Using Tax Logic to Manage the Value of your Business

Using Tax Logic to Manage the Value of your Business

In the real world of business management ownership you can only create income in 2 basic ways. These two income methods are taxed differently by good ‘ol Uncle Sam.

The first method income is “earned” income. Let’s say I’m a graphic artist and you hire me to create a logo. I design the logo and you pay me $250. That is earned income to me (assuming it goes to me and not into a corporation). The $250 goes into my gross income and I pay tax on it as high as 35% federal and depending on what state you live in, it could be over 45%. So your $250 of earned income (assumes no state tax) is worth only $162.50 in your pocket.

The second method is capital gains income. Capital Gains can be generated in many ways. Let’s look at a simple example. You get on Ebay and find a great bike for $100, you buy it. Then a year later you’re riding around the block on your $100 bike and a guy stops you and offers you $350 on the spot. You take it and walk home! You made $250 (same as if you designed a logo above) but this is capital gains and your tax on that is only 15% of your gain ($350 rec’d  – $100 paid = $250 gain). Your tax for this is $37.50 and your net in pocket is $212.50.

You get to keep $50 more if you earned your money through capital gains income.  This is just another reason why accumulating capital is important to long term wealth…if you have capital you can manage your taxes a lot better than if you only have earned income.

When running your business think of all the ways to build value that is taxed at 15% instead of 35%…over time it could be a lot more money in your pocket. Talk to your CPA to see if you have opportunities to maximize the availability of the capital gains tax rates.

Are you a business owner that wants to grow? Part 1

This is Part 1 of what will be several posts about growing your business. I’ll cover some free ways to grow and I’ll also talk about growth opportunities that aren’t free.

I meet many business owners who want to grow but very few know how to grow.  Let’s look some common ways to grow your business.

Low cost/no cost growth.

Train your people better so they get the most sales out of every customer encounter. 

        Example – How many times would you have ordered dessert in a restaurant if someone would just ask? At a restaurant that is missing opportunity, the server sees that I am finished with my dinner and the server walks up and asks “Would you like anything else?” My response, “No thanks.”

At a different restaurant, the server sees I’ve completed my meal and asks “how would you like a slice of blueberry pie or a hot fudge sundae?”  I don’t know about you but for me it’s a lot easier to say no to the first server than the second one.

What’s it mean to the business owner? If a dessert costs $5 and the restaurant serves 100 people per night, getting just 4 more people out of 100 people per night to order dessert means $7,300 per year in additional sales and the cost on that sale is the lowest you can have. All the help is already paid, rent doesn’t go up, light bill is the same, etc. So the owner of that business could make $7,300 more per year because his servers just asked the same question a different way. That’s as close to free money as a business owner can get.

Every business has these kinds of opportunities regardless of the industry. Take a close, a very close, look at your business and you will find opportunities to increase sales to your existing customers. Often the secret to good selling is knowing how to ask good questions. Are your people asking the good questions?

When is 95% less than 20%? When the 95% is wrong!

In my day to day activities I meet with 250 – 350 small business owners a year who are considering selling a business for one reason or another. In discussing their business the topic of customer service is brought up by me. The reason it is discussed is because significant value is added to a business with a loyal and happy customer base.

It is extremely rare (I can only remember 1 instance is last 5 years) when the business owner actually has any real data to determine their performance. In most cases the owner doesn’t even track the number of complaints the business receives each year. Nor do they track repeat customers.

So therefore, in my discussions with the business owner what I am told about customer service is what the business owner thinks is true as opposed to any evidence it is true.

When I ask the question “How is your customer service?” about 95% of the time the answer is “good” or “great”!!

In thousands of discussions with business owners over the years I have never had a business owner answer, “Our service is really lousy but we’re the cheapest in town so some customers put up with it.” I may not have gotten that answer from business owners but it has been true for many, many businesses.

So….. 95% of the business owners think their service is good or great. Hmmmm, I consistently see customer surveys whose results state that customers get good or great service less than 20% of the time. I wonder which is closer to true?

Why don’t most business owners track their customer service results? My guess is they really don’t want to know the answer. If they knew the answer they would be faced with the choice of ignoring the issue or doing the hard work of fixing their customer service problems.

If you are a small business owner which category do you fit into:

  1. You know (through reliable data and survey results) what your customers think and you manage your business to improve your customer service?
  2. You don’t really know what your customers think about your service and you really don’t want to find out.

 If you are serious about increasing the value of your business and your profits it’s time to take customer service issues seriously.

New 1099 Rules effect on Small Business

    This post provided by Paul Ikard, CPA

March 17, 2012  – Some of the below rules may have been modified, check with your CPA before taking any action.

Businesses and not-for-profit organizations are accustomed to IRS rules that require them to report certain payments on annual Form 1099 information returns. However, the recently enacted healthcare law imposes surprising new Form 1099 reporting requirements. Complying with them may add significantly to your organization’s paperwork burden. While the new rules don’t apply to payments made before 2012, it’s not too early to start gearing up to deal with them.

