What Makes a Business Valuable – Part One

As an expert in wealth building and business management, I often consult with owners who are preparing to sell their businesses. We work together to identify areas of improvement that will ensure the best selling price in the market. My outsider perspective, high-level focus, and unique ideas all work to cut through the resistance that all too often prevents otherwise intelligent business owners from realizing maximum value on the company they’ve spent so much time and energy building. I make sure this transition really pays off.

These consulting engagements have a very simple purpose: to increase the value of the business. Increasing cash flow to the owner and increasing enterprise value are the two primary ways to increase the business’ value. Of course, increasing cash flow to the owner also typically increases enterprise value.

Each engagement is defined as a quick or a long engagement. The process is the same either way, but in a long engagement, we might spend months or years going over every item, focusing on just one item at a time to produce maximum value.

Since the value of the company is most commonly calculated as a multiple of cash flow, we’ll spend much of our time focused on increasing the amount of cash available to the owners, which increases the amount of value received by the owner when selling.

There can also be significant strategic value extracted when negotiating the multiple upon which the selling price is calculated. The multiple is based almost entirely on soft factors or intangibles. Most owners ignore the effect these items have on their business and leave money on the table. Improving operations, culture, and general competitiveness, while not increasing the bottom line, can increase this multiple, thus bringing significant amounts of cash to the owner during a sale.

Is the business a good fit?

The first step in a consulting engagement is to determine if your business is a good candidate for a sale. Not all businesses are. We also spend some time learning what factors are present that might detract from or increase the value of your business.

Three items drive the value of your business: profit, growth, and risk. The first two increase and the third decreases the value. Before discussing these items, there are a couple assumptions we make for our overview and initial conversation:

  • We assume that we are selling 100% of the company and not taking minority, partial, or restricted sales into account.
  • We are ignoring “strategic” acquisition opportunities. We assume that all value has to come from the business being sold and not its value after being combined with another business.
  • We are assuming these are “arm’s-length” transactions of privately- or closely-held companies.
  • We are agnostic to the various valuation models (income versus market approach) and assume that increasing profit or growth increases value and decreasing risk factors increases value in all cases.
  • Finally, a comparison of the subject firm’s numbers to peers is appropriate.

Areas of the Business to Review

After determining that a business is a good candidate for a sale, we collect a large amount of data that we then analyze, looking for opportunities for improvement. Below are the areas we look into and some details about the type of information we’ll need and why it’s important.

Financial

A discussion and analysis of financial trends is first. We track two to three years of changes in:

  • gross sales
  • gross margin (where applicable)
  • net margin or cash flow (as appropriate)

We also look at the leverage in the company. There are two types of leverage to consider: operational and financial. With operational leverage we are looking at the overhead structure of the firm. How easy is it to scale expenses up and down with changes in revenue? We attempt to determine minimum operating levels and the cost of growth.

When looking at financial leverage we examine the past growth or decline of debt levels and consider what the optimal capital structure might be, based on consistency of cash flows, levels of fixed assets required, and credit worthiness.

Leverage will be intertwined with the customer analysis, looking at the company’s leverage risks as they pertain to customer or sales concentrations and asset needs.

Sales & Customers

A variety of items need to be looked at as they pertain to sales and customers. Almost all the analysis of sales and customers revolves around the risks of losing business. An analysis of customer concentration is always important to understand the risk exposure of a single customer or group of customers leaving. For example, high operational leverage combined with a large customer concentration can be a highly risky business. But many other factors can also come into play:

  • presence of sales contracts
  • switching costs
  • length of relationships

We will also look at customers from a growth opportunity standpoint when analyzing the company’s growth and opportunities.

Strategic Analysis

Analyzing strategic factors can be both the most difficult to do and the most rewarding. It is here where significant values can be created by demonstrating to a buyer ways in which they could grow the business. We look at factors that include the market a business operates in, the channels through which it sells, and the effect that current market share has on the company.

Costs & Vendors

A brief review of the risk and opportunities involved in the purchasing side of the equation will involve reviewing vendor contracts, concentration, and how the lead times and purchasing requirements affect the way the business operates.

Assets

While most companies do not have significant value attached to their fixed assets, reviewing those assets can add significant value to the business. A buyer will also want to understand the schedule of capital investments that have been made and will need to be made. Aging and old equipment can be a detractor from value.

Intellectual property is a popular way to try to assign more value to a company. Our analysis will challenge the often over-valuation of ideas and goodwill. How well protected an idea is, how executable it is, and the ease of substitution all need to be looked at before trying to determine a value.

Operations

Operational issues tend to be the most neglected area of a business. Many businesses grow out of smaller operations and their workflows have not kept pace. Or worse, the way in which people work has been completely ignored. A business that relies heavily on the owner destroys significant value for the buyer. A variety of areas need to be documented and understood:

  • the workflows of the company, including how people do their jobs
  • the internal controls that empower employees while protecting the company from fraud
  • staffing issues, including turnover, training, and efficiency
  • management issues, including non-competes and the experience, skills, and ability of the company to continue in the same manner after a sale
  • the information technology supporting the business and its investment and maintenance requirements
  • the culture of the company and its effect on the operations and growth opportunities

Growth & Opportunities

As with strategic analysis, this can be a significant source of value. Just a few of the ideas that we have seen add value include:

  • Customer saturation: What is the opportunity to increase the size of each relationship?
  • Operational improvement: Where are the demonstrable increases to margin that can be realized?
  • Market opportunities: What complimentary markets can our products or services be expanded into?

