Surviving a Debt Euroclydon (Segment VI)

Preface: Now you have a financial target, and now you know when you “don’t have enough (working capital or equity).” We omit the “when you have too much” because that’s usually not the problem.

Surviving a Debt Euroclydon (Segment VI)

Credit: Donald J. Sauder, CPA | CVA

Typically, as an entrepreneur builds equity with profitable earnings, liabilities decrease as they are paid-off, and investment increases. Therefore, the measurements and grades improve with time. Startup business ventures should appreciate that their most substantial risk is liquidity, i.e., measured as working capital.

Diligent financial managers will measure this monthly, and possible graph the trends on comparable actual working capital to the 100% level

The above working capital tool is advisedly applicable to businesses in almost every industry. Diligent financial managers will measure this monthly, and possible graph the trends on comparable actual working capital to the 100% level.

Preparing for a Debt Euroclydon can begin with two easy tools. Tool one is working on optimizing the analytical ratio of equity to total assets or total liabilities and equity.  Tool two is tracking trends with working capital levels and grades. These are quantitative financials to bring a mathematical approach to what some advisors say is too much…debt, payables, etc. Now you have a target, and now you know when you “don’t have enough (working capital or equity).” We omit the “when you have too much” because that’s usually not the problem.

…..while financial tools and weather forecasts may be helpful, always keep the following (Questions) top of mind, because that’s what your financials reflect.

If your business has all the necessary financial reporting to begin these steps towards diligent financial preparedness, then your also advised starting to be your own business “financial weatherman.” You can achieve this following these two easy tools. If you don’t know where to start, then all you need to do is ask for help.

Above all, when preparing for any business risks or pressures, i.e., a Debt Euroclydon, while financial tools and weather forecasts may be helpful, always keep the following questions top of mind, because that’s what your financials reflect.

1)    What is our enterprises’ purpose?
a.     Are we achieving that purpose effectively?
2)    What is our enterprises’ vision?
a.    Are we working successfully towards the vision?
3)    What are our enterprises’ core values?
a.    Do we commendably exemplify those values?
4)    What is our enterprise core focus?
a.    What do our customers appreciate most about our core focus?
5)    What does our business contribute to the community?
a.    Are our products or services, adding the most exceptional         value possible?

Finally, many business successes and opportunity are a matter of “time and chance.” They are not necessarily indications of superior strength, wisdom, understanding, or skill, so as an entrepreneur give thanks daily, and live with gratitude.

Surviving a Debt Euroclydon (Segment V)

Preface: Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides an understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.

Surviving a Debt Euroclydon (Segment V)

Credit: Donald J. Sauder, CPA |CVA

Measuring working capital is the second easy tool to help maintain a well-oiled enterprise. Working capital is a balance sheet calculation, or current assets minus current liabilities equals your business working capital. Working capital measures the operational liquidity level of a business.

So what are currents assets? They are often your cash and equivalents accounts, accounts receivable, vendor prepayments, and inventory. Assets that are easily convertible into cash with a year. Current liabilities are often your accounts payable, credit cards, line of credit, tax liabilities, accrued expenses, customer prepayments, and deposits, and don’t forget the current portions of debt.

To precisely measure an enterprise’s working capital, it is necessary to have accurate accounting with appropriate accountant oversight for proper classifications of both current and noncurrent assets and liabilities.

The current ratio applies for the same financial numbers as working capital, yet instead of subtracting current liabilities from current assets, the current ratio divides current assets by current liabilities. Typically, a current ratio should be higher than two and likely two and a half, to be solidly established from an analytical measurement metric.

….the working capital grading tool is to help clients measure optimal working capital levels, i.e., how much is enough when discussing working capital? Let’s call it the working capital grade. It requires analysis of both the balance sheet and profit and loss statement.

Working capital measurement is an analytical approach to monitor a business’ capacity to continue operations with sufficient cash flows and to pay operating expenses and satisfy current liabilities cash uses.

Sauder and Stoltzfus, as an entrepreneurs CPA firm, has developed a working capital grading tool to help clients measure optimal working capital levels, i.e., how much is enough when discussing working capital? Let’s call it the working capital grade. It requires analysis of both the balance sheet and profit and loss statement.

