Sales and Use Tax Compliance and Assurance is Advised Before an Audit

Preface: Assurance services with regards to sales tax are advised for entrepreneurial business’s, because charges from tax audits can be expensive. Appropriate sales and use tax compliance costs can repay your business with greater confidence of lower audit risk, to happier customers from reductions in unnecessary charges.

Sales and Use Tax Compliance and Assurance is Advised Before an Audit

Credit: Donald J. Sauder, CPA

Sales tax is an increasingly important tax compliance area for many businesses. Sales tax can be charged at more than just the state level. Forty-five states impose sales and use tax on purchases of tangible goods, and 4,696 cities and 1,602 counties also impose sales tax. If you’re conducting business across state lines, you should assess your nexus for jurisdictional sales and use tax compliance risks. More importantly for your customers, these sales tax deductions continue to be an itemized deduction on Schedule A with the passage of 2015 “tax extenders” bill, called Protecting Americans Tax Hikes (PATH).

Sales tax is often assessed on the retail level for sales of inventory or services, or transfers and exchanges of taxable inventory or services. All sales are presumed taxable at the retail level unless proven otherwise. Sales tax is added to the price of the product or service and remitted to the state by the seller who charges and collects the tax. Your business purchases a new snow blower from Your Hardware Superstore, sales tax is charged on the sale, and the seller, Your Hardware Superstore, remits that sales tax to the state. The complexity begins with special sales tax rules state-to-state specific on inventory items or services. Investing in sales tax compliance assurance is advised for every business.

Use tax, on the other hand, is a tax on the use or consumption of a taxable item or service when no sales has been charged or paid. The tax often applies to purchases made outside the state and used in the state, such as when you live in Pennsylvania and purchase a snow blower in Delaware from Snowblower Central. Then you need to pay use tax on the purchase. Use tax also applies to goods initially bought exempt from sales tax, but used for a non-exempt purpose. Use tax can be self-assessed and paid to the state, or collected from the customer from an out-of-state vendor registered with the purchaser’s state. Investing in use tax compliance assurance is advised for every business.

Use tax rates are the same as sales tax rates. Use tax levels the playing field for in-state vendors to keep them from pricing advantages of purchasing in sales-tax-free zones. States with budget concerns are now placing more scrutiny on sales tax with expanded jurisdiction on out-of-state vendors, increasing audit aggressiveness, expanding the tax base to include more inventory items and services, and sometimes increasing the tax rates.

The seller is primarily responsible and liable for collecting and paying the sales tax, whether they have collected the tax or not on the sale. Most often, a vendor must collect tax with respect to taxable sales unless the customer or client shows a valid exemption certificate. If the seller fails to assess sales tax, the state can collect that tax from either the seller or purchaser. Yet, often the vendor pays the tax as an additional expense in instances where collection is overlooked. This can be expensive. While the vendor has the right to collect from the purchaser, it may be impractical or imprudent. Even if the vendor is fortunate enough to collect the tax from the customer after the fact, the penalties, interest, and cost of collection can be steep.

In summary, if your business sells inventory or services, be sure to follow proper sales and use tax guidelines and regulation, collecting and remitting the appropriate taxes on applicable sales. Talk with a tax expert for sales and use tax assurance, especially when adding new inventory items or services in your business, or selling into foreign tax jurisdictions.

A CPA Can Provide Valuable Opinions on Partnership or LLC Agreements

Preface:  Tax codes and their implications to partnership or operating agreements may be like deciphering hieroglyphics to some entrepreneurs yet the implications of a well-written tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement by working with your attorney to keep you in compliance with tax laws. Here are examples of how they can add value.

A CPA Can Provide Valuable Opinions on Partnership or LLC Agreements.

Credit: Donald J. Sauder, CPA

Business’s taxed as a partnership filing a Federal Form 1065 for tax purposes always involve more than one individual or entity in ownership. The “agreement,” whether a partnership agreement for a general partnership (GP) or limited partnership (LP) or an operating agreement say or an LLC, outlines the business rules and legally describes the business relationship with rights and responsibilities among ownership.

