolve a corporation or liquidate any of its stock.

C Corporations. File Form 1120, “U.S. Corporate Income Tax Return,” for the year you close. Report capital gains and losses on Schedule D. Indicate this is the final return.

S Corporations. File Form 1120-S, “U.S. Income Tax Return for an S Corporation” for the year of closing. Report capital gains and losses on Schedule D. The “final return” box must be checked on Schedule K-1.

All Businesses. Other forms may need to be filed to report sales of business property and asset acquisitions if you sell your business.

Employees and contract workers

If you have employees, you must pay them final wages and compensation owed, make final federal tax deposits and report employment taxes. Failure to withhold or deposit employee income, Social Security and Medicare taxes can result in full personal liability for what’s known as the Trust Fund Recovery Penalty.

If you’ve paid any contractors at least $600 during the calendar year in which you close your business, you must report those payments on Form 1099-NEC, “Nonemployee Compensation.”

Other tax issues

If your business has a retirement plan for employees, you’ll want to terminate the plan and distribute benefits to participants. There are detailed notice, funding, timing and filing requirements that must be met by a terminating plan. There are also complex requirements related to flexible spending accounts, Health Savings Accounts, and other programs for your employees.

We can assist you with many other complicated tax issues related to closing your business, including Paycheck Protection Plan (PPP) loans, the COVID-19 employee retention tax credit, employment tax deferral, debt cancellation, use of net operating losses, freeing up any remaining passive activity losses, depreciation recapture, and possible bankruptcy issues.

We can advise you on the length of time you need to keep business records. You also must cancel your Employer Identification Number (EIN) and close your IRS business account.

If your business is unable to pay all the taxes it owes, we can explain the available payment options to you. Contact us to discuss these issues and get answers to any questions.

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The coming audit season might be much different than seasons of yore. As many companies continue to operate remotely during the COVID-19 pandemic, audit procedures are being adjusted accordingly. Here’s what might change as auditors work on your company’s 2020 year-end financial statements.

Eye on technology

Fortunately, when the pandemic hit, many accounting firms already had invested in staff training and technology to work remotely. For example, they were using cloud computing, remote access, videoconferencing software and drones with cameras. These technologies were intended to reduce business disruptions and costs during normal operating conditions. But they’ve also helped firms adapt while businesses are limiting face-to-face contact to prevent the spread of COVID-19.

When social distancing measures went into effect in the United States around mid-March, many calendar-year audits for 2019 were already done. As we head into the next audit season, be prepared for the possibility that most procedures — from year-end inventory observations to management inquiries and audit testing — to be performed remotely. Before the start of next year’s audit, discuss which technologies your audit team will be using to conduct inquiries, access and verify data, and perform testing procedures.

Emphasis on high-risk areas

During a remote audit, expect your accountant to target three critical areas to help minimize the risk of material misstatement:

1. Internal controls. Historically, auditors have relied on the effectiveness of a client’s controls and testing of controls. Now, they must evaluate how transactions are being processed by employees who work remotely, rather than on-site as in prior periods. Specifically, your auditor will need to consider whether modified controls have been adequately designed and put into place and whether they’re operating effectively.

2. Fraud and financial misstatement. During fieldwork, auditors interview key managers and those charged with governance about fraud risks. These inquiries are most effective when done in person, because auditors can read body language and, if more than one person is present during an interview, judge the dynamics in a room. Auditors may request video conferences to help overcome the shortcomings of inquiries done over the phone or via email.

3. Physical inventory counts. Normally, auditors go where inventory is located and observe the counting process. They also perform independent test counts and check them against the inventory records. Depending on the COVID-19 situation at the time of an audit, auditors may be unable to travel to the company’s facilities, and employees might not be there physically to perform the counts. Drones, videoconferencing and live video feeds from a warehouse’s security cameras may be suitable alternatives to on-site observations.

Modified reports

In some cases, audit firms may be unable to perform certain procedures remotely, due to technology limitations or insufficient access to data needed to comply with all the requirements of the auditing standards. In those situations, your auditor might decide to issue a modified audit report with scope restrictions and limitations. Contact your CPA for more information about remote auditing and possible modifications to your company’s audit report.

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A conflict of interest could impair your auditor’s objectivity and integrity and potentially compromise you company’s financial statements. That’s why it’s important to identify and manage potential conflicts of interest.

What is a conflict of interest?

