When trying to learn information about an individual, many companies turn to online background checks to uncover or confirm information. However, doing so could prove a mistake if this is the primary step taken to understand an individual’s background, as relied upon information may not be fully verified.

Hiring a licensed investigator can not only help ensure high-quality information is obtained, it can also facilitate the analysis of this information to provide a complete picture of an individual, says Theresa Mack, CPA, CFF, CAMS, CFCI, PI, a senior manager with Cendrowski Corporate Advisors.

“A simple background check may provide an incomplete picture of an individual and overlook critical information,” says Mack. “By hiring a licensed investigator to conduct background due diligence, you can ensure that no stone is left unturned.”

Smart Business spoke with Mack about how a licensed investigator can help your business uncover the information you need and put it in an appropriate context.

Why should a company hire a licensed investigator to conduct background due diligence activities rather than perform an online background check?

Most online or database-driven background checks are actually ‘record checks.’ In other words, data from records is compiled and the quality of source information is not thoroughly verified.

For some purposes, this cursory check of public records may be sufficient. However, depending on the information found, the nature of the background check, the check’s intended use and the access to confidential/proprietary information that a potential employee may have, a complete background due diligence investigation may be warranted.

A background due diligence investigation, as performed by licensed investigators, is far from a cursory background check. No single record or method of search is generally employed; instead, an investigator uses multiple resources to verify data accuracy and corroborate information. Thus, background due diligence investigations help reduce the risk of client reliance on false information.

What process is employed by investigators to perform background due diligence activities?

An investigator generally works on a six-step methodology: prepare, inquire, analyze, query, document and report. This methodology is highly applicable to background investigations.

An accurate and comprehensive investigation is based upon existing, determined and verified information. Leaving no rock unturned and making every conceivable effort to locate all possible information is generally the objective of an investigator.

Investigators will tailor their activities to suit the needs of their clients, which typically include attorneys, businesses and individuals. Client needs will define both the records checked by the investigator and the type of documents that can be released to the investigator and the client.

Where will an investigator begin his or her research?

An investigator often begins the research process by examining open source information. In this instance, open source refers to sources that are overt and publicly available, as opposed to covert or classified sources; it is not related to open-source software or public intelligence.

Open source information includes public documents that are created over a person’s lifetime, allowing the investigator to follow a paper trail leading to a complete history of the individuals being searched. These may include court filings, property tax documents, vehicle registrations and social media sources, among others.

Open source intelligence is a form of intelligence collection management that involves finding, selecting and acquiring information from publicly available sources and analyzing it to produce actionable intelligence.

How does an investigator evaluate source information?

Any record that is kept or provided is only as good as the chain of events involved in its creation. While doing online record checks simply provides information on an individual, investigators are often tasked with evaluating the veracity of the source data.

Record maintenance, storage and dissemination procedures can often impact the accuracy of information. Typos, misprints and mistakes introduced by human error can also affect the accuracy of records. These latter items are often seen on personal credit reports, criminal convictions and even civil litigation histories, which, although they are official records can nonetheless contain errors.

Processes for updating records can also have an impact on the accuracy of information, as records are only as accurate as their frequency of update. Some records are never updated and may provide stale data if a user is unaware of this underlying issue.

Finally, the method data that warehouses employ for acquiring information critically impacts information integrity. For instance, the provider may have purchased information from a secondary source. In such an instance, it is essential that the provider have accurate retrieval processes and is knowledgeable about handling special data items.

Each of these issues is evaluated by an investigator over the course of conducting background due diligence activities.

Theresa Mack,CPA, CFF, CAMS, CFCI, PI, is a senior manager with Cendrowski Corporate Advisors. Reach her at (866) 717-1607 or tbm@cendsel.com.

Published in Chicago

Patents, trademarks, copyrights and trade secrets, or intellectual property (IP), have become an increasingly important asset for today’s businesses.  In particular, IP provides strategic and financial advantages against competitors in the form of improved business and/or manufacturing processes and new product technology or designs.

The U.S. Patent and Trademark Office (USPTO) indicated the number of patents granted in 2011 (247,713) was the largest since 1963, and as of 2011, there were 1.75 million active trademark registrations.  Further, the U.S. Copyright Office indicated that between 1790 and 2009, approximately 33.65 million copyrights were registered.

“While we have seen the number of patent grants and the volume of trademark and copyright registrations increase, in my experience, companies are not appropriately identifying and managing their IP,” says Andrea Gonzalez, CPA, a senior manager at Cendrowski Corporate Advisors. “As a result, companies are missing valuable strategic and economic opportunities.”