Tracking the working capital balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”

Working capital seems easy enough to calculate. You look at your financial statements and subtract current liabilities from current assets. If you should have the financial accuracy to calculate the balance, the numbers independently, do not provide much analytical guidance. Tracking the balance from consecutive period to period will provide a data map, but you need to know, “Do you have enough yet?”

Numerous business owners have an intuitive feeling on working capital levels, but quantifiably grading working capital provides understandable and mathematical measurement where your business is at now, and where your business working capital could and should be.

Here’s how we grade working capital. You can do math or follow along with current assets minus current liabilities as the formula.) Let’s say the cash $5,000 + accounts receivables $45,000+ inventory $70,000 is $120,000. Now subtracting accounts payable $30,000 + accrued wages $15,000 + current portion of debt $25,000 is $70,000. Now the working capital calculation is $120,000 – $70,000 = $50,000.

In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon.

Next, we compare that working capital level of the balance sheet to the profit and loss statement, measuring both direct labor expenses, and operational or general and administrative costs on a quarterly basis, e.g., what do you pay indirect labor expense or general and administrative expense, on average, every three months? This example can include multiplying a year of data with .25 for 1/4th of the annual costs or merely looking at quarterly data. This number is an estimate only, like a professor grading essay papers, the difference between the grade of a B+ or A is discretionary.

Now following with a business that has a direct labor expense in cost of sales of $300,000 per year, you would multiply the twelve-month fiscal year number by 0.25; that calculates to $75,000 per quarterly 300,000 * 0.25). If your operating expenses or general and administrative expenses are $250,000 for the twelve-month fiscal year, then you would multiply that balance by 0.25 to arrive at a calculated $62,5000 ($250,000* 0.25).

The greater of those two numbers is your optimized working capital. That is the $75,000 or $62,500. The greater is the direct labor of $75,000. Do you make the grade? Your business is solidly pillared if you have the greater of these two numbers in the working capital formula, i.e., $75,000.

In our example, the working capital was $50,000, so the business is not yet solidly positioned or fully prepared for a debt Euroclydon. If you have working capital above the calculation, your business can take on additional risk to safely develop the expansion of operational activity, as long as you continue to maintain or monitor appropriate working capital levels in your business.

In the above-calculated working capital scenario, the $50,000 of working capital measurement divided by $75,000 is a 66% ($50,000 balance sheet working capital / $75,000 profit and loss measurement)  Making the grade? Yes, it’s that simple.

The working capital grading tool works like this:
1.    35% equals one month of working capital
2.    70% equals two months of working capital
3.    100% equals three months of working capital.
4.    You can score well above 100% in a firmly positioned business, and you’re ready for the debt Euroclydon.

If your business working capital grade is below 15% to 25%, your business likely needs immediate help from an expert financial advisor. On the other hand, the $25,000 increase required from $50,000 to achieve $75,000 can be obtained with steady additional earnings and profits retained in the business, i.e., you can earn your way out of the problem, or maybe a long-term amortization of say a line of credit, i.e., reducing current liabilities.

To be continued.

Did I Purchase What You Sold?

Preface: Buyers are well-advised to give appropriate attention to asset allocations for tax purposes with transactions to avoid being pressured by uncooperative sellers after signing.

Did I Purchase What You Sold?

By Jacob M. Dietz, CPA

Sometimes a hardworking entrepreneur decides to move on to new adventures. The new adventure could be another enterprise, it could be mission work, or it could be a slower lifestyle and grandchildren. When this happens, there may be a sale of the business. When selling a business, make the allocation of the price a part of the agreement of the sale.

The Case of the Missing Allocation

Imagine if a custom chopping business owner named Reuben decided to sell his business, ABC Custom Chopping, LLC to another custom operator, Henry. He is selling the entire business including the equipment, the customer list, the employees, etc.

They agree to sell it for $750,000. In June, Henry writes a check (with the help of a bank loan) and takes over the business. Everything seems great until February.

In February, Reuben goes to his accountant and says he sold the business for $750,000. His accountant asks for an allocation schedule showing how much was paid for different asset categories. Unfortunately, no such allocation was ever created.

Purchase Price Allocation to Assets

What is an asset allocation, and why does it matter? IRS Form 8594, Asset Acquisition Statement, lists 7 classes of assets. A full treatment of this form is beyond the scope of this blog, but in certain cases when a business sells both the buyer and seller must fill out form 8594, which shows how the price of the business is allocated among asset classes.