According to the America Institute of Certified Public Accountants (AICPA), “A conflict of interest may occur if a member performs a professional service for a client and the member or his or her firm has a relationship with another person, entity, product or service that could, in the member’s professional judgment, be viewed by the client or other appropriate parties as impairing the member’s objectivity.” Companies should be on the lookout for potential conflicts when:

• Hiring an external auditor,
• Upgrading the level of assurance from a compilation or review to an audit, and
• Using the auditor for a non-audit purposes, such as investment advisory services and human resource consulting.

Determining whether a conflict of interest exists requires an analysis of facts. Some conflicts may be obvious, while others may require in-depth scrutiny.

For example, if an auditor recommends an accounting software to an audit client and receives a commission from the software provider, a conflict of interest likely exists. Why? While the software may suit the company’s needs, the payment of a commission calls into question the auditor’s motivation in making the recommendation. That’s why the AICPA prohibits an audit firm from accepting commissions from a third party when it involves a company the firm audits.

Now consider a situation in which a company approaches an audit firm to provide assistance in a legal dispute with another company that’s an existing audit client. Here, given the inside knowledge the audit firm possesses of the company it audits, a conflict of interest likely exists. The audit firm can’t serve both parties to the lawsuit and comply with the AICPA’s ethical and professional standards.

How can auditors prevent potential conflicts?

AICPA standards require audit firms to be vigilant about avoiding potential conflicts. If a potential conflict is unearthed, audit firms have the following options:

• Seek guidance from legal counsel or a professional body on the best path forward,
• Disclose the conflict and secure consent from all parties to proceed,
• Segregate responsibilities within the firm to avoid the potential for conflict, and/or
• Decline or withdraw from the engagement that’s the source of the conflict.

Ask your auditors about the mechanisms the firm has put in place to identify and manage potential conflicts of interest before and during an engagement. For example, partners and staff members are usually required to complete annual compliance-related questionnaires and participate in education programs that cover conflicts of interest. Firms should monitor conflicts regularly, because circumstances may change over time, for example, due to employee turnover or M&A activity.

For more information

Conflicts of interest are one of the gray areas in auditing. But it’s an issue our firm takes seriously and proactively safeguards against. If you suspect that a conflict exists, contact us to discuss the matter and determine the most appropriate way to handle it.

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Cash flow is a top concern for most businesses today. Cash flow forecasts can help you predict potential shortfalls and proactively address working capital gaps. They can also help avoid late payments, identify late-paying customers and find alternative sources of funding when cash is tight. To keep your company’s cash flow positive, consider applying these four best practices.

1. Identify peak needs

Many businesses are cyclical, and their cash flow needs may vary by month or season. Trouble can arise when an annual budget doesn’t reflect, for example, three months of peak production in the summer to fill holiday orders followed by a return to normal production in the fall.

For seasonal operations — such as homebuilders, farms, landscaping companies, recreational facilities and many nonprofits — using a one-size-fits-all approach can throw budgets off, sometimes dramatically. It’s critical to identify peak sales and production times, forecast your cash flow needs and plan accordingly.

2. Account for everything

Effective cash flow management requires anticipating and capturing every expense and incoming payment, as well as — to the greatest extent possible — the exact timing of each payable and receivable. But pinpointing exact costs and expenditures for every day of the week can be challenging.

Companies can face an array of additional costs, overruns and payment delays. Although inventorying all possible expenses can be a tedious and time-consuming exercise, it can help avoid problems down the road.

3. Seek sources of contingency funding

As your business expands or contracts, a dedicated line of credit with a bank can help meet your cash flow needs, including any periodic cash shortages. Interest rates on these credit lines can be comparatively high compared to other types of loans. So, lines of credit typically are used to cover only short-term operational costs, such as payroll and supplies. They also may require significant collateral and personal guarantees from the company’s owners.

4. Identify potential obstacles

For most companies, the biggest cash flow obstacle is slow collections from customers. Your business should invoice customers in a timely manner and offer easy, convenient ways for customers to pay (such as online bill pay). For new customers, it’s important to perform a thorough credit check to avoid delayed payments and write-offs.

Another common obstacle is poor resource management. Redundant machinery, misguided investments and oversize offices are just a few examples of poorly managed expenses and overhead that can negatively affect cash flow.

Adjusting as you grow and adapt

Your company’s cash flow needs today likely aren’t what they were three years ago — or even six months ago. And they’ll probably change as you continue to adjust to the new normal. That’s why it’s important to make cash flow forecasting an integral part of your overall business planning. We can help.

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On September 30, the Financial Accounting Standards Board (FASB) finalized a rule to defer the effective date of the updated long-term insurance standard for a second time. The deferral will give insurers more time to properly implement the changes amid the COVID-19 pandemic.