We collect all of this data, looking into each detail as it relates to increasing cash flow or improving the often-overlooked factors that can increase the multiple used to calculate your business’ selling price. The next step, which I’ll cover in an upcoming post, is to formulate a strategy that deals with four overarching areas within a successful business: strategy, operations, revenue, and culture.

Business is simple, but it’s easy to forget that when you’re caught up running one. I’m here to remind you of that and to cast a light on the details you’ve overlooked by being so close to the action. I’ll help you overcome your resistance.

The War of Art Translation – Part Two

This post is a continuation of my first War of Art Translation post, where I examine how Steven Pressfield’s thoughts about Resistance to creating art also apply to business. Pushing forward often seems impossible, as seen below, but it’s the only way to achieve the goals you create for yourself.

Resistance obstructs movement only from a lower sphere to a higher. It kicks in when we seek to pursue a calling in the arts, launch an innovative enterprise, or evolve to a higher station morally, ethically, or spiritually.

When you started your company, did you envision yourself in a corner office? Not right away, sure. But did you ever think that you would have lots of employees and you would be focused on solving the big problems that your big company had? Probably. Maybe you even had some measure of success. You don’t quite have the corner office in a high rise now, but you are certainly beyond the single room you started in. You have learned a lot by this point.

To grow like you have, you had successes and failures. You still imagine yourself in a corner office, but the difference now is that you actually know what it will take to get there. You might have to fire that family member you hired, to make the department function the way it should. You might need to change cherished policies, or enforce them, to get the kind of systematic business that can grow very large. You might have to expand into other types of products that will make your business more valuable in a sale, even though they aren’t the ones you’re passionate about.

Maybe, at this time, you start thinking back to why you got into this business. Was it really to have a corner office? Maybe it was just to be your own boss, which you are! You start thinking that maybe you are fine where you are, that your dreams of a big business weren’t really valid, that it was naive and stupid. If you had known then what you know now, you would have set your goal a little less lofty. You would have set it, in fact, right where you are now. Which, convientenly, means that you are done!

Is that really true? Or is that just a very insidious and tricky form of Resistance? I think this is Resistance using your own experiences against you. How do you know if you have really changed as a person or if Resistance is trying to get you to slow down or even scale back? Easy: Resistance opposes in one direction. If you decided to cut your product line, scale back staff and go back to the two-room office, how easy would it be? Could you start it tomorrow? I bet so. But if you wanted the corner office in a high rise, how much more work would that be? Your fear of this extra work is Resistance.

Pretty powerful stuff, that.

Resistance by definition is self-sabotage. But there’s a parallel peril that must also be guarded against: sabotage by others

Are you afraid of success because your friends will look at you differently if they knew? They will. Success and money come with lots of baggage. Entitlement is rampant. Not in the over-politicized way that a Republican will accuse a Democrat, but in the much more subtle, insidious way. Your becoming successful will serve to point out others’ failures, even though that’s not your intent. As a general rule, people tend to associate with people like themselves. So if you have a two-room business, you likely know lots of other two-room business owners. You likely don’t know many high-powered executives because they hang out with, you guessed it, high-powered executives.

This isn’t a problem, it is just an inherent characteristic of being human. But Resistance uses that against you. If you sell your two-room business, or move it into a high-rise building, it is unlikely that your friends and family will stop liking you. But they might resent you. If they haven’t overcome their own Resistance, your growth just demonstrates how they are failing.

People love Resistance. Most people work together to maintain it.

Sometimes entire familes participate unconciously in a culture of self-dramatization. The kids fuel the tanks, the grown-ups arm the phasers, the whole starship lurches from one spine-tingling episode to another. And the crew knows how to keep it going. If the level of drama drops below a certain threshold, someone jumps in to amp it up. Dad gets drunk, Mom gets sick, Janie shows up for church with an Oakland Raiders tattoo.

Anyone that has worked for a company larger than a certain size has seen this. Department A all of sudden is overwhelmed and needs more people. By the time Department A is stabilized, Department B has an issue. Then Bill in marketing quits because of the “drama.” Then Management starts a new initiative to help stop, once and for all, the problems and issues that Departments A and B have had. And everyone hates the solutions because they weren’t fully consulted.

Ever try to change a workflow in a company with more than five people? Then you have come to face to face with Resistance, my friend. “Boss” is just a title. If you think people will do what you say just because you are in charge, you have been listening to Resistance too long. They will find a hundred ways you never dreamed of to stop the changes. Why? Because Resistance has convinced them that change is bad, that they are happier in the suffering than they are about making changes and trying new things.

The danger is greatest when the finish line is in sight. At this point, Resistance knows we’re about to beat it. It hits the panic button. It marshals one last assault and slams us with everything it’s got.

I have seen this more times that I care to remember, and it is always sad. I have seen more business deals fall through than go through. People who started with nothing in this world and screwed a deal that would net them $7MM because they thought the business was worth $7.5MM. The truth is, they didn’t know or care what their business was worth. Resistance had them so scared they wanted to do everything themselves, they didn’t trust anyone, they couldn’t understand how these kinds of things worked.

But they understood the suffering. They understood the long days, the stress, the tension, the constantly being behind and scrambling. They understood all that it took them to get where they are now. And Resistance convinced them they were more comfortable in the suffering than taking the leap to being independently wealthy and having the freedom to do whatever they want. Resistance convinced them that freedom is scarier and harder than the suffering of building a successful business from nothing.