Ignoring most of the classes, let’s look at class V and class VII. Class V includes various items, including equipment. Class VII includes goodwill. Goodwill has also been referred to as “blue sky” and can be the amount of the purchase price not allocated to other items.

Back to Reuben and Henry. How should they allocate the purchase price? Henry hopes to allocate as much as possible to the equipment, which is class V. Why? Equipment can be depreciated quicker than goodwill is amortized, and with accelerated depreciation Henry may even be able to deduct it all in year 1. Goodwill (class VII) on the other hand, is amortized (expensed) over 15 years.

Reuben, however, may want to allocate more to goodwill. Why? All or part of the sales price allocated to equipment will be subject to ordinary income treatment. The price allocated to goodwill can be subject to capital gain treatment. Ordinary income is often taxed at a higher rate than capital gain income.

Unfortunately, Reuben and Henry are motivated in opposite ways on how to allocate the purchase price, and they lack a business incentive to compromise. Henry has the business. Reuben has the money.

Agree when Negotiating

What could have been done differently? They could have agreed on an allocation before the deal was signed. When they were still negotiating the price, then they would have had a business incentive to compromise.

For example, assume Henry wants to allocate $700,000 of the purchase price to equipment, and Reuben wants to allocate $600,000 to equipment. They could perhaps meet in the middle, and agree to $650,000.   Alternatively, perhaps Reuben could agree to Henry’s number, $700,000 for the equipment, but negotiate an additional $10,000 or so to the sales price.

Although it may seem like one extra hurdle to selling the business, make sure your purchase agreement includes an asset allocation. What is purchased should be the same as what is sold. If there is disagreement, it is better to compromise at the time of the sale instead of trying to agree months later when the business incentive to compromise is no longer present. Months after the sale is a good time to enjoy the new adventure, but it is not a good time to argue over the allocation.

Surviving a Debt Euroclydon (Segment IV)

Preface:  A fisherman is certainly not ready to troll for big-game saltwater fish with a 20lb braided test line. But if you’ve got an 80lb braided test line, then you should be equipped to troll the saltwater seas for Marlins.

Surviving a Debt Euroclydon (Segment IV)

Managing a business with a high liability to assets ratio requires continuous cash flows to keep the financial pumps primed. Preparing appropriately for such changes in cash flows, for even short durations i.e., rain on a parade, can ease cash flows shock risks and strengthen balance sheets.

Preparing for a Debt Euroclydon can begin with two easy tools. Tool one is working on optimizing the analytical ratio of equity to total assets or total liabilities and equity. To calculate this ratio accurately requires precise balance sheet accounting and accurate month-end closing processes.

A business that has accurate financials with an equity to total assets ratio above 80% is prepared for a host of financial risks. To build a balance sheet of that strength requires either back-to-back years of grand performance earnings that need to be retained in the enterprise, or a strong capital base. A business with less than 50% equity to total assets is average in balance sheet strength, and with when measured with 20% or less equity to total assets is operating with maximum risk. The analytical ratio tool of equity to total assets can be likened to fishing with a braided fishing line. A fisherman is certainly not ready to troll for big-game saltwater fish with a 20lb line. They are advised to best fish easy for small native fish because the line will snap on the first big-game bite. But if you’ve got an 80lb test line, then you should be equipped to troll for some saltwater Marlins.

Here is how you can assess your businesses strength with the Equity to Total Assets or Total Liabilities + Equity ratio analytic.

Analytical Ratio

Notice on the left side of the above analytic with the $5,000 of equity, there is a 3% equity ratio to total assets on a hypothetical $150,000 of total assets. Building equity can occur with two possibilities. 1) earn more net income and retain it in the business, 2) contribute capital to the company in the form of investments. The 87% ratio on the right side of the above analytic is the equivalent of 80lb braided fishing line you’re ready to plan to fish for Marlins. In addition to building equity, a keen financial analyst would also suggest to scale back the balance sheet reducing both assets and liabilities with say a sale of assets including lower inventory, or collections on receivables with a corresponding payment of balance sheet liabilities with the cash.

Watching trends in this ratio will provide confidence in your financial management decisions. The ratio is rarely static and should be closely monitored for the range on trend developments. A 100% is unrealistic because there are usually some accounts payable, accrued expenses, and say credit card expenses month-to-month.