Often an attorney tailors these agreements as “boiler plate” papers that may omit certain key characteristics or be ambiguous on certain details of the business relationship, e.g. distributions of cash, buy/sell terms, earnings or loss allocations or management oversight. While a CPA cannot write a partnership agreement or operating agreement, (it would be prohibited as unauthorized practice of law or UPL); they can provide valuable insights into aspects of the business agreement document.

There is a story where Noble Prize winner Richard Feynman was visiting a Tennessee plant where the atomic bomb was to constructed. Feynman was confused about a unique symbol on the blue prints, and not being an expert on reading design prints, he needed to know what he did not understand. As an expert authority on the project he took a risk and ask “what happens if that value gets stuck”. He feared the answer might be a response that would make him appear ignorant to the group. The engineer assigned to answered needed to trace the blue print to answer his question, discovering a serious design flaw that could have destroyed the  Facility. When Feynman was asked later how he identified the problem, Feynman’s answer was “sometimes you just need to ask if it’s a value;” when in actuality he simply ask a direct question. Why hadn’t anyone else in the entire group asked? Moral: group collaboration has benefits. Feynman humble approach to understanding what he did and did not know was very helpful to the other experts.

One reason a CPA can provide value to business agreements is that they understand the tax aspects of the agreement. Some attorneys have tax expertise; but wordsmithing and tax are two different areas.

In corporate agreements or LLC’s taxed as S-Corporations, the distributions provisions per ownership in S-Corporations can be an important detail to tax compliance. For instance, what if a shareholder draws a disproportionate share of capital during the year? Does the agreement resolve the tax risk? Secondly the economic arrangement of distributions whether liquidating distributions or special allocations including preferred returns or guaranteed payments and tax distributions are best described and agreed upon at the signing of the partnership agreement. Thirdly, many agreements boiler plate 704(b) book capital with three safe harbors.

Typically well versed agreements hold the most value in challenging business ownership situations and therefore an improperly drafted agreements that doesn’t prioritize distributions of capital can lead to substantial risks for agreements in a liquidation, or restructuring, e.g. say an agreement provision requiring capital accounts to at all times be in accordance with Code Section 704(b) regulations and qualified income offset provisions provide clear details on what happens if a capital goes negative.

Guaranteed payments on capital or for services should be specifically outlined in numeric terms with schedules with addendum updates following to that the business relationship on capital is well documented, e.g. A CPA can help assess if rates on capital are necessary.

In addition, allocations of profit and loss and an agreement on economically accrued earnings and distributions of built in gains or basis step-up on ownership changes are all relevant to a well-crafted agreement.

Another item is Code Section 469 Regulations on economic groupings or activities, a business agreement should outline who has authority to make grouping elections for the business or decision making authority with regards to an appropriate economic unit. An agreement can even state that a tax filing must be made available before a certain day, requiring adherence to tax filing deadlines among management. A CPA can also help edit boiler plate documents to not require a partnership be bound by Code Section 754 elections for basis adjustment.

While some of the Code Sections and tax implications of partnership or operating agreements described above may be like deciphering hieroglyphics to some entrepreneurs, the implications of a well-written, tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement, by working with your attorney to keep you in compliance with tax laws.

While paper sits quietly for anything, a well-documented business agreement is well-advised for your business.

Investing to Double Your Business’s Value – Part IX

Preface: Why is working capital management important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost”. Working capital is the science of cash flow management – an important fuel to any business craft.

Investing to Double Your Business’s Value – Part IX

Appreciation for astute working capital management is pillar nine of doubling your business’s value. Working capital techniques are vital to any entrepreneurial business; the difference between current assets and current liabilities is working capital simplified. A business with deep pockets, has plenty of working capital. Yet too many entrepreneurs do not understand the term working capital, nor the value of expert working capital management. (If you’re an entrepreneur and your business advisor or CPA has schooled you in working capital management — please take the time to email me; no response is a vote.) Cash flow management is a more frequent term applied to the science; but working capital management is the appropriate application of cash management, i.e. trend setting.

Working capital is the fuel of business. Often your lead technicians, sales team, production supervisor, shop supervisor, or office staff are not attending to working capital or cash flow management, and yet calculating and maintaining optimal levels of working capital is imperative, and as important as good customer service, or product quality, for any business.