Are you starting to see what Resistance is and how it can affect your business? Resistance is, at its core, unhappiness. But you know what makes you happy. If you are a true entrepreneur, then happiness comes with the success of your business. Sure, that great meal out and bottle of wine probably make you feel pretty happy. You are also likely to be pretty happy sitting on the couch on a Sunday afternoon with a bag of chips.

But none of these compare to the wins in your business. When you make that big sale. When you cover payroll with cash to spare. When you hire your first employee. When you hire your tenth. When you walk through the halls of your office and realize that everyone is working and knows their job, without being told, because of the systems you designed. When you realize that you could walk away for a week and everything would run just fine. In those moments, Resistance is defeated. You did the work that you were meant to do.

Keep an eye on this site for more information on overcoming Resistance in your business. Bookmark the home page, subscribe to the RSS feed, or get in touch with me, and I’ll let you know about new resources as they become available.

All quotations are from The War of Art by Steven Pressfield.

The War of Art Translation – Part One

Steven Pressfield’s The War of Art addresses writers and artists as it talks about Resistance, understanding it and overcoming it. As I read the book, I could see how those same principles apply to running a business. The post below is part one of two where I share my thoughts from reading the first section of the book, Defining the Enemy. Grab your copy of the book and join me in examining what it looks like to encounter Resistance in your business.

Most of us have two lives. The life we live, and the unlived life within us. Between the two stands Resistance.

Why did you start your business? It certainly wasn’t to file quarterly tax forms. It wasn’t to worry about resolving employee disputes. But this is the life you are living now.

Let’s think back to that reason you did start your own business. Was it to grow a large company and become wealthy? Was it to be able to have freedom, both the freedom that comes with monetary goals and the freedom of destiny? Or was it to create something larger than yourself, something that would outlast your short time in this world? The answer is different for everyone but likely contains pieces of all of these.

Are you there right now? I didn’t think so. That is your unlived life. How did you end up stuck worrying about tax forms you don’t care about on the way to building a legacy?

You guessed it: Resistance.

Those tax forms are Resistance. Those employee problems are Resistance. That new marketing plan that you haven’t launched yet? The new product you have in the back of your head? The great new app? All the ideas you have to improve your company that never seem to happen? Resistance. Resistance is the reason that you have failed. And no, just because you’re bringing a few bucks home does not mean you have succeeded. Success, for the purpose of this guide, is living up to your potential. Living your “unlived life,” if you will. Because make no mistake: Anything less than that is a failure, no matter what trappings of success you have managed to pull together.

Resistance arises from within. It is self-generated and self-perpetuated. Resistance is the enemy within.

Why is your business not the success you envisioned? I bet it’s because of the economy. Just surviving in this environment is a success, right? Or maybe the bank wouldn’t give you the loan you deserved, those greedy bankers. Perhaps your employees are underperforming. You know how employees can be. Or maybe it’s the government with their meddlesome taxes and regulations.

The answer is that not one of these is the actual reason you fail.

Successful people think of creative ways to work with, or around, regulations.

Successful people consider taxes, have strategies to minimize them, but never worry about them.

Successful people take advantage of economic downturns to snatch up or eliminate the failures that will compete with them when things inevitably turn around.

Successful people have the ability to make any of their staff members successful right alongside themselves, with no hesitation, comparisons, or envy.

Resistance is like the Alien or the Terminator or the shark in Jaws. It cannot be reasoned with. It understands nothing but power. It is an engine of destruction, programmed from the factory with one object only: to prevent us from doing our work.

Just when you finally, finally, fix the one issue that was holding you back, lo and behold, a new problem even stickier than the last crops up. Now, if we can just get this one thing fixed . . .

But you never will. Things will never be completely fixed. Sometimes you have to make do with the imperfect. Sometimes you have to find workarounds. Resistance will always find a reason. Success does not suffer fools and doesn’t care at all about your excuses. So if you want to run with Success and avoid Resistance, you had better do the same.

Like a magnetized needle floating on a surface of oil, Resistance will unfailingly point to true North—meaning that calling or action it most wants to stop us from doing.

We can use this.

You know that task at the bottom of your list? The one that could change the face of your company? That one you are going to start as soon as you get your plate clear so you can really, truly, honest to God FOCUS on that big idea?

You should probably start it now.

Resistance’s goal is not to wound or disable. Resistance aims to kill.

Success takes time. Just like every bit of stress takes time off of your life, every minute delayed by Resistance reduces the Success you will have. This is it. Every dollar you don’t make is a dollar lost. Resistance is the sports team in the lead; all they need to do to win is run out the clock.

The warrior and the artist live by the same code of necessity, which dictates that the battle must be fought anew every day.

Who or what do you use as your measure of success? It likely depends on your motivations and how you define success. Maybe it’s the person who owns the business just like yours but is ten times the size. Maybe it’s the guy who has retired and plays golf three times a week. Maybe it’s the woman whose app changed how people look at the world.

But only someone who is listening to Resistance thinks that Success is an end point.

All quotations are from The War of Art by Steven Pressfield.

The War of Art – Review

I recently read another Steven Pressfield book that I really enjoyed. The War of Art is the first book in Pressfield’s series of books about overcoming “Resistance.” It is a fascinating book to read because we get to see him working through the process of developing his thoughts about Resistance while he shares them with us.

The War of Art is broken into three books: Defining the Enemy, Combating Resistance, and Beyond Resistance. As with Pressfield’s other books, I sometimes wondered how a portion applied to the higher message he was getting across. But, all in all, it is a great book with a wonderful message: You can take steps to defeat those feelings and fears that try to stop you from succeeding.