Smart Business spoke with Gonzalez about the necessity for companies to identify and manage their IP.

Why it is important for a company to identify its IP?

It is important for a variety of reasons; in particular, it allows a company to fully understand its IP portfolio. Once a company identifies its IP portfolio, it is able to determine the development stage of in-process IP; determine the ongoing cost of its IP development, including whether the company should continue to fund development; assess and critically review the IP’s continuing value to the company; identify potential licensing in/out opportunities; identify potential IP purchasing needs or sales of nonperforming IP; comply with financial reporting requirements; and monitor for potential misappropriation or infringement of its IP.

How can a company identify and manage its IP?

A company can start by implementing a formal process of identifying and managing all IP assets within the company on an annual basis. The first step is to establish a standardized method for identifying specific IP by department or functional area, by the type of IP (e.g., patents, copyrights) and by the type of product it relates to or the process for which it applies. The categories of identification can vary by company depending on the depth and variety of IP assets.

The second step is to implement the formal IP identification process. The implementation begins by interviewing various employees. Employee interviews enable a company to identify all of its in-process and established IP and appropriately categorize by department, type and product/process.

Once all IP is identified and categorized, the company can easily manage its IP portfolio. Specifically, it can perform annual audits of its IP portfolio either internally or via outside IP consultants and implement computerized or automated audits. The audits enable a company to monitor the current status of in-process IP; estimate the useful life and use of its IP; determine its value for purposes of financial reporting, insurance or collateral; and identify potential business opportunities (e.g., licensing in/out, sales, purchases), among other items.

Don’t a company’s financial statement auditors perform this function?

Not necessarily. If IP is self-created, the costs of creating the property are expensed rather than capitalized. As such, there may not be an asset included in the balance sheet for the IP.

Is it also important for a company to safeguard its IP?

Safeguarding a company’s IP is important to maintaining the economic and business benefits previously discussed. It has also become increasingly important because the accessibility of information has never been easier than it is today.

Further, there is an increasing availability of tools capable of obtaining information maintained in electronic environments.   Therefore, it is crucial for a company to identify its various forms of IP and work to not only implement appropriate internal security measures but to also work with their legal counsel to ensure the appropriate IP protection afforded under U.S. laws are in place to protect the company’s IP assets. Enterprise risk management extends to IP, as well as ‘hard’ assets.

What if a company suspects its IP rights have been infringed or stolen?

The first step is to contact legal counsel.  If legal counsel determines there is an alleged infringement or misappropriation, financial and accounting professionals can be retained to determine the economic damages that may have resulted from the alleged unlawful acts prior to or after a formal complaint is filed with the court.

How are damages quantified if a company believes its IP has been infringed or misappropriated?

There are a number of different methods forensic accountants and valuation analysts use to quantify IP damages. Bearing in mind damage remedies available under the law vary based on the type of IP allegedly infringed or misappropriated, damages may be quantified by estimating a reasonable royalty rate, quantifying the profits the IP inventor would have earned but for the alleged infringement, or by quantifying the unjust enrichment the infringer earned as a result of their alleged misappropriation or infringement.

Andrea Gonzalez, CPA, is a senior manager at Cendrowski Corporate Advisors. Reach her at arg@cendsel.com.

Published in Chicago

According to the Association of Certified Fraud Examiners, a typical organization loses roughly 5 percent of its annual revenue to fraud. When applied to the Gross World Product, this figure translates into approximately $3 trillion in fraud losses each year.

Though the economy appears to be on the mend, fraudulent activity remains prevalent in today’s business environment. When a fraud is suspected, a company or its counsel may retain a forensic accountant to investigate the matter.

“Forensic accounting is an important branch of accounting, and perhaps one of the most opaque,” says Walter McGrail, CPA, senior manager of Cendrowski Corporate Advisors. “It is a crucial tool in the investigation of white collar crime.”

Smart Business spoke with McGrail about fraud, forensic accounting and the tools used by forensic accountants in their work.

What is a forensic accountant and how is that person involved in fraud investigations

A forensic accountant is an individual who combines expertise in accounting, auditing, finance and investigations to assist legal professionals. Forensic accountants are typically engaged as expert witnesses, or they employ investigative skills that may require courtroom testimony; these individuals serve at the intersection of business and law.