Working capital can be segregated into level one and level two balances. Level one working capital is a minimal balance of working capital required at all time. Dip below that level = fuel lights. While a business current ratio measures working capital metrics, it doesn’t give you a level one or level two balance requirement. Level two is peak working capital requirements for peak season cash requirements, e.g. financing holiday inventory levels.

Few entrepreneurs have an adequate understanding of what their business level one and level two working capital balances should be; and fewer have accurate accounting records to calculate the balance. In order to accurately calculate working capital, you need to account not only accurately for inventory balances and accounts receivables on the assets side, but also for current liabilities, e.g. portions of long-term, accrued payroll, accrued expenses; and of course, accounts payable. This requires accurate accounting records.

Working capital, or operating cash liquidity, can be measured with a formula of currents assets, i.e. accounts receivable days + inventory days – current liabilities, i.e. accounts payable days. Therefore if your average accounts receivables are 30 days and $50,000 and your inventory is an average of 50 days or $100,000 and your accounts payable are 20 days or $30,000, then the $50,000 + $100,000 – $30,00 is your working capital requirement, i.e. $120,000. If sales are $1,200,00 your business working capital is 10% of revenues. Inventory increases financing on a line of credit will increase both the numerator and denominator of the current ratio. Operating expenses financed with a line of credit will only adjust liabilities and equity, e.g. assets stagnate while liabilities increase.

Now you’re likely asking how is working capital management applicable to doubling business value? Each adjustment to current assets or liabilities is an adjustment to working capital or operating liquidity. Let’s consider a hypothetical scenario. If a business wants to expand and increase sales with the assumption of a $50,000 software development contract it will need to increase working capital based on the % of those additional potential sales, i.e. it is challenging to increase value without increasing revenues, e.g. you will need finance the cost of the contract either with customer deposits or other sources of cash say equity or debt.

For a service business that has only accounts receivables and accounts payable the scenario would work like this example. With $150,000 sales a month, and $145,000 of expenses per month, if receivables are 30 days and payables 30 days, then working capital before cash balances would be $5,000. In this scenario working capital would 2% of revenues, before cash is added.

A child once ask a successful businessman what was required to be in his industry. The response: Deep pockets. In accounting that is working capital. Software businesses that invest $4m say in development of a license must have adequate working capital to finance the start-up development and programming phase leading to implementation. If your business burn is $20,000 per year on start-up, you need working capital access to fuel the craft.

A secure business often has a current ratio minimum of 2.0 – 2.5 typically. This business’s current ratio would be a concerning 1.03, before cash. Therefore, unbeknownst to many, firstly, increased sales are connected to increased working capital, i.e. current ratio management. In this example, the business would need cash reserves of $140,000 before it should embark on a business expansion of sales revenues from a CFO advisor perspective, e.g. cash of $140k + AR of $150k / AP of $145k = current ratio of 2.0.

If the business has $20,000 of cash it should not plan to immediately implement to double business value. It should plan instead build a foundation of solid level one working capital, i.e. $140k of cash, before implementing increases in sales; and therefore associated overhead expenses.

Once the business builds the foundation of the accurate financial metrics, then it would need to calculate the sale increase and working capital requirements. In the above example the $1.8m of sales with $145k or working capital would equal 8% of sales. Therefore, for every $100,000 increase of planned sales would require $8,000 of working capital. Every entrepreneur should understand the science of working capital management to ease financial management and make more informed decisions. [Too many entrepreneurs rationalize financial performance without adequate financial oversight, i.e. analytical intelligence, resulting in non-optimal performance. The opportunity to access analytical resources for the entrepreneur with powerful accounting software is quickly changing the landscape of small business accounting. Authors note]

A good CPA is more than a qualified tax preparer or financial statement expert. For the astute entrepreneurs they are an advisor for financial decisions, with accurate financials as a map for business decision. To an expert CPA, financials provide insightful information that has substantial business value, i.e. well-advised decision making from financial metrics.

A business advisor consulting to develop your business should always rely on accurate numbers as a substantial factor in successful business decisions. Be very respectful of analytics and financial metrics, e.g. working capital calculations, because when appropriately applied, they can help you make very successful business decisions.