If you measure this ratio analytic on your business and it is below 20%, don’t expect to win the current weeks saltwater fishing derby for the big game. Begin to accumulate and build the ratio on smaller fry until you have the capital to troll for larger big-game saltwater fish in the future, i.e., additional employees and general overhead.

To be continued…..

Surviving a Debt Euroclydon (Segment III)

Preface: You’re living the college student dream if you’re debt free.

Surviving a Debt Euroclydon  (Segment III)

Then the hypothetical debt Euroclydon came. The only man who sticks closer to you in adversity than a friend is a creditor – Author Unknown. Today, debt drives the economy from credit cards and real estate mortgages to personal and business lines of credit.

We can gain valuable and keystone business insights into the economic power of debt and the credit cycles from the book, The Big Debt Crisis; credit: author Ray Dalio.

If you understand the game of Monopoly®, you can pretty well understand how credit cycles work on the level of a whole economy…..Early in the game, “property is king” and later in the game, “cash is king.”

Now, let’s imagine how this Monopoly® game would work if we allowed the bank to make loans and take deposits. Players would be able to borrow money to buy property, and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which in turn would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other on credit.

If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. The amount of debt-financed spending on hotels would quickly grow to multiples of the amount of money in existence. Down the road, the debtors who hold those hotels will become short on the cash they need to pay their rents and service their debt. The bank will also get into trouble as their depositors’ rising need for cash will cause them to withdraw it, even as more and more debtors are falling behind on their payments. If nothing is done to intervene, both banks and debtors will go broke, and the economy will contract. Over time, as these cycles of expansion and contraction occur repeatedly, the conditions are created for a big, long-term debt crisis.

Today, central banker vocabulary doesn’t include the word “bankruptcy.” As of May 2019, the United States consumers in aggregate had $4.02 Trillion in consumer debt, says credit cards, and $1.50 trillion of student debt on educational loans, and $1.20 trillion of auto loans. In 2018, the average American household had too much debt, with an average of $135,000. The average US household had $47,500 of student loans, $27,500 of auto loans, $6,000 of credit card debt, and the remainder of the $135,000 of total debt is either a mortgage, line of credit, and home equity loans. With average wage earnings of $60,000 per household, approximately 8% to 10% of Americans think they will never be free of credit card debt in their life. The statistics are increasingly bleak for long-term economic vibrancy with the absence of continual injections of credit for new consumer spending highs.

Now, let’s ask a rhetorical question. Where will this average American likely receive the necessary future capital to acquire or pay for what your business will sell? Will it be from new credit cards, or say will it be a mortgage? Will it be a home equity line of credit? You hope it’s discretionary earning, right? Look at the statistics. Simply because someone earns more than $60,000 doesn’t say they save more capital or have a higher percentage of investable assets than someone who is earning less. Higher earnings permit more opportunity to accumulate debt with greater credit access. The economic gaps among the haves and have nots continue to widen creating expansions in the underlying tectonic pressures in the greater society.

A debt crisis is deflationary because the artificial price increases per the Monopoly game example above, simply cease to support inflated asset prices when the credit compressor stops. Deflation is a decline in asset prices. Hence real estate and business values decline in deflation. A Debt Euroclydon in terms of this article does not outline what happens in that scenario. The best answer may be that the actual economic playbook is almost impossible to design for most, but likely outlines bleak economic conditions that have not been seen in most generations in the business industry and entrepreneurship today.

Surviving a Debt Euroclydon (Segment II)

Preface: And the rains came and winds blew and beat upon that business, yet it  stood firm, because it was built on the rock.

Surviving a Debt Euroclydon  (Segment II)

Credit: Donald J. Sauder, CPA | CVA

To double the financial impact of the business quicksands, the new project pipeline had nearly evaporated, while profitability from costs on the signature project was 25% above the bid. Instead of immediately decreasing overhead risks, Paul drew on his new line of credit to finance payroll and equipment loan amortizations. Paul was having an out of money experience. But he was a successful entrepreneur, and he had confidence he’d work it out.