Fraud investigations, including activities centered on obtaining evidence, performing interviews, writing reports and testifying in a case of fraud, are generally performed by forensic accountants looking to reconstruct historical events leading to the event. Historical event reconstruction is often critical for the accountant to understand the motive for perpetrating a fraud, the opportunity that allowed the fraud to occur in the organization and the rationalization employed by the fraud perpetrator in performing a fraudulent act.

These three elements comprise what forensic accountants call the ‘fraud triangle,’ and each element must be present in order for a fraud to occur.

Where might a forensic accountant begin his or her fraud investigation?

One of the first steps involved in a forensic investigation is to conduct a background investigation on the key players believed to be involved in the fraud. Knowing as much as one can about the individual or individuals in question sets a good foundation for future work that will be conducted in piecing together historical events.

Background checks will reveal if an individual has a history of criminal or civil litigation, as well as whether or not he or she is under financial duress or other pressures. These pressures may provide the rationalization needed for a fraud to occur. Background checks might also shine light on the motives for an individual to perpetrate a fraud.

Can a forensic accountant discern information from tax filings and documents?

Tax matters can become a basis for leads and disclosures on any forensic accounting engagement, and tax professionals are a vital part of any forensic accounting team.

Tax filings and documents are often a great source of information in the conduct of a forensic accounting engagement. These reporting devices are oftentimes generated by third parties. Information included on Forms W-2, 1099, 1098, etc., is typically prepared by third parties and reported directly to the taxing authorities, as well as to taxpayers.

Tax reporting may reflect financial information that is not otherwise made readily available by the target of a forensic examination. Taxpayers that otherwise keep information close to the vest often feel compelled to make accurate filings with tax authorities to avoid running afoul of tax laws. It’s one thing to treat financial information as proprietary and restrict its disclosure to third parties; it’s another thing altogether to misrepresent tax matters to federal, state, or local tax authorities.

Taxpayers also often use professionals to assist with their tax reporting compliance. While tax professionals may serve as advocates for their clients, rarely will independent accountants risk becoming complicit with inaccurate reportings.

How might a forensic accountant use tax returns to deduce information?

Tax filings can often be compared one to another in order to identify forensic financial information. Comparing business returns such as Schedules K-1 to US 1040s and federal returns to state returns and business returns (US 1065 or US 1120S) to business general ledgers often results in financial revelations not otherwise readily available to the forensic accountant. Moreover, there may be tax benefits motivating persons to make full disclosures to taxing authorities. For example, tax refund claims generated by losses or credits which can result in immediate cash flow generally require a fair amount of supporting disclosure and documentation.

By utilizing a forensic accountant, an organization can not only determine how and why a fraud occurred but can use the information gathered in a courtroom against the perpetrator.

Walt McGrail, CPA, is senior manager of Cendrowski Corporate Advisors. Reach him at (866) 717-1607 or wmm@cendsel.com.

Published in Chicago

Successful organizations achieve a diverse set of objectives. The pursuit of these objectives is especially challenging in today’s highly competitive environment.

Operational assessments assist organizations in achieving their objectives by ensuring that their strategic goals are appropriately translated into operational objectives and that the risks associated with the achievement of these operational objectives are mitigated.

“Operational assessments help firms evaluate how they are performing with respect to their goals and the chance they will continue to achieve these goals in the future,” says James P. Martin, CMA, CIA, CFE, managing director of Cendrowski Corporate Advisors. “Irrespective of the economic environment, operational assessments can provide significant benefits to firms.”

In last month’s issue, Smart Business spoke with Martin about the basics of operational assessments. This month’s issue provides further context regarding the purpose and execution of these assessments.

What is the purpose of an operational assessment?

All businesses, regardless of size, face risks in pursuing strategic objectives. Operational assessments focus on the mitigation of risks in the design and execution of processes created to achieve strategic goals.

The distinction between process design and execution is central to operational assessments, and different procedures must be followed depending on the type of assessment that is being performed within an organization.

What are the key components of a process design assessment?

The first step in a process design assessment is an evaluation of the organization’s process design objectives. More specifically, this evaluation will examine how process design objectives reinforce the organization’s strategic goals; if feedback from prior risk assessments was considered in the design process and whether or not process owners understand their role in achieving the organization’s strategic objectives.

After process design objectives have been evaluated, process design risks must be tabulated and assessed. The likelihood and impact of risks that may prevent the achievement of the organization’s objectives should be assessed by numerous individuals, and the results of these assessments should be shared with all participants. Special attention should be paid to outlying likelihood and impact assessments, as the individuals who provided an outlying estimate may have specialized knowledge of specific risks facing the organization.