Again, why is working capital management so important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it? Lest haply, after he hath laid the foundation, and is not able to finish it, all that behold it begin to mock him, Saying, This man began to build, and was not able to finish.” Luke 14:28-30.

Working capital management in this blog context, is about proactively counting the costs when planning a doubling of your business’s value.

Part IX of doubling your business value– Working capital management.

Farm Hobby Losses Are An IRS Audit Risk

Preface: Hobby loss rules are applicable to small activities, i.e. hobby farms. The following blog is pertinent to those who would like to deduct expenses on say small flock activities in the backyard.

Farm Hobby Losses Are an IRS Audit Risk

Credit: Jacob M. Dietz, CPA

Do you operate a small farm in addition to your main source of income? If so, does profit motivate your small farming operation? The answer to that question may determine how the farming operation is taxed. The question is not “is the farm profitable” but “is there a profit motive?” The tax law limits deductions for farms with no profit motive under the hobby loss rules. If you operate a small farm with a profit motive but no profit, then know what a hobby loss is, learn what the IRS factors into its decisions, and act to avoid the hobby loss classification.

Although the term hobby is frequently applied to the rules limiting deductions when there is no profit motive, the activity doesn’t need to be pleasurable. A taxpayer cannot escape the hobby loss rules by explaining that dealing with a frozen watering hose in winter is not pleasurable. The key is lack of a profit motive. Someone running a small farm on the side who never tries to turn a profit appears to lack a profit motive. On the other hand, a farmer sincerely motivated to make a profit but who suffers a loss due to crop failure is not a hobby loss farmer. The profit motive was there even if the profits weren’t.

So how does the IRS determine if there is a profit motive? The IRS lists some factors to determine if there is a profit motive. These factors are:

“You carry on the activity in a businesslike manner,

The time and effort you put into the activity indicate you intend to make it profitable,

You depend on the income for your livelihood,

Your losses are due to circumstances beyond your control (or are normal in the start­up phase of your type of business),

You change your methods of operation in an attempt to improve profitability,

You (or your advisors) have the knowledge needed to carry on the activity as a successful business,

You were successful in making a profit in similar activities in the past,

The activity makes a profit in some years, and

You can expect to make a future profit from the appreciation of the assets used in the activity.”


What can you do if you have a small unprofitable farming operation that is not your main source of income, but you have a sincere profit motive? First, continue to try making a profit. Second, demonstrate that you have a profit motive using factors listed by the IRS.

  • Farm like it is a business. Track your income and expenses, and prepare reports showing how the operation performed.
  • Track how much time you spend on the farming operation. It might surprise you, and the IRS, how much you work if you add up all those Saturdays and evenings.
  • If you have another main source of income, then you might not be able to say that you depend on the farm for your livelihood. Losing on a single factor, however, doesn’t mean that there is no profit motive.
  • If something beyond your control hurts your profitability, document it. You can’t help that a tornado ravished your corn right before harvest.
  • If you are changing the crops you plant to increase profitability, document that change and your reason.
  • If you have skill in farming, considering documenting it. Document attempts to gain farming skill, such as through reading, classes, talking with seasoned farmers, etc.
  • If you made money farming in the past, keep tax returns or other records to substantiate that income.
  • If the activity occasionally makes a profit, keep records of that. The IRS presumes an operation to have a profit motive if 3 out of 5 years, or 2 out of 7 years for some activities, it shows a profit. If you expect to make profits later in the 5 or 7-year period, but not at the beginning, you can file a form asking the IRS to wait until enough time has passed to apply the time test.
  • If you expect to make profit by selling the farm, let the IRS know that if they question you. Perhaps you can show that the value has already appreciated since you bought it. Note that if you are planning to pass the farm to your descendants upon your death, then the appreciated value doesn’t help your case.

While the best way to demonstrate a profit motive is with profits, unfortunately that is not always possible. If you are trying unsuccessfully to make profits, then be familiar with the IRS factors, and try to document the ones that support your profit motive. If you have questions about your small farming operation and the hobby loss rules, talk to your accountant.