Need for change

After 12 years of work, the FASB issued Accounting Standards Update (ASU) No. 2018-12, Financial Services — Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, in August 2018 to improve and simplify the highly complex, nuanced reporting requirements for long-term insurance policies. The rules were designed to simplify targeted areas in reporting life insurance, disability income, long-term care and annuity payouts.

Specifically, the update requires insurers to:

• Review annually the assumptions they make about their policyholders, and
• Update the liabilities on their balance sheets if the assumptions change.

Under the updated guidance, insurance companies must measure updated liabilities using a standardized, market-observable discount interest rate based on the yield from an upper-medium-grade, fixed-income instrument. The method required by ASU No. 2018-12 is a more conservative approach than one used for insurance policies under existing guidance.

Requests for deferral

When the updated standard was issued, the original effective dates were fiscal years beginning after December 15, 2020, for public companies and a year later for private companies. In November 2019, the FASB postponed the standard’s effective dates from 2021 to 2022 for public companies and from 2022 to 2024 for smaller reporting companies (SRCs), private companies and not-for-profit organizations. This delay was designed to give insurance companies more time to update their software and methodology, train their staff, and conduct educational outreach to investors.

In March, the American Council of Life Insurers (ACLI), the trade organization that represents the sector, requested an additional delay, citing unprecedented challenges stemming from the COVID-19 crisis. The ACLI told the FASB that the impacts of the pandemic continue to escalate, with little clarity about how long the capital markets may persist within their current turbulent state.

During a recent meeting, the FASB voted 6-to-1 to postpone the effective date from 2022 to 2023 for large public companies and from 2024 to 2025 for other organizations.

We can help

The FASB has been sympathetic to companies that have been trying to navigate major accounting rule changes during these uncertain times. In addition to deferring the updated rules for long-term insurance contracts, the FASB in May postponed the effective dates for the updated revenue recognition and lease rules for certain entities. Contact us for more information about impending deadlines or for help implementing accounting rule changes that affect your organization.

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Are you wondering if the passive activity loss rules affect business ventures you’re engaged in — or might engage in?

If the ventures are passive activities, the passive activity loss rules prevent you from deducting expenses that are generated by them in excess of their income. You can’t deduct the excess expenses (losses) against earned income or against other nonpassive income. Nonpassive income for this purpose includes interest, dividends, annuities, royalties, gains and losses from most property dispositions, and income from certain oil and gas property interests. So you can’t deduct passive losses against those income items either.

Any losses that you can’t use aren’t lost. Instead, they’re carried forward, indefinitely, to tax years in which your passive activities generate enough income to absorb the losses. To the extent your passive losses from an activity aren’t used up in this way, you’ll be allowed to use them in the tax year in which you dispose of your interest in the activity in a fully taxable transaction, or in the tax year you die.

Passive vs. material

Passive activities are trades, businesses or income-producing activities in which you don’t “materially participate.” The passive activity loss rules also apply to any items passed through to you by partnerships in which you’re a partner, or by S corporations in which you’re a shareholder. This means that any losses passed through to you by partnerships or S corporations will be treated as passive, unless the activities aren’t passive for you.

For example, let’s say that in addition to your regular professional job, you’re a limited partner in a partnership that cleans offices. Or perhaps you’re a shareholder in an S corp that operates a manufacturing business (but you don’t participate in the operations).

If you don’t materially participate in the partnership or S corporation, those activities are passive. On the other hand, if you “materially participate,” the activities aren’t passive (except for rental activities, discussed below), and the passive activity rules won’t apply to the losses. To materially participate, you must be involved in the operations on a regular, continuous and substantial basis.

The IRS uses several tests to establish material participation. Under the most frequently used test, you’re treated as materially participating in an activity if you participate in it for more than 500 hours in the tax year. While other tests require fewer hours, all the tests require you to establish how you participated and the amount of time spent. You can establish this by any reasonable means such as contemporaneous appointment books, calendars, time reports or logs.

Rental activities

Rental activities are automatically treated as passive, regardless of your participation. This means that, even if you materially participate in them, you can’t deduct the losses against your earned income, interest, dividends, etc. There are two important exceptions:

• You can deduct up to $25,000 of losses from rental real estate activities (even though they’re passive) against earned income, interest, dividends, etc., if you “actively participate” in the activities (requiring less participation than “material participation”) and if your adjusted gross income doesn’t exceed specified levels.
• If you qualify as a “real estate professional” (which requires performing substantial services in real property trades or businesses), your rental real estate activities aren’t automatically treated as passive. So losses from those activities can be deducted against earned income, interest, dividends, etc., if you materially participate.

Contact us if you’d like to discuss how these rules apply to your business.

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