Next, the design of process controls must be evaluated, along with the ability of these controls to bring risks in line with the organization’s risk tolerance. Those processes in which inefficiencies and inadequate controls exist must be redesigned in accordance with the organization’s risk tolerance.

Special attention should be paid to high likelihood/high impact risks, as these present the greatest level of exposure to the organization. Low likelihood/high impact risks should also receive attention, as the organization may rarely face these events and be unaccustomed to dealing with them should they occur.

What are the key components of a process execution assessment?

A process execution assessment begins with the disaggregation of designed processes into executable tasks. Process operators should be interviewed to determine their perception of a process’s tasks, and they should also be observed to make certain that any process tasks were not forgotten in the initial interview.

Once executable tasks have been identified, an assessor must determine the existing level of process controls that mitigate each task. This includes the tabulation of preventive controls, as well as detective and corrective controls designed to minimize the likelihood and impact of risks, respectively.

Subsequent to the evaluation of process controls, key controls are tested to ensure they are functioning as intended. Testing should focus on those risks identified by process operators as having a low likelihood of occurrence or low impact. An assessor should also consider altering a company’s internal audit plan and rotation schedule to make control testing a periodic activity.

Lastly, a plan must be developed to correct processes requiring improvement, especially high likelihood/high impact processes. The root cause behind a high likelihood or high impact score must be well understood prior to developing a process improvement plan.

What resources exist for organizations looking to perform operational assessments?

Interested parties should view Cendrowski Corporate Advisors’ Operational Assessment Guide included in this month’s issue of Smart Business, as well as last month’s introductory article. Both provide an excellent starting point for any organization looking to perform an operational assessment.

JAMES P. MARTIN, CMA, CIA, CFE, is managing director for Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or jpm@cendsel.com.

Published in Chicago

Challenging times present an opportunity for organizations to perform detailed assessments of their operations.

While recent stock market turmoil has many organizations worried about both short and long-term prospects, the risky environment can present opportunities for those that are ready to capitalize on change.

Performing operational assessments can help organizations identify, mitigate and take advantage of the risks that they face.

“These assessments focus on process design and execution risks,” says James P. Martin, CMA, CIA, CFE, managing director of Cendrowski Corporate Advisors. “When properly performed, operational assessments identify areas where process design and execution risks are not aligned with the organization’s risk tolerance.”

Smart Business spoke with Martin about the benefits of operational assessments and how to conduct them.

How can operational assessments assist organizations?

Organizations must achieve a diverse set of strategic objectives. This is accomplished by translating strategic objectives into often interdependent and disparate operational objectives. Operational objectives include revenue growth, operational efficiency, compliance with laws and regulations, public perception, corporate responsibility and market leadership, as well as customer and employee satisfaction. Attainment of each operational objective requires the assumption of inherent risks.

Operational assessments focus on mitigating inherent process design and execution risks through the use of controls. Controls are employed to reduce the organization’s residual risk, or risk after control implementation, to a tolerable level.

What steps are included in an operational assessment?

Operational assessments examine whether the organization’s processes enable the achievement of strategic objectives. The first step in performing an operational assessment is breaking down process design and execution elements into tasks performed by the organization’s employees. This is often accomplished through employee interviews, as well as through observation in the workplace.

Once tasks have been identified, risks associated with the accomplishment of tasks are enumerated, as well as controls centered on mitigating risks. Risks are quantified by likelihood (what is the chance of this risk occurring?) and impact (what consequences will the organization face if it occurs?).  High-likelihood and/or high-impact risks are prioritized for mitigation in operational assessments, as these risks pose the greatest threat to the organization.

How can organizations decrease high-likelihood and/or high-impact risks?

High-likelihood risks can be decreased through preventive controls, while high-impact risks can be decreased by detective controls. For example, organizational training regarding fire hazards decreases the likelihood that a fire will occur. This is a form of preventive control.

Proper placement of fire detectors throughout the organization’s premises decreases the potential impact should a fire occur. This is a form of detective control.

For risks that remain at a level too high for the organization to tolerate, new controls must be developed to bring residual risks in line with the organization’s risk tolerance, or the organization should consider outsourcing the risk to a third party.  For example, numerous firms employ hedging strategies and insurance contracts to transfer risk to a third party outside of the organization.

Are there any key elements that organizations sometimes miss when they are performing operational assessments?

A key element that is sometimes missed by those performing operational assessments is the assignment of clear roles and responsibilities to team members who will oversee the creation and redesign of process controls. Without accountability, proper incentives are not present, and the operational assessment may struggle to achieve its intended results.