Even though The War of Art is written in the context of artists creating their art, I couldn’t help but think about it in business terms. We always hear stories of business owners achieving success and becoming wealthy. However, there are many more stories of business owners struggling to make ends meet, stagnating in their business, or working long hours for not enough pay. Why is this? Why are so many people misguided in their time and effort? How do so many people have failing, or worse yet, mediocre businesses when the principles and examples of success are so clearly laid out for them? I think Mr. Pressfield nails the reason on the head: Resistance.

I decided to write a guide to translate his ideas into the context of small business.

I believe that for true practitioners of this occupation I call business, there is an inherent art form to it. This is not a mainstream or well-understood idea. I’d like to help you see that the Resistance impeding the creation of art that Mr. Pressfield discusses is immediately and directly transferrable to the practice of running your business.

Sure, you might think a book about overcoming obstacles to writing the great American novel might have nothing to do with your business making large metal things to sell to other businesses making even larger metal things. But if you thought that, you would be fundamentally missing what drove you to start your business in the first place. The same energy (muse?) that inspires a writer or painter is what makes you the owner of a metal stamping company, instead of one of the dozen people working in it. There is much more art to business than there is science.

My next two posts will take a close look at the principles discussed in The War of Art and how they apply to operating a small business. If you haven’t read it, yet, I encourage you to pick up a copy of The War of Art, so you can read along while I discuss how it all relates to the world of running a business.

The War of Art Translation – Part One
The War of Art Translation – Part Two

Minimum Wage Laws

The mayor of San Francisco recently announced a new measure to bring the city’s minimum wage up to $15 per hour. Setting a baseline living standard for all members of our society is a reasonable, just, and valuable thing to do for a society as prosperous as ours. I totally understand setting a floor for livable wages.

The problem is in applying these kinds of solutions in a blanket manner. Not everyone who is working is trying to live on their wage. I don’t know anyone that would not support a “living wage” for full-time workers. But there are two other types of workers that are very common and critical to businesses: part-time/seasonal workers and interns/students.

The minimum wage cuts these people out by assuming that everyone needs to fully support themselves. Is it so crazy to think that there might be someone who wants to pick up a few extra bucks on weekends, or between classes, or while the kids are at school? I think it is wrong to assume that every task that needs to be performed at every company is worth $15 an hour.

Let’s talk about my company, because I use both of these types of workers.

Part-time Workers and Seasonal Help

We send out 1,800 tax organizers every year. It takes about a week to do it and we bring in temporary workers to staff the printers, stuff envelopes, and prepare the mailings. We most commonly recruit friends of our current employees for these sorts of temporary projects. Tax season is our other peak time. For about 12 weeks we are a flurry of activity. There are huge amounts of paperwork that need to be scanned and stored and then later shipped back out. We have a couple stay-at-home moms who only work with us during this season for the hours their kids are in school. They love it because we are flexible with the schedule, it is easy work that doesn’t really add any pressure to their already stressful lives and they can start and stop without any difficulties. The season starts after the kids have gone back to school and by summertime they are done. They also pick up enough extra cash to cover their family vacation or pay a property tax bill.

These flex workers are critical for businesses to help with peaks and valleys in workload. We love these folks because they are reliable, hard working, and are not competing with other staff for hours or career spots. Win/win, right? To say that we are an unfair employer by not providing a “living wage” because we only pay these folks $10 or $11 an hour seems a bit far-fetched. They aren’t trying to live on the wage, just meet some smaller financial goals on the side.

Interns and Students

While this living wage may be an inconvenience for businesses, and will result in higher prices for our customers, the real trouble comes in the form of interns and students (or any worker, really, who is developing a new set of skills). Ask any business owner what their top five challenges are, and I guarantee that one of them will be finding and retaining good workers. Add to that an unemployment rate that is still too high and hundreds of thousands of people underemployed, and you realize that we have a major problem in skills and training mismatching. There are people who want to work, yet businesses can’t find qualified people. This is a complex problem with lots of facets, and I won’t pretend to solve all of those here. But I can tell you how my company deals with it.

At our firm, we never hire for career positions externally. We only promote from within. We do this because cohesive culture is the key to quality and success in a business like ours. We hire bright students while they are in college and have them work as interns for a year or two before we slowly move them up the chain to being a partner. They learn the skills they need to succeed alongside their “book” education at the local university. For us those dollars are an investment, not a cost. We are overpaying those people because they don’t actually know how to do anything valuable, yet. We are willing to invest the money in them, hoping that we reap the benefit of their being productive employees later.

This is one of the single best solutions to the skills mismatch. Encouraging businesses to invest in the training of their employees will get employees the skills they need to have good jobs and will allow businesses to shape the training they want. But it is a two way street. Employees need to understand that they have a stake in this training as well. Forcing up the cost of that investment is exactly the opposite way to encourage more of this investment to happen!

After a person has fully developed their new skills, they should be entitled to a living wage. But to assume that every student needs to fully support themselves, regardless of whether or not they have the skills and knowledge to do so, compounds the already serious problem in our economy of mismatched skills and training.

Let’s make sure the steps we take to provide for all members of our society are best for the long term, not just the immediate future.

Taxes on Kickstarter

I know, this is boring. Kickstarter is supposed to be a fun, exciting dynamic place. Full of new ideas and concepts and people making things and making money.