The banker began to stop in at regular intervals to discuss the work-out possibilities on the loans. What steps could be taken to make sure Paul could make his monthly loan payments? The banker continually reassured Paul that calling the loan was only a last step, even if all the loan covenants designed to maintain prudent financial ratios created repayment risk. Paul had the hunting cabin listed for sale at a steep discount to raise cash fast. Selling that was painful enough, but the fact it turned into a capital loss, doubly pained him. Placing the proceeds from that sale as contributed capital into the business, the accumulated accounts payable made only a slight decline with the cash infusion. Paul’s wife began to become concerned too about the business predicament and liquidated her IRA account to help.

His team also began to become increasingly concerned about the financial woes and began to explore safer and more secure paychecks. Keeping optimism on the team, resulted in a plateau of lackluster operational performance in the field. The financial pressure was now stressing Paul to the point that Sundays were a day of stress, instead of a day of rest. Would he get that next bid? What if he had an unexpected business expense such as a truck engine overhaul? What is couldn’t make payroll next month? What if the economy turned south? What if the bank would not renew his line of credit in a few months?

As the weeks elapsed, the business work-out possibilities diminished. Paul began to reduce business overhead out of necessity, and with that, his opportunity for larger project bids because of the team experience required. The banker continued to hunt for optimism among the financial atrophy. Paul began to liquidate excess assets, the extra truck, the loader, etc. for working capital.

Then the week arrived to renew the line of credit with the bank. Paul talked with other financiers about an additional cash infusion. The banker had warned him that they were losing confidence in Paul’s ability to find a solution. The worries turned into fear when the bank denied the line of credit renewal. Paul began to have some serious doubts; doubts about his expert business acumen, and more precisely his ability to make effective business decisions.

But all was not lost. Paul’s Uncle George has just sold his investment real estate in town. He had an inkling Paul needed help. Paul’s phone rang. It was Uncle George “Your business is going to recover nephew, stop in for your check.”

A little wiser, and little more experienced, Paul had assembled a team of advisors, including a trusted business leader, accountant, and business consultant. As the team worked to help Paul out of his predicament, they noticed some unusual gaps in cash flow. Upon further accounting review, it became apparent that Paul’s bookkeeper had embezzled more than $85,000 in cash, in just the prior year, from his business.

And so, goes the story of how Entrepreneur Paul survived another day as an entrepreneur. The day the phone rang with Uncle George on the line, Paul understood for the first time, the definition of “experienced businessman.” That hypothetical story is just that, a typical distressed business story. How do entrepreneurs survive a Debt Euroclydon where the business problem is an economic snafu that pressures entire industries?

 

Surviving a Debt Euroclydon (Segment I)

Preface: “I’ve seen successful squirrels, and successful entrepreneurs can learn a lot from such continuous future planning, diligence and focus.” Quote from a Canadian entrepreneur.

Surviving a Debt Euroclydon 

Credit: Donald J. Sauder, CPA | CVA

 

“The economy depends about as much on economists as the weather does on weather forecasters.” Jean-Paul Kauffmann. Experienced entrepreneurs know more about their marketplace than most economists or experts. Why? They have a vested interest in the market activities; they have chips in the game. Entrepreneurs communicate. They talk to customers, they talk to friends, or hear rumors, and read news and industry publications, and from all these information sources they develop and construct a narrative of data for an understanding that helps them form an accurate opinion on the best course of actions. Most importantly, they know more about their small business marketplace because of their year of actual in the field experience. Some economists do have more experience than entrepreneurs, and hence, sometimes we need to listen carefully and closely when they talk.

Let’s begin with an exploration of the hypothetical story of Entrepreneur Paul to learn and gain insight from hypothetical business history. Entrepreneur Paul was a capable craftsman when he started his new entrepreneurial business. Although it was a challenging economic environment in the early years, his ambition and diligence with his developing enterprise, mitigated the low-risk business landscape.

Navigating through the new enterprise’s terrain, Paul rapidly built confidence and credibility in his industry. Soon he had a team of six employees. As his business grew, he needed to acquire additional trucks, equipment, and tools. Of course, the bank was happy to lend him the necessary money for these new assets. Paul’s first business debt from the bank was a truck loan. The terms and ease of the loan, along with the marketplace opportunity for his craft, boosted Paul’s confidence that he was beginning to be an expert businessman.

Within less than a decade, Paul had a crew of fourteen employees, along with ample equipment, and trucks for nearly any opportunity inside his businesses service area of expertise. With $450,000 of approximate debt, Paul was earning a nice profit each year on his growing enterprise, and the economy continued to boom. There was always some extra money for the new cabin, the church building fund, and the hunting trip. Financial calibration was not on Paul’s mind, although he talked to his accountant about tax reduction strategies and effectively maximizing depreciation deductions when necessary.