It seems as though risk assessments are an important component of operational assessments. How do these assessments differ?

Risk assessments primarily assist organizations is preserving shareholder value, while operational assessments also help organizations grow shareholder value. More specifically, a risk assessment is really a deep dive into one component of an operational assessment. It involves the identification and analysis of potential risks that may impede an organization from achieving its strategic objectives.

By performing risk assessments across the organization, organizational managers can develop plans to mitigate the risks an organization may face, helping preserve its objective from potential threats and, hence, its shareholder value.

Actively identifying internal risks can also help organizational managers remove the opportunity for fraudulent activity.

What resources exist for organizations looking to perform operational assessments?

Interested parties may download Cendrowski Corporate Advisors’ free Operational Assessment Guide from www.cca-advisors.com/operational-assessments-overview.html.

It’s an excellent starting point for any organization looking to perform an operational assessment. <<

Published in Chicago

When President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) on July 21, 2010, it was one of the most sweeping changes to financial regulation in the United States since the Great Depression.

Among other things, the act created the Financial Stability Oversight Council, whose role is to identify and respond to emerging risks that may pose a threat to the U.S. financial system. Members of the council will include the secretary of the Treasury, the Federal Reserve Board and SEC administrators.

Dodd-Frank applies to all public, non-bank financial companies, as well as larger public bank holding companies. However, the act’s implications can and should be used as best practices in other types of organizations. For example, private companies can benefit by implementing risk management processes in the same vein as those discussed in the act. Dodd-Frank also affects all federal financial regulatory agencies and almost every aspect of the nation’s financial services industry.

On May 25, 2011, the SEC adopted final rules implementing whistleblower provisions of Dodd-Frank. While politicians and practitioners have touted the Dodd-Frank provisions as an advancement in corporate governance, these provisions may provide less incentive for whistleblowers to come forward in tax-related matters than the existing rules on which they are based, the Internal Revenue Code, says James P. Martin, CMA, CIA, CFE, managing director of Cendrowski Corporate Advisors LLC.

“More specifically, whistleblowers may elect to report unlawful actions to the IRS as opposed to the SEC due to greater perceived anonymity and monetary rewards, a lower materiality threshold for tax assessments than financial statements and the administrative structure of the IRS and SEC whistleblower programs,” says Martin.

Smart Business spoke with Martin about Dodd-Frank and how it affects whistleblowers.

What types of pressures do whistleblowers face?

Whistleblowers often face significant pressure to remain quiet rather than report unlawful actions. Recent studies indicate that between 82 and 90 percent of whistleblowers are fired, quit under duress, or are demoted. Competitive employers have blacklisted more than 60 percent of whistleblowers.

For individuals working in a geographical area with few employers, or in an industry with little competition, the effects of whistleblowing can be substantial. Whistleblowers may find themselves ostracized by local, regional and national businesses for their actions. They may also face adverse social consequences.

How are these pressures mitigated by legislation?

Many whistleblower laws have anti-retaliation provisions. For example, whistleblower provisions of Dodd-Frank provide for anti-retaliation protection and state that the SEC will protect the identity of the whistleblower to the largest extent possible. However, a whistleblower must satisfy numerous conditions to receive these benefits — arguably more conditions than the Internal Revenue Code on which Dodd-Frank is based.

Many whistleblowers may not come forward because they might assume they will eventually be exposed. Whistleblower laws also incentivize individuals to come forward by offering them a bounty reward in the event that a governmental body successfully recovers monies.

How does Dodd-Frank compare to existing IRS whistleblower laws?

With respect to Dodd-Frank, the SEC must pay an award of between 10 and 30 percent to eligible whistleblowers. Section 7623 of the Internal Revenue Code, however, mandates a whistleblower award of between 15 and 30 percent of the amount recovered by the IRS. Thus, the IRS is required to minimally pay a 50 percent larger award than the SEC for information resulting in successful enforcement of unlawful actions.

Existing IRS whistleblower laws are also more favorable than Dodd-Frank due to the concept of materiality. In enforcing securities laws (including the Sarbanes-Oxley Act of 2002), the SEC is largely concerned with matters that are material to financial statements. The concept of materiality thus constrains the SEC’s actions. If the SEC feels an item is immaterial, it may forego investigation of the issue, and the whistleblower will not receive a monetary reward. The concept of materiality, however, largely does not apply to tax assessments.

As such, a whistleblower with knowledge of tax issues is incentivized to report the issue to the IRS as he or she is unconstrained by the concept of the materiality; the IRS may elect to investigate an issue that the SEC would otherwise not investigate.