No one wants something as boring as taxes involved.
But, before you start your Kickstarter you should know the ramifications of using it. They might surprise. Don’t set yourself up to get screwed.
Let’s pretend that you want to Kickstart your cumin waffle maker (hat tip to Evernote Essentials). You set a funding goal of $100,000. You know through your research that it will cost you $75,000 to produce said waffle makers which should net you a nice little profit of $25,000 less some overhead expenses. Sounds good, right? You make $25,000 and you pay tax on that number, fair enough.
The trap of Kickstarter, however, is in timing.
Once your campaign is funded, Kickstarter will release all of the funds to you. That’s one big deposit of $100,000 (I’m ignoring their cut and other issues to keep this simple). If you are an individual you are, by default, a cash basis tax payer. So what? That means that you have income of $100,000. Once you spend the $75,000 to make the cumin waffle makers, you will have expenses of $75,000 giving you the taxable amount of $25,000.
What if your Kickstarter funds in December of year 1? In January, you make your first payment to the manufacturers making your waffle maker. This means that, in year 1, you have $100,000 of income. You tax on that number. Which will be about $30,000. Which means when you have to come up with $75,000 to build your items, you are out of money.
Sure, it will all even out in the end. In Year 2, you will have $75,000 of expenses, no income, for a loss of $75,000. When you carry back that loss to year 1, you end up with a net result of $25,000 profit. Who cares? Cash flow cares! April of Year One you have to make a $30,000 payment to the IRS. Sure, you will get most of that back. But not until April of Year 2. Well after your cumin and waffle loving backers have stormed your castle with pitch forks.
There are lots of solutions to this problem, but they usually need a competent CPA to help you. Feel free to contact me if you have questions.
Don’t let your Kickstarted dreams get crushed because of bad timing!

Maximizing Tax Deductions

Having your own corporation and being self-employed is a fantastic way to save money on taxes, but the IRS is cracking down on deductions for small businesses. This doesn’t mean there aren’t lots of things you can do, or can still do, but it is now even more important to make sure you have the proper supporting documentation, so that your legally allowed deductions aren’t taken away due to technicalities.

 

Capitalization Policy & 179 Deductions

Chances are, if you bought any fixed assets in the last ten years, you were able to expense them in the year that you bought them. We never gave much thought to whether something was a capital asset versus something that you could expense because we could expense capital assets up to half a million dollars in one year. But now the rules are going back to where they were: Section 179 deductions are limited to $25,000. This means that you will have to depreciate FAR more stuff than you ever had to in the past. Do you have a written capitalization policy to support your deduction of small tools and equipment? Do you know how to tell when you are repairing (which you can expense) or rebuilding (which you have to depreciate) a piece of equipment? What depreciable life are things going to be depreciated under?

Tasks

[ ]Create a written capitalization policy to support your deductions

[ ]Re-do tax planning to take the smaller deductions into account

[ ]Make sure that your Fixed Asset schedule is accurate

 

Auto Use Policy

If you have a business you also have a company vehicle. It is likely that the company pays all the expenses of maintaining that automobile. At least it should be. But does your company have a written auto policy in the employee manual explaining to the employee what the permitted use is? If not, then it is likely the IRS would disallow your auto deductions under audit.

Tasks

[ ]Add an ‘Employee Auto Use Policy’ to your employee manual

 

 

Loans to/from Shareholders

Have you put money back into the company at some point? Have you taken all your distributions out of the company in proporortion to ownership? Have you been running at a loss, funding it from personal money, and taking a deduction on your personal return? The IRS is getting much more strict on allowing loans to and from your company and yourself. Not having them set-up properly could limit your deduction.

Tasks

[ ]Review equity accounts and loan accounts for accuracy

[ ]Create a promissory note, with interest, for any loans to the company and record these properly in the books

[ ]Create corporate minutes reflecting the company’s decision to take a loan

 

 

General Maintenance

All of the things above are examples of what the IRS refers to as being run in a business-like manner. “Business-like manner” is the amorphous concept that separates individual rules (where you have to prove every business expense) from the business rules (where the IRS has to prove it ISN’T business). Like I said, being self employed and having your own corporation is an amazing way to increase wealth and your standard of living. But it requires some work!

 

Have you gotten lax in your separation of business expenses and personal expenses? Time to check your accounts and tighten that up! Maybe there are deductions you have missed! Make sure your weekly, monthly, and quarterly checklists are being completed so your records are in decent shape.

 

Have you maintained your corporate documents? Make sure your corporate and officer information is correct with the Secretary of State for the the state you set up your business in. Make sure you have minutes showing any major changes (like taking a loan out from a shareholder or changing your company’s auto use policy!).

 

Have people doing work for you? If they are employees make sure that you have time cards on file and that their employment paperwork is in order and in their employee file. Have independent contractors? Review how you manage those folks and make SURE they are not employees. The 1099 vs W-2 question is a tough one to solve, even tougher to fight, and the IRS is cracking down on it. Consider getting agreements in place that specify a 1099 contractor is in fact independent, and that both you and they understand the difference.

 

This is all simple stuff that can go a LONG way in protecting you.

 Tasks

[ ]Review personal versus business expense split

[ ]Calendar weekly, monthly, and quarterly books and records checklists

[ ]Check with the Secratary of State to verify information and corporation status

[ ]Prepare minutes noting any major changes

[ ]Review employee files for correct paperwork

[ ]Review Independent contractor payments to verify accuracy

 

I love helping clients make things as simple as possible. It really doesn’t take much to make sure that you are maximizing your tax situation. A little bit can go a long way to making a big difference!