Then one day, Paul received the big opportunity to bid his enterprises largest signature project in his business history. He won. Commencing the work required two more employees, and another truck, plus some additional equipment. The project required all of Paul’s key employees’ attention too with; it’s signature visibility. There was minimal time to bid on new projects to keep the work backlog fueled. As the signature project, neared completion, the customer began to express discontent with trivial features of the project craftsmanship and began to withhold payment. With thirty percent of the payout remaining, Paul had a challenging decision. The decision, for better or worse, completion was necessary with the projects community visibility. After many meetings and tense communication, Paul never received the remaining payments on the project.

To be continued.

Entrepreneurial Financial Planning

Preface: Always plan ahead, it wasn’t raining when Noah built the Ark — Richard Cushing

Entrepreneurial Financial Planning

Credit: Michael Whiteman

When I think of entrepreneurs, I think of folks who build things. Not necessarily brick and mortar building, but more figurative building. They build businesses, they build organizations, they build communities. When I do think of building in a more literal sense, I think of my time when I worked in home construction.

Despite the differences, there are significant similarities between the two.

My construction years taught me that the best of buildings start with a strong foundation. In the same light, successful entrepreneurs are wise to have a strong foundation for their financial lives. Among the building blocks that pave the way for innovation are:

Cash Flow Planning – Having a command on money that comes in and goes out is crucial to any budget, being family or business. Skillful cash flow planning reduces stress and worry and allows entrepreneurs to focus on building and innovating.

Protection Planning – What happens when “life happens?” Insurance is something nobody likes to talk about and certainly nobody likes to buy but provides crucial protection for assets and resources when challenges arrive.

Investment Planning – Successful entrepreneurs always have an eye on the future. Investment planning encourages you to look ahead is also another opportunity to integrate values into your financial planning.

Retirement Planning – Many of the entrepreneurs I know don’t “turn off” the creativity and building mindset when they reach retirement age; they just restart. Good retirement planning takes the labor out the retirement, and allows you enjoy and savor this time of life.

Tax Planning – What are the tax consequences of your success? How are those consequences best managed?

Estate Planning – What is your legacy? How is your hard work transitioned to someone who will carry the ball even further? How do you bless your loved ones?

Now, the six tools listed above are standard within the Financial Planning Community. At Everence we’ve added another tool:

Charitable Planning – How do you give back after your hard work has resulted in financial blessings?

Now, my time in construction gave me some “skills” that I have used around my home. When I’ve planned extensive projects, I didn’t fool around. I brought in experts to do the job right. As we build our financial legacies, isn’t it wise to do the same?

An Everence Financial planner can help you reach financial peace and allow you to focus your skills and efforts on your passions in life.

Mike Whiteman is a Financial Advisor for Everence Financial Advisors. He can be reached at 717-394-0769 and michael.whiteman@everence.com. Michael Whiteman is not affiliated with Sauder and Stoltzfus LLC.

Advisory services offered through Everence Trust Company and Investment Advisors, a division of ProEquities Inc., Registered Investment Advisors. Securities offered through ProEquities Inc., a registered broker-dealer, member FINRA and SIPC. Investments are not NCUA or otherwise federally insured, may involve loss of principal, and have no credit union guarantee.  Everence entities are independent from ProEquities, Inc. Mike Whiteman is licensed to discuss with and/or offer financial services and/or products to residents of PA, CO, FL, MA, MD, MS, NY, WA, VA and NJ.

Taxes and Equipment Purchases (Segment III)

Preface: If your business generates significant tax liabilities, and if you are purchasing significant amounts of equipment or other capital assets, considering discussing with your tax advisor what an “in-service asset” is for IRS purposes

Taxes and Equipment Purchases (Segment III)

Credit: Jacob M. Dietz, CPA

If the asset was purchased by year end, and fully functional and used by the business by year end, then the asset is likely in service. However, in some cases, the asset can be in service even if not used.

Here is an example found in IRS Publication 946

“Example 1. Donald Steep bought a machine for his business. The machine was delivered last year. However, it was not installed and operational until this year. It is considered placed in service this year. If the machine had been ready and available for use when it was delivered, it would be considered placed in service last year even if it was not actually used until this year.”