How do the SEC and IRS differ in their administration of whistleblower claims?

Currently, the SEC lacks an independent whistleblower office to handle tips, whereas the IRS has a separate, independent whistleblower office, which serves as the central repository for all whistleblower claims. The director of this independent office reports to the IRS commissioner, decreasing the possibility that a claim remains uninvestigated by lower-level IRS managers. The IRS’s organizational structure, with its separate whistleblower office, may incentivize potential whistleblowers to report their concerns to the IRS as opposed to the SEC.

JAMES P. MARTIN, CMA, CIA, CFE, is managing director for Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or jpm@cendsel.com.

Published in Chicago

As the economy picks up and there is a renewed interest in the sale and acquisition of business interests, buyers and sellers should consider the tax rules regarding sales of S corporation shares.

Some of the most misunderstood transactions involve the sale and transfer of interests in entities taxable as an S corporation. The rules regarding the taxability of S corporations are often rigid and transactions involving transfers of S corporation interests can produce some harsh results.

“As most people are aware, S corporations are ‘flow-through’ entities,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC. “S corporation shareholders, not the S corporations, are subject to income tax on S corporation earnings. S corporations also provide a shelter from self-employment tax, as an S corporation shareholder’s allocable share of the S corporation’s earnings are exempt from self-employment taxes.”

Smart Business spoke with McGrail about ways to mitigate S corporation taxation issues.

How rigid are S corporation rules?

Of all the flow-through entities, the rules regarding S corporations are the least flexible. Each shareholder must generally be allocated income on the same basis as every other shareholder, on a per-share per-day basis, regardless of when the distributable cash was generated. Also, to qualify as an S corporation, each shareholder must receive the same distributions, regardless of when the cash was generated from S corporation earnings. However, there is no requirement for an S corporation to distribute its earnings. The combination of these rules has historically resulted in some unanticipated results.

How are transfers of S corporation shares affected by these rules?

While many examples of the pitfalls of transferring S corporation shares exist, transfers can have the same result: a shareholder is allocated income and does not receive a distribution commensurate with the income allocated. For example, S corporation shareholders sell their interest to a third party or have their shares redeemed by the S corporation. The shareholder negotiates the sale price or, in the case of redemption, the sale price may be in accordance with the terms of an existing buy-sell agreement. The S corporation has a history of distributing cash to at least cover the tax liability associated with the allocated earnings. Former shareholders receive their Schedule K-1 reporting a large share of earnings and discover that policy and obligation are two different things. The corporation does not have any obligation to distribute and the former shareholders failed to account for this when negotiating the sale price. This happens even when the selling shareholder receives counsel, but not necessarily tax counsel.

There is another way in which shareholders can get surprised when receiving their schedule K-1 for the year that they sell shares. Perhaps selling shareholders were sophisticated enough to determine a fair price for their shares, which takes into account the taxable income to be allocated on their final S corporation Schedule K-1. But if the S corporation has significant earnings after the sale date of their shares, the selling shareholders’ Schedule K-1 may include such post sale date earnings. If the earnings after the date of sale are disproportionately higher from the pre-sale period, such a shareholder will find himself or herself surprised. They will receive a Schedule K-1 that reports earnings far in excess of what they anticipated or for which they receive cash. Similarly, shareholders paying what they believe to be fair market value may think they have paid the selling shareholder for the tax associated with earnings prior to their acquisition, only to discover on their Schedule K-1 that they are picking up a share of earnings from before they became shareholders. Further, they may find the S corporation has already distributed the earnings attributable to this period prior to the sale date.

Are there remedies to avoid unintended results?

First, make sure that whomever you use to assist with the sale or purchase has a working knowledge of the taxation of S corporations and their shareholders, as there are some things you can do to avoid surprises. The S corporation rules permit an exception to the per-share-per-day rule for transfers and redemptions, which results in the termination of a shareholder’s interest. If properly elected, the S corporation can ‘cut off’ its books and records as of the share transfer date and allocate items among shareholders before and after the sale date. While this typically eliminates surprises, it may require analysis of the income allocated between such pre- and post-transfer dates to ensure that the cut-off is properly made. For example, if the acquiring shareholder has control of the books and records, there is an incentive to defer deductions to the post-sale date or to accelerate income into the pre-sale period.

Secondly, an S corporation is permitted to distribute amounts to former shareholders after the effective date of the transfers. Consideration should be given to post-termination distributions at the time of the share transfer. Likewise, selling shareholders should consider the income to be reported on their final Schedule K-1 in negotiating a fair price.