 

 

 

MyRA Reaction

A friend asked for my reaction to President Obama announcing the creation of a new retirement account called the MyRA. Because of my unique combination of jobs, he asked for my opinion from three points of view: as a matter of policy, as a business owner, and as a wealth advisor. Here’s what I told him.

I was very intrigued when I saw this but have been disappointed by the reality of it. I will give you three different answers, one for each of the three different points of view that you asked about.

Policy

Fantastic policy. Trying to get people to save now means they will be less likely to incur more crippling debt later when they get to retirement. There is some debate about how much the savings rate really needs to be: Is China’s too high? Although low in America, why not continue to keep it low, since the world will loan us money cheaply? How much does the current account deficit actually matter in the scope of global economics? Despite the debate I think that it safe to assume:

A) America will experience a lower rate of growth over the next 30 years than it has in the past. The education system and new technologies will take some time to produce the significant gains in productivity that are needed for big growth. In addition, globalization will continue to pull emerging and 2nd-world economies’ standards of living up faster than it will grow America’s standard of living. It might even pull America’s down, as the entire world normalizes.

B) A lower growth rate means that the real value of the debt will decrease substantially less than it has in the past. “Growing” your way out of debt is a good long-term solution, especially when that debt is being used to fund infrastructure. But with a lower growth rate, our capacity for debt has to decrease, meaning the savings has to come from somewhere. Enter the American saver.

Given all that, increasing savings levels helps this goal from both ends. The first being that the safety net doesn’t need to be as big because people have their own wealth. Secondly, the debt that supports the existing safety net will continue to find new sources of loans as savings increase.

Contra Arguments:

The fact that it can only be invested in US treasury debt—while I understand the rationale behind that and they don’t really have any other options—is not great. Going back to our scenario above, all of the deployable capital in being sucked up in low yield assets (treasuries) that have a low productivity. This is theoretically part of the reason why the economy is growing slowly, productivity growth is flat, and infrastructure is struggling. Instead of Government spending being used on externality type things it is being used to fund spending. And spending really has only a short-term impact on the economy. It doesn’t have the long-term impacts that things like building infrastructure (a National Highway System or improved utilities transmission methods) or making big, risky investments (like clean energy or nano-tech) or making massive overhauls to existing systems (like teaching our outmoded education system how to keep up with the modern world) would have. It’s one thing to take out a mortgage to buy a house, entirely another to rack up a credit card eating out. And the US Government is sucking up HUGE amounts of capital to do it. Given that all productive activities are a combination of labor and capital, and we have a surplus of labor right now, capital is clearly our limiting constraint. This is having a deleterious affect on the economy. The MyRA plan would, seemingly, exacerbate that problem. However, I make this argument my caveat, not my expectation, because if we take it as read that the lower growth rates are going to happen and debt will continue to pile up, the savings effect will be more beneficial than the sucking up capital will be harmful. (I think. Armchair economist speculation.) Would I rather see them rack up massive debt to invest in clean energy, retraining the people who still cant do basic computer activities, and overhauling from the ground up our K-16 (yes, 16, including college) system? Of course! But fat chance of that happening, so we hedge against what we know they will do.

Business Owner

Meh. The business owners that can’t set up a 401(k) because they don’t want to deal with the paperwork are kind of zero-sum people. They want to do NOTHING or they are willing to do the work to set up a plan. And if they are willing to do the work, a 401(K) won’t be much of a stretch from a MyRA. If the government really wanted more plans established, they should have just taken away a bunch of the crazy requirements on 401(k)s. All you have done now is made ANOTHER choice for a business owner, in an already bewildering landscape. SIMPLE IRAs are pretty damn simple. 401(k)s aren’t that hard either. They are hard for business owners that can’t figure out how to do payroll or don’t have books, but those people will still not be able to figure out a MyRA, no matter how simple you make it. This is a classic example of politicians making decisions based on rhetoric and not actually talking to small businesses. Small businesses who are the ones driving all the job growth, and will continue to do so, and are much more likely to not have a retirement plan for employees.

I think their real angle in this is that, long term, they are going to mandate that employees have the “right to save for retirement” which means they are going to require employers to offer this plan. And then they will set the default to auto enroll. And then the money goes into treasuries only. Which, really, is just a a new tax, directly on employees, administered by employers, but dressed up real fancy-like to make people feel better about the fact that we just upped their Social Security tax. It’s not a bad plan in the long run, since Social Security is insolvent anyway; this is a much easier sell than a new tax, and accomplishes the same thing. I know that sounds all “tea party” and what not, but I think it might be the truth. Plus, no politicians get re-elected for something as boring as re-vamping and refining existing regulations. They get credit for “new” big ideas.

Wealth Advisor

If you go to your bank they will open a ROTH IRA for you and set up a $25 per month/week/bi-week automatic transfer from your checking account to that new ROTH IRA. It will take you, literally, 30 minutes to set up. And it will be invested in, basically, US Treasuries. So, all the systems are in place to do everything the MyRA is supposed to do. But this isn’t Field of Dreams. Building it does not mean they are going to come. If they didn’t take that 30 minutes two weeks ago to help secure their future, why would they now? The MyRA looks great, but it doesn’t address—at all—the actual reason people do and do not save. And because of that, it will fail. Not addressing the emotional aspects of money dooms any and every financial plan. I can tell you that from personal experience.

As for my wealth advising business, this has nothing to do with me. Won’t touch my business at all. We deal with people who are trying to get as much as possible into accounts that defer taxes, and given the tax rates now, they pay significant money to us to figure that out and handle it for them. If anything, it will likely shut down a bunch of my small 401(k) plans. Which is great because they are typically ones we are doing as a courtesy to good clients and aren’t making any money on, anyway. I don’t think that shutting down existing 401(k) plans was the goal. But it will happen.