In the Donald Steep example, it is interesting to note that just because the equipment was on the company property did not mean that it was in service for depreciation. This could particularly apply to a manufacturing company, where the equipment purchased may not be something that can be plugged in and operated immediately.

On the other hand, it is interesting to note that the Donald Steep example indicated that it did not actually have to be used for it to be in service, if it was “ready and available for use.”

Guidelines on all the complexities of placing fixed assets in service is beyond the scope of this article. If your business is purchasing new assets, and there is a question as to when it is in service, talk to your accountant about the specific facts and circumstances of your situation.

Proper Planning

If your business generates significant tax liabilities, and if you are purchasing significant amounts of equipment or other capital assets, considering discussing with your tax advisor before the year ends. If possible, talk to them early enough that there is time to alter the facts and circumstances to achieve a more favorable outcome if that would be beneficial. When considering and discussing these matters before year end, it can be hard to know exactly what the income will be for the year. Waiting until after the year ends, however, may make it harder for taxpayers to change the facts and circumstances to get the desired results.

For example, assume that Donald Steep had met with his accountant, and the accountant told Donald in October that having his machine in service would benefit him. Perhaps Donald would then have made sure that the machine was “installed and operational” by December.

Alternatively, suppose that Donald Steep already had enough deductions in the current year, and wanted to wait until next year to depreciate the machine. Then he could have made sure that it was not installed and in service.

Service

If a large piece of machinery comes rolling into your business, what thoughts will be running through your mind? Perhaps you will be thinking “I can hardly wait to operate this piece.” Perhaps you will be thinking “This machinery will not be in service until about two weeks from now.” Whatever you are thinking, enjoy the pleasure of being in service to your customers.

Taxes and Equipment Purchases (Segment II)

Preface: Without going into all the tax complexities, in the past sometimes the IRS and tax courts have varying historic stances on the tax implications of when an asset is placed in service. Here’s how it works.

Taxes and Equipment Purchases (Segment II)

Credit: Jacob M. Dietz, CPA

Many business owners dislike rendering taxes to Caesar, so getting a tax break in the current year seems beneficial.

Sometimes, however, a business may choose to wait to place assets in service. Why would you wait to take a tax break? The federal tax system uses different rates for different amounts of income, and certain tax benefits phase out at higher income levels. A taxpayer may aim to have income within certain ranges to take advantage of more favorable tax rates or benefits.

The details of the tax system can be quite complex, but without getting into all the details the tax rates range from 10% to 37%. One important thing to note is that the higher brackets only apply to the higher income. Therefore, if someone had enough income to be taxed at the 37% income bracket, not all their income would be taxed at 37%. For example, some would be taxed at 10%. Taxpayers do not need to worry that if they bump up into a higher bracket that suddenly all their income will be taxed at the higher percentage. Nevertheless, if they bump into a higher bracket, they will need to pay the higher percentage on the income that is in that bracket.

Suppose a business placed many assets in service in the current year, but they do not need all the deductions in the current year. The business owners may fear getting pushed into higher tax brackets in the next year.

What can be done to generate deductions next year? The business could avoid immediately deducting all the equipment in the current year. Instead they could depreciate it over the recovery period. That defers some of the depreciation to next year. If the taxpayer does not take all the expense in one year, then it must be taken over a certain number of years. Exactly how many years is beyond the scope of this article, but the government provides guidance. If it is not all taken in year one, expect it to take multiple years to get the deduction. The remainder is not all deducted in year 2. But what if the taxpayer wants to take it all in year 2? Generally, the taxpayer is not permitted to do this unless the asset is placed in service in year 2.

Therefore, if a business has enough deductions in year 1, and not enough in year 2, they may want to wait until year 2 to place the asset in service, if they can wait that long without significantly hindering operations. If all the conditions are met, they may be able to fully deduct the equipment in year 2 if placed in service in year 2.

When is the Asset in Service

It can make a significant difference in your taxes depending on when the asset is placed in service. When is it placed in service? That answer can get complex. One of the regulations states that “Property is first placed in service when first placed in a condition or state of readiness and availability for a specifically assigned function.” Without going into all the complexities, in the past sometimes the IRS and courts have sometimes taken a looser and sometimes a stricter stance on when an asset is in service.