When acquiring S corporation shares, perform due diligence to find out whether buy-sell agreements apply and, if so, whether they include provisions to handle the tax allocations on a transfer of shares. Likewise, investigate the contractual obligations of the S corporation to distribute earnings or to make post-transfer distributions and not on its historical practices.

With sales of S corporation shares, the old adage of forewarned is forearmed is all too true.

WALTER M. MCGRAIL, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or wmm@cendsel.com, or visit www.cendsel.com.

Published in Detroit

In the past two months, we have defined tax risk management (TaxRM), discussed the optimal structure of TaxRM processes and provided examples of tax risks. More specifically, TaxRM is an enterprisewide process that is effected by a company’s board of directors, management and/or other personnel, and is designed to minimize tax liabilities and maximize compliance, each within the guidelines of tax laws. TaxRM processes are most effective when they are treated as a component of the organization’s overall enterprise risk management (ERM) process. Typical risks mitigated by TaxRM processes might pertain to uncertainties in the application of tax law to numerous areas of the business, financial reporting decisions, acquisitions and divestitures, and asset purchases and sales.

In this month’s article, Smart Business sat down with Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC, to discuss how risks can be identified and prioritized in TaxRM processes.

“Prioritization of tax risks is an essential component of TaxRM processes. It may directly impact the effectiveness of a business’s tax function,” says McGrail.

What are some prevalent tax risks?

Many tax risks exist for any organization; however, one of the largest risks an organization faces is the risk of proper tax compliance. IRS audits are costly, time consuming events. The risk of an IRS audit should be mitigated by an organization’s TaxRM process. While TaxRM processes are seemingly the domain of the tax department, tax professionals are dependent on data from outside the tax department. For instance, tax managers must understand the basis of information presented in a business’s financial statements, including the derivation of GAAP-based accounting estimates. Without such an understanding, a tax professional may improperly prepare tax-basis financial statements, increasing the likelihood of an IRS audit. Furthermore, tax professionals should bear in mind that there exists no standard of materiality in the event of a tax audit. Unlike audits of GAAP-basis financial statements, where a threshold of materiality governs the audit, every item in a tax-basis financial statement is material. This is a significant, often overlooked tax risk that organizations must assess and mitigate.

How should tax risks be identified?

One way to promote tax risk identification is through risk workshops. In these workshops, participants from various levels of the organization jointly voice their concerns regarding prevalent tax risks. Workshop participants must possess a personality that affords them the ability to freely voice their concerns. If participants do not possess this personality, the workshop will not optimally identify risks.

Additionally, risk identification in workshops requires participants to identify foundational risks rather than superficial risks or effects of risks. For example, workshop participants might enumerate ‘poor tax compliance’ as a risk. However, poor tax compliance is a consequence of risk realization, not a foundational risk itself.

Poor tax compliance might be caused by the receipt of inaccurate information from a business’s operations. Going a step further, a lack of accurate information might be caused by an outdated IT system, a lack of an appropriate data entry policy, or a poorly executed but well-intentioned data entry policy, among other things.

In any event, it is essential for participants to identify foundational risks in order to properly analyze and mitigate them and the exposure associated with these risks.

How should tax risks be analyzed?

Once identified, tax risks should be quantified along two dimensions, impact and likelihood, before a detailed analysis of the risks is performed. The impact of a risk denotes the consequences of its realization. For instance, if a risky event is realized, this realization may cause the business to be subject to tax-related interest and penalties.

Furthermore, while the realization of tax risks will generally have a negative impact on the business’s after-tax earnings, numerous spillover effects may also occur. These spillover effects may include degradation in the business’s revenue, profits, reputation with customers and reputation with suppliers. It is important to include spillover effects when quantifying the impact of tax-related risks.

The likelihood of a risk is the probability or chance that it may occur. Likelihood is a function of the business’s internal environment, including the tone at the top set by management and the board of directors; business’s organizational structure; chain of communication; assignment and authority of responsibility; human resources policies and practices; and the culture of risk awareness present at the organization. It is also a function of the controls designed to mitigate the likelihood of risky events, including the implementation of risk assessment and monitoring policies.

Lastly, the likelihood of risky events is dependent on the business’s external environment, including its susceptibility to regulatory changes and shifts in its competitive landscape.

What types of tax risks should businesses prioritize?

