Tax and Financial News February 2019
When Is A Loan Not A Loan?
With the sweeping new tax legislation in 2018 capturing everyone’s attention, other changes have taken a back seat. There were several Tax Court cases in 2018 that rendered important decisions impacting how things work – one of which was Povolny Group, Inc. v. Commissioner, T.C. Memo 2018-37.
The Povolny Group decision centers on a common issue where an individual uses his corporation like a personal pocketbook, transferring money in and out without any formality.
Facts of the Case
James Povolny joined his spouses’ company (LLC) as a minority owner. Later in 2002, he went out and started his own real-estate brokerage firm, the Povolny Group (PG), as a 100 percent owner.
At one point, PG won the bid to build a hospital for the Algerian Ministry of Health. To perform the job, Povolny formed another company as the sole owner: Archetone International (AI). To secure the contract, the government mandated guaranties and collateral. To meet this obligation, Povolny had AI, PG and LLC borrow money from lenders.
Unfortunately, the Algerian government quit paying Povolny and terminated the project. In the end, Povolny had a lot of debt and AI couldn’t pay it so he used LLC to pay $241k of AI’s debt, with LLC claiming a deduction for bad debt for tax purposes.
Later, Povolny used PG to pay $70k of the debt for both LLC and AI, with PG deducting these amounts as cost of goods sold. Eventually, when he was audited, Povolny changed his position claiming the amounts were really loans from PG to the other two companies.
The IRS denied LLC’s $241k deduction for bad debt, claiming that the amounts were capital contributions and not loans and therefore could not be deducted as bad debt. The IRS also denied PG’s $70k deduction again on the premise that it was not a loan, but a capital contribution.
Relevant Law for Business Owners
If an individual owns 100 percent of a company or group of companies, they often treat business transactions informally because they view it as all their own money – taking cash in and out of the business without any formal process. This is something that could never happen if the business had multiple owners.
Example and Why It Matters
This often results in midstream changes in how the owner treats the transactions for accounting purposes. One example is where a business owner takes cash out and later discovers that these distributions exceeded their stock basis. This should result in a capital gain, but due to the informality of the transactions the shareholder changes how they treat the cash withdrawal from a distribution to a loan.
Another example of what frequently happens is there is a shareholder who puts money in a corporation, either themselves or through another entity they own, without any formal designation and then later accounts for it as a loan instead of a capital contribution.
What Really Matters
The rules are that you can only claim a bad debt deduction if there’s been a loan. Problems stem from the informality of the treatment between the individual and the entities they control; the IRS wants these types of dealings to be treated like arms-length transactions to validate the treatment and classification as either debt or equity.
Generally, there are 11 factors the IRS considers – all of which focus on how the transaction is structured and documents to see if it acts more like a real loan from a third-party lender or more like a capital contribution from the owner.
In the end, the court sided with the IRS and disallowed all of the deductions. The lesson here is that if you or a company you own advance money to another company and you want it to be considered a loan, then you need to treat it as a loan. Make sure you use a formal note with a stated maturity date, post collateral, pay interest, and record it as a loan on the tax return. If you want to write off debt as bad debt, you need to prove that you’ve done everything possible to collect and that repayment isn’t possible.
At the end of the day, the IRS doesn’t care if you own it all. But they do expect you to treat each entity you own as a separate entity rather than extensions of each other, making sure that everything is documented and treated with the appropriate formalities.
General Business News February 2019
How Businesses Can Effectively Manage Seasonal Sales
When it comes to businesses dealing with seasonal sales, making payroll and other financial obligations can be stressful on budgets. However, one way to deal with fluctuating sales and cash flow problems is to see if invoice factoring is appropriate to meet year-round needs.
One way for businesses dependent on seasonal sales is to have better financial predictability and available resources, as the Journal of Accountancy explains. Businesses can accomplish this by selling their accounts receivables through factoring.
Companies looking to increase cash flow during the slow sales season can benefit by selling their accounts receivable to a third-party business called a factor. When a company sells its invoices through the factoring process, it can collect much faster on that invoice from recent customer purchases compared to Net 30, Net 60 or Net 90 when an invoice is submitted.
How the Process Works
During the course of this arrangement between a company and the factor, there are three main phases. The company receives an advance, or a portion of the invoice’s outstanding balance from the factor. The difference between the portion the factor pays the company initially and the remaining portion of the invoice is called the reserve. This remaining amount is held by the factor until the invoice is completely paid off by the company’s customer –more commonly referred to as the debtor.