So, in summary:

Great and noble goal, increasing savings. Despite the economic arguments for and against investing increased savings in US Debt, it is safe to say that more good than bad would come from achieving this goal. I think it is actually a disguised tax, but I don’t really have a problem with that. We need to increase tax to make Social Security solvent. Every economist knows that. And I don’t want to start banging the “Obama is raising taxes and trying to trick you” tea party schtick, because it’s a load of crap. I just wish the government would be honest and say, “Hey we, as a country, messed up and we need to save some more to offset it. And it needs to come from everyone. No more NIMBY.”

But in the end, all the noble goals will be for naught, because they are basically trying to affect financial behavior, but have ignored the emotional motivations behind the problem, which dooms it to nothing more than mediocre performance.

Reduce, Defer, Eliminate – Part Three

Welcome to the final installment of the “business is simple guide” to dealing with the sale of a business or large assets. Let’s talk about my favorite topic, eliminating taxes. This is where all the real fun things are. But, as you can imagine, some significant complexity as well…

 Eliminate

The final method can eliminate gain altogether. But as you can imagine, the tools for doing that require some significant concessions. Namely, you have to give the money away. Not a lot of people want to do that. But if you do, here is how you do it.

 Save by Giving it Away

Two options are the Charitable Remainder UniTrust (CRUT) and the Charitable Remainder Annuity Trust (CRAT). OK, the difference between these two is just how the payments are calculated. So for our purposes, I will only refer to CRUTs and I will use the term CRUT and CRAT interchangeably.

A CRUT is a trust that has a charity (legal, 501(c)3 and all that) as the beneficiary. It has you, typically, as what we call the income beneficiary. It is an irrevocable trust. This means you cannot change your mind! Once you set this up it is permanent. After establishing it, you contribute the assets you don’t want to pay tax on to it. The trust itself doesn’t pay any tax, so it gets to hold and manage all the assets. Typically, you have someone like a bank, lawyer, or financial advisor as the trustee who makes the investment decisions. The trust agrees to pay an income stream to you (it can be a fixed percentage of assets, a fixed dollar amount, or just about any combo you want) that is fixed ahead of time. You only pay tax on the income that comes out to you, as it comes out to you. The idea is, generally, to have the income pay out to you so that you end up getting most of your money back. But, this is an irrevocable gift to a charity. It requires some serious planning and thought. If you have charitable intentions, this is a FANTASTIC tool!

A Charitable Lead Trust (CLT) is the same thing as a CRUT except the opposite. It pays out the income to a charity while you are alive and then pays the remainder to a beneficiary you name (your kids, your spouse, etc). It is not used in a business sale purpose very often. It is used when you have an income property that you don’t need the income from but where you want to preserve the underlying asset for your heirs.

 Reduce, Defer, Eliminate

And there you have it! If you are selling a business, property, or any asset really and have gains, you now have the theories behind how to deal with it. I hope that the main idea came across clearly. It doesn’t matter the tools, tips, or tricks that you use. For every additional amount of gain you defer or eliminate it will require you to have additional restrictions or limitations, or to give something up. So, how much do you want to give up? How much do you need now? Once you have those questions answered go through the list: Reduce, Defer, Eliminate.

 

If these strategies are interesting, or you think you might need additional help, please go to the contact page. I would love to work with you!

Big shout out to Jason Rehmus and http://sweatingcommas.com/ for all his help in making this readable. I would be unintelligible if he wasn’t around.

 

Reduce, Defer, Eliminate – Part Two

In Part One we talked about the immutable law of taxation. By way of reminder:

 As you increase the amount of tax deferred, you also increase the amount of control you have to give up to do it.

Since we have already discussed the “low-hanging fruit” of reducing gain and rate, let’s get to the meat of the discussion, and talk deferral.

 Defer

Deferring gain is another great trick for two major reasons. The first is that tax rates are tiered. The more years we can stretch a gain over (generally) the lower the overall tax rate we will pay on it. If I can split my gain up over a couple years and stay out of the 39.6% bracket, I am going to be in better shape. We also are taking advantage of the time value of money. I will gladly pay you Tuesday for a Hamburger today. But how?

 Stretching Out the Taxable Income

The most common way to stretch out a gain is through a method called an installment sale. If you sell something for $500k, and have $300k of gain, under normal situations you would receive $500k and pay tax on $300k. But if you sell it and you agree to take your payment in five equal installments of $100k each for five years (usually plus interest), then the gain of $300k will be recognized at $50k a year for the five years. $300k is enough to jump several tax brackets. $50k might not be. You also get five more years of deductions to take against the gain. Sounds awesome, right? And it is! Except that you run the risk of the buyer going bust and never paying you. See what I mean about limitations? If you want all the money now, you pay all the tax now. If you are willing to reduce your level of control (because all you have is a promissory note, not cash) you can save a bunch of tax! No right or wrong here, just a different situation.