Current Rules in a Nutshell

Background: For many years, businesses have been required to report various payments on different versions of Form 1099. For instance, when a business pays $600 or more during a calendar year to an independent contractor for services, the business must issue the contractor a Form 1099-MISC that reports the amount paid that year. The business must also furnish a copy of the Form 1099-MISC to the IRS. This reporting procedure helps contractors remember to include the payments on their tax returns, and it helps the IRS ensure that income is reported. Under rules now in effect, other types of payments that businesses must report on Forms 1099
1. Commissions, fees, and other compensation paid to a single recipient when the total
amount paid in a calendar year is $600 or more.
2. Interest, rents, royalties, annuities, and income items paid to a single recipient when
the total amount paid in a calendar year is $600 or more.
When a Form 1099 is required, it must show:
The total amount for the calendar year;
The name and address of the payee;
The tax ID number (TIN) of the payee (For privacy reasons, it’s okay to show a truncated
TIN on a 1099 issued to an individual);

Contact information for the payer; and

The payer’s TIN.

If your business doesn’t have a payee’s TIN, you may be required to institute backup federal income tax withholding at a 28 percent rate on payments under Internal Revenue Code Section 3406. In most cases, the rules summarized above apply to payments made by not-for-profit organizations since they are generally considered to be businesses for Form 1099 reporting purposes. If a payer inadvertently fails to issue a proper Form 1099, the IRS can assess a $50 penalty. The penalty for each intentional failure can be $100 or more.

Reporting Payments to Corporations

Under the rules that currently apply, most payments to corporations are exempt from Form 1099 reporting requirements. However, there are a few exceptions. For instance, payments of $600 or more in a calendar year to an incorporated law firm must be reported on Form 1099-MISC.

Example:  our business makes $30,000 in monthly payments to rent office space from a corporate lessor. Under the current rules that apply today, there is no 1099 reporting requirement for the payments, because they are made to a corporation.

Reporting Payments for Property

Under current rules, there is also generally no requirement to issue 1099s to report payments for property (such as merchandise, raw materials and equipment).

Example: Your business buys a delivery van, display shelving, and computer equipment. Under today’s rules, there’s no 1099 reporting requirement for these purchases.

What Will Change in 2012 and Beyond?

The healthcare legislation makes two big changes to the existing Form 1099 reporting rules and a third change that is hard to assess without further guidance from the IRS.

First Change: Payments to Corporations Must Be Reported. Starting in 2012, if your business pays a corporation $600 or more in a calendar year, you must report the total amount on an information return. Presumably, Form 1099-MISC will be used for this purpose, or the IRS will develop a new form. (Payments to corporations that are tax-exempt organizations will be exempt from this new requirement.)

In 2012, your business pays $30,000 to rent office space from a corporate lessor. Under the new rules that take effect in 2012, the $30,000 must be reported on a Form 1099. Your business pays $2,000 for four employees to attend a seminar in 2012 put on by a corporation. Under the new rules that go into effect that year, the $2,000 must be reported on a Form 1099. Several employees go on a business trip in 2012, and your business pays $1,500 to a corporate hotel. The $1,500 must be reported on a Form 1099 for that year.
In 2012, your business spends $1,000 at a local restaurant for an employee holiday dinner. The restaurant is operated by a corporation. Under the rules scheduled to become effective that year, the $1,000 must be reported on a Form 1099.

Second Change: Payments for Property Must Be Reported. Starting in 2012, if your business pays $600 or more in a calendar year to any party (including an individual) as “amounts in consideration for property,” you must report the total payments on an information return for that year. The term “property” means computer equipment, office supplies, raw materials, and just about anything else you can put your hands on. Again, Form 1099-MISC might be used to reported affected payments, or a new IRS form might be created.

In 2012, your business buys cash registers from a supplier for $25,000. It also spends $1,000 at a food and beverage store to buy refreshments for a company party. Later that year, the company pays an individual $1,500 for an old pickup truck and spends $750 at an office supply store for copier ink and computer paper. Under the new rules that are scheduled to go into effect in 2012, all these transactions will require your business to issue 1099s. As you can see, the new requirements to report corporate payments and amounts to buy property will undoubtedly result in the issuance of many millions of additional Forms 1099 each year.
(Presumably, payments between related corporations will not be exempt.)

Another Burden. 

Your business must also obtain a TIN from each affected payee to avoid the requirement for backup withholding of federal income tax. On the other side of the coin, if your business sells property or you operate a corporate business, you will have to supply customers with your TIN to avoid backup withholding on payments made to you.

Third Change: Payments of “Gross Proceeds” Must Be Reported. Here’s where the new upcoming rules get more confusing. Under a third new rule that will take effect in 2012, payments of $600 or more in “gross proceeds” to a payee in a calendar year must be reported on an information return. At this point, it is unclear what this new reporting requirement is meant to cover. The best guess is that it is meant to cover payments add to non-corporate payees, such as restaurants and other small businesses. We are awaiting IRS clarification on this issue.

Action Plan

Dealing with the new Form 1099 reporting rules is going to be difficult for many organizations — resulting in an avalanche of paperwork. Your business will likely have to modify its accounting procedures to capture payee information that will be needed to comply with the new requirements.