Depending on the factor, there could be an initial invoice fee, along with an “interest charge fee,” which is determined by how much is advanced from the factor’s purchased invoices multiplied by the factor’s interest rate and how long it takes the debtor to pay the invoice.
Accounting for Recourse and Non-Recourse Factoring
Depending on how invoices are arranged to be sold to a factor, accounting must be noted accordingly. If receivables are sold to a factor with no recourse, it should be classified as a sale on the balance sheet.
The Journal of Accountancy discusses how Generally Accepted Accounting Principles (GAAP) applies to factoring contracts with recourse. A company looking to sell its accounts receivables sells them to the factor with no stipulations attached. If an invoice transferred to the factor can’t be paid for within 90 days by the customer, the borrowing company assumes all risk for the factored invoice.
Factoring for Companies and Accounting Considerations
According to the FASB Account Standards Certification (ASC) Section 860-10-40, if receivables are sold to a factor with recourse, there are guidelines that determine if it’s a sale or a secure borrowing. If the three following tests, referring to the example sale above and according to the above referenced ASC Section are satisfied, it can be accounted for as a sale.
First, if the invoices are put “beyond the reach of the transferor and its creditors” including in times of bankruptcy or if a company’s assets and/or its operations are put in a legally appointed receiver, it has met the “isolation condition.”
Second, the factor has the right to exchange the asset. Third, the company relinquishes control over the transferred invoices by not having an agreement the permits the company to rebuy or reclaim the accounts receivables prior to the date of maturity. The other prohibited method of control for the transferor is to have a one-sided ability to demand the transferee give back certain assets, except through a cleanup call – which is when the factoring company can make the initial company buy back the invoices before the factoring term has expired.
Tip of the Month February 2019
5 Tips for First-Time Tax Filers
Filing taxes for the first time can be overwhelming. But if you have the right tools and advice before you start, it won’t be. Here are a few critical things to know before you begin, which will make the seemingly daunting process much easier.
Start Prepping Early
Even though the deadline to file a tax return is April 15, you’ll want to start as soon as you can. You’ll need time to gather all of your important documents like a W-2 from each employer and, if you’re a contractor, your 1099 forms. If you have a full-time job and worked freelance on the side, you’ll need both. The good news is that the forms show how much you made in the past year and how much tax was withheld. According to Kathy Pickering, executive director of The Tax Institute at H&R Block, you should gather any additional forms that show big expenditures, such as paying for education or charitable giving. Finally, proofread your form. Karen M. Reed, director of communications for Citrus Heights, California-based TaxResources Inc., said that a mistake in just one digit can lead to disastrous results.
Learn Key Terms
If you have a basic understanding of key terms, the entire process will be much more manageable, according to CPA Tim Wolfe. Wolfe recommends that you understand the meaning of things like effective tax rates, the average rate at which someone is taxed, and tax-deferred, which refers to investments on which applicable taxes – typically income taxes and capital gains taxes – are paid at a future date instead of during the period in which they are incurred. Other important terms to know are the difference between tax deduction and tax credit – a deduction lowers taxable income, while a credit reduces the amount of taxes you owe.
Consider Educational Expenses
If you’re a student and paying for your education, you just might be in luck. Deductions for your education are key. Arthur Agulnek, an accounting professor at the University of Texas at Dallas, said that new taxpayers should make sure they don’t leave money on the table by looking into the education tax credit and earned income tax credit. In fact, Agulnek said that education deductions can save a student as much as $4,000.
Get Familiar with New Tax Laws
You don’t have to be an expert the first time around, but there have been a few changes you’ll want to be aware of. First, there are new tax brackets. Second, the standard deduction has increased to $12,000 for single filers, up from $6,500 for the 2017 tax year. Third, the personal exemption of $4,050 has been eliminated this year. With all the changes to tax laws, you’ll want to keep up-to-date about the latest information.
Ask the Tax Professionals
If you have a question on your return, don’t guess. Ask a tax professional. If you’re a student, consult your advisor or parents. Remember, there is no such thing as a dumb question. It’s only dumb if you don’t ask it!
Taxes are an inevitable part of living in the United States and something you will learn to harness. The good news is that the process and terminology will get easier each year you file your return. Having informative resources at your fingertips are all you need to be a success.