What if you don’t need the money right now, want to do an installment sale, but don’t trust the buyer to pay you? That is where the other option, a Deferred Sales Trust, comes in. Basically it works the same as an installment sale, but instead of getting a promissory note from the buyer, you sell the assets/stock to a trust for the note (which has to be run by a neutral third party) who then sells them to the buyer. The trust basically holds the cash and pays out on its promissory note to you. That way you still can stretch it out, but you have more security because the note is backed by assets you can verify. A couple caveats on this though. First, for this to be an arm’s length transaction, the trust has to have a profit motive. Which means that if you charge 5% interest on the note the trustee is going to invest that cash and try to make more than 5%, generating a profit for itself. Which means it could lose the money. Secondly, this setup has only been approved by the IRS via Private Letter Ruling. What does that mean? It’s complicated, but basically the IRS could come right back and say “never mind, we don’t like this and don’t want you to do it anymore” and force you to pay the tax, plus penalty and interest at any time. It is legal now, but the IRS can make things retroactively illegal. That’s right. I have seen it happen. They basically say, “Well yeah, it was legal when you did it, but now it’s not so you broke the law when you did it. Sorry.” Again, risk and reward people!

Another great option, usually only available to attorneys and other people that do contingency work is a structured settlement. Basically if you work for a portion of a reward (like a lawyer suing someone on your behalf), instead of having them pay you 30% of the settlement directly (the typical fee) you can write into the settlement that they have to pay you a monthly payment for life (or for 20 years, or five years, or pay you in three years, whatever you want, really) instead. This is accomplished by their taking the 30% and buying an annuity to fund their obligation. This is very similar to an installment sale as you only recognize the income when you receive it. This is a pretty niche trick though, so I won’t spend much time on the ins and outs.

 Reverse That

The other option for deferring is what I call the reverse deferral. In this situation you do not defer the gain, you pay it all at once. But you defer the opportunity to take losses and deductions against it. Primarily you use the Net Operating Loss (NOL) rules to accomplish this. The NOL rules allow you to “carry back” losses in the current year up to two years. So, let’s imagine that you do an asset sale of your business in 2013 and get $1MM. You still own the corporation. We set up a defined benefit pension plan and defer $250k into the plan for 2013, which means you have income of $1MM minus expenses of $250k for taxable income of $750k. Ouch. But you pay your tax. In 2014, you defer another $250k into the pension plan. You have income of $0 minus expenses of $250k for a $250k loss. You carry that loss back to 2013 and file an amended return. You take the $750k profit minus the $250k loss and get a refund. Repeat this process for 2015. In the end, you moved $750k of the $1MM into a pension plan (which you can withdraw from at whatever rate you want, whenever you want, thereby stretching the tax out) and paid tax on only $250k now. This could work for all kinds of other expenses, by the way, not just a pension plan. If your company still operates it might still need to have a company car, a company phone, or might have meals and entertainment expenses. All these deductions add up to what you can carry back.

Another method of the reverse deferral is to use something like a Family Limited Partnership (FLP). With this setup you make a partnership and contribute the assets you plan to sell. Typically to stand up, this needs to be done years before the sale takes place. You gift shares of the partnership to family members (primarily kids). When the asset sells, that gain is split up amongst all their returns, thereby stretching the gain across lots of smaller tax brackets. This tool is primarily an estate tax tool and not an income tax tool, but it can be used to help offset income tax while you are accomplishing your estate tax goals. As a side note, like in the NOL example above, the FLP might have operating expenses that it can pay that would be used to offset future or past gains. This tool can work really well if you want to give money to your kids now. And you have to. You cannot run an FLP and then not distribute the assets to them. Remember what I said about having your cake and eating it, too? You can’t use your kid’s tax brackets without losing that money.

 Gone for Good

The only trick that comes close to having cake and eating it is the stepped-up basis on inherited property. This is a pretty good trick. Let’s go over some terms. Remember, you pay tax on gain. Your gain is your sales price (X) – minus your basis (Y). Your basis is, typically, what you paid for it. It can be increased if you put more money in and decreased if you take money out. But to keep the example simple, assume it is what you paid for it. So X – Y = your taxable gain (Z). Z is what you pay tax on.

Now let’s assume Mom and Dad bought a house. They bought it 30 years ago and lived in it their entire lives. They paid $50k for the thing and now, when they both pass away, it is worth $750k. If you live in Southern CA like I do, this is a pretty common story. If Mom and Dad sold the house, they would pay tax on $700k ($750k – $50k). With me? Ok, now assume instead of selling the house, Mom and Dad pass away and leave you the house. What is your basis in the house? It gets “stepped up” to the Fair Market Value on the date of Death. So, your basis is now $750k. You immediately sell the house. You sell it for $750k with $750k of basis. How much tax do you pay? That’s right! ZERO! Death is the only legal way to make income/gain disappear forever. This works for any inherited assets: real estate, closely held businesses, stocks, bonds, etc.

Of course, in keeping with our theme of everything having a downside, with this, the greatest way to eliminate tax ever, you have to die. So there’s that. But still, neat trick right?! When you combine this with the 1031 exchange rules for real estate it can be a really great combo. A 1031 exchange allows you to not pay tax on the gain of a sale of real estate, as long as you immediately reinvest the proceeds from the sale in another property. So, if you have decided that you will always have rental real estate as part of your portfolio you can not pay tax on any gains, keep rolling the money over into new properties as the market allows. Then, all the gain you make along the way will be 100% tax free because whoever inherits the property will get a stepped up basis. Of course the other downside is that all that gain becomes taxable if you ever need the cash out of the property.

That is all the basics you need to know about deferral. Hopefully you can find something useful to help you! In our third and final part of the series, we are going to discuss ways to completely eliminate taxes.

 

If these strategies are interesting, or you think you might need additional help, please go to the contact page. I would love to work with you!

Big shout out to Jason Rehmus and http://sweatingcommas.com/ for all his help in making this readable. I would be unintelligible if he wasn’t around.