Remember: TINs must be obtained from your vendors to avoid having to institute backup federal income tax withholding on payments made to them. By the same token, your business must ensure that your customers have your TIN to avoid backup withholding on payments made to you. What if backup withholding does occur on payments made to you? You must be prepared to track the withheld amounts so you can claim edit for them at tax return time. If your business winds up on either side of the backup withholding rules, it can be a real mess. And with lots more 1099s flying around, the odds of errors rise proportionately. To compound the problems with the new reporting requirements, many businesses use accounting methods other than the cash basis. In addition, a number of businesses file their returns using reporting periods other than calendar years. In an audit, imagine your business and the IRS attempting to reconcile 1099s with these complications.
Fortunately, the new Form 1099 reporting rules (including any backup withholding implications) don’t cover payments made before 2012.

 Click here to visit the website for Mr. Ikard.

The Bush tax cuts debate and the real small business story

It’s hard to avoid the politicians ranting either for or against the extension of the Bush tax cuts. Like many issues in life, for every complex problem there is a simple solution that is absolutely wrong.

Those opposed to the extension often try to separate the issue of “who” gets the extension. The theory is the high income earners should not get the extension and therefore pay more in taxes because they can afford it.

Those in favor of extensions for everyone say if the extension of the cuts isn’t done it will cost jobs and be a drag on the economy.

In this case the unfortunate truth is they may both be right. So if they are both right how do we decide which policy is best.

Let’s take the case of Mary who owns a pest control business. Like many small business owners her income can vary wildly from year-to-year. For the sake of this discussion let’s say that she and her husband, who also works in the business, make $300,000 combined. Since many politicians have said that the tax cuts should not be extended for those who make over $250,000 let’s use that as income above which the Bush tax cuts expire.

So let’s go with that, Mary and Bob currently make $300,000 per year and, if the Bush tax cuts are eliminated, they are going to get a 10% tax increase on income over $250,000. I’ll use round numbers again..their new tax rate goes to 40% from today’s current 36%.

Now Mary and Bob have a good idea. They think they can grow their business next year and increase their income by $50,000 to $350,000 but they will need to hire someone for $32,000 a year to do the job. Seems like a good idea right? Spend $32,000 and make an extra $50,000..easy decision. Well, maybe not. Here’s the math if the Bush tax cuts expire for her:

  1. Mary pays an employee $32,000.
  2. Mary makes additional $50,000 before tax and $30,000 after taxes (40% tax rate)
  3. Mary pays additional tax of 3.6% (difference between old rate and new) on the $50,000 she already makes above the $250,000 tax increase line. That’s another $1,800 in taxes

So what happened here? Mary made $50,000 more and has $3,600 less in cold hard cash. (The math is $50,000 – $32,000- $20,000 – $1,600 = -$3,600)

What would you do? Take the risk of hiring someone for $32,000 so you can lose $3,600?

The same situation if the tax rate for Mary is extended:

  1. Mary hires and pays an employee $32,000
  2. Mary makes additional $50,000 before tax and $32,000 after taxes (36% current tax rate)
In this case if her plan works Mary is break-even. Remember from above, if the tax increase goes into effect Mary will lose $3,600 if her plan works perfectly. Without increasing her taxes she’s break-even.
What’s the difference? If the tax increase goes into effect and Mary decides not to hire the new employee
 the tax effect to Mary is $1,600 and the new employee doesn’t have a job.
If the tax increase doesn’t go into effect what happens? Mary hires the new employee, Mary pays $18,000 MORE in taxes because she made $50,000 more taxed at old rate AND the IRS gets to tax the new employee on his $32,000 salary. Mary makes more money, another person has a job and IRS gets more money. But Mary had to be willing to take the risk! None of this happens unless Mary takes the risk. It’s not the government taking the risk, it’s Mary that has to take the risk. 
There are millions of people like Mary and Bob in the U.S. today making these same decisions every day.
The point of this is that nearly all financial decisions are made at the margin not based on the overall. Mary didn’t make her decision based on the $300,000 she makes, she made the decision based on the next $50,000 she might make. 

Is the small business owner world upside down?

This post falls under the category of “what the heck is going on”!

The following is from a small business consultant who talks to small business owners several times a week and has done so for about 10 years. Their name is being with held for obvious reasons.

They say, many of the following are found to be true for abut 75% of small business owners:

  • Business owners who sleep very well ….probably shouldn’t.
  • Business owners think because their employees don’t complain the employees are happy
  • Business owners whose employees complain blame it on the government
  • Business owners personal spending is often unrelated to their personal income, some spend a lot more than they make and some spend a lot less…..very few are break-even
  • Business owners who are chronically behind in paying suppliers are often right on time replacing their boat.
  • For every one minute a business owner spends talking to an employee (shouting instructions doesn’t count) they spend 54 minutes talking to sales people about a new copier.
  • Whenever a customer says “your price is too high” the business owner believes it.
  • Whenever a customer says “your price is too high” the business owner grumbles about how his competitors are losing money.
  • A business owner would rather pay 5% more to a vendor than lose his invitation to the vendor’s hunting trip.
  • For every one minute a business owner spends getting expert advice they spend 92 hours giving it.