Businesses should prioritize high impact/high likelihood tax risks, as these risks present the greatest exposure to the organization. High impact/high likelihood risks may be known to the organization due to their frequency of occurrence, but they must be properly mitigated to ensure the business does not suffer frequent, severe consequences. High impact/low likelihood risks, including ‘Black Swan’ events are also of high importance. A business is often highly vulnerable to such risks as employees may be unfamiliar with their occurrence, and proper ways to mitigate these risks in the event they arise.

Walter M. McGrail, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or wmm@cendsel.com, or visit www.cendsel.com.

Published in Detroit

As the economy picks up and there is a renewed interest in the sale and acquisition of business interests, buyers and sellers should consider the tax rules regarding sales of S corporation shares.

Some of the most misunderstood transactions involve the sale and transfer of interests in entities taxable as an S corporation. And the rules regarding the taxability of S corporations are often rigid and transactions involving transfers of S corporation interests can produce some harsh results.

“As most people are aware, S corporations are ‘flow-through’ entities,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Corporate Advisors LLC. “S corporation shareholders, not the S corporations, are subject to income tax on S corporation earnings. S corporations also provide a shelter from self-employment tax, as an S corporation shareholder’s allocable share of the S corporation’s earnings are exempt from self-employment taxes.”

Smart Business spoke with McGrail about ways to mitigate S corporation taxation issues.

How rigid are S corporation rules?

Of all of the flow-through entities, the rules regarding S corporations are the least flexible. Each shareholder must generally be allocated income on the same basis as every other shareholder, on a per-share-per-day basis, regardless of when the distributable cash was generated. Also, to qualify as an S corporation, each shareholder must receive the same distributions, regardless of when the cash was generated from S corporation earnings. However, there is no requirement for an S corporation to distribute its earnings. The combination of these rules has historically resulted in some unanticipated results.

How are transfers of S corporation shares affected by these rules?

While many examples of the pitfalls of transferring S corporation shares exist, transfers can have the same result: a shareholder is allocated income and does not receive a distribution commensurate with the income allocated. For example, S corporation shareholders sell their interest to a third party or have their shares redeemed by the S corporation. The shareholder negotiates the sale price or, in the case of redemption, the sale price may be in accordance with the terms of an existing buy-sell agreement. The S corporation has a history of distributing cash to at least cover the tax liability associated with the allocated earnings. Former shareholders receive their Schedule K-1 reporting a large share of earnings and discover that policy and obligation are two different things. The corporation does not have any obligation to distribute and the former shareholders failed to account for this when negotiating the sale price. This happens even when the selling shareholder receives counsel, but not necessarily tax counsel.

There is another way in which shareholders can get surprised when receiving their schedule K-1 for the year that they sell shares. Perhaps selling shareholders were sophisticated enough to determine a fair price for their shares, which takes into account the taxable income to be allocated on their final S corporation Schedule K-1. But if the S corporation has significant earnings after the sale date of their shares, the selling shareholders’ Schedule K-1 may include such post sale date earnings. If the earnings after the date of sale are disproportionately higher from the pre-sale period, such a shareholder will find himself or herself surprised. They will receive a Schedule K-1 that reports earnings far in excess of what they anticipated or for which they receive cash. Similarly, shareholders paying what they believe to be fair market value may think they have paid the selling shareholder for the tax associated with earnings prior to their acquisition, only to discover on their Schedule K-1 that they are picking up a share of earnings from before they became shareholders. Further, they may find the S corporation has already distributed the earnings attributable to this period prior to the sale date.

Are there remedies to avoid unintended results?

First, make sure that whomever you use to assist with the sale or purchase has a working knowledge of the taxation of S corporations and their shareholders, as there are some things you can do to avoid surprises. The S corporation rules permit an exception to the per-share-per-day rule for transfers and redemptions, which results in the termination of a shareholder’s interest. If properly elected, the S corporation can ‘cut off’ its books and records as of the share transfer date and allocate items among shareholders before and after the sale date. While this typically eliminates surprises, it may require analysis of the income allocated between such pre- and post-transfer dates to ensure that the cutoff is properly made. For example, if the acquiring shareholder has control of the books and records, there is an incentive to defer deductions to the post-sale date or to accelerate income into the pre-sale period.

Secondly, an S corporation is permitted to distribute amounts to former shareholders after the effective date of the transfers. Consideration should be given to post-termination distributions at the time of the share transfer. Likewise, selling shareholders should consider the income to be reported on their final Schedule K-1 in negotiating a fair price.

When acquiring S corporation shares, perform due diligence to find out whether buy-sell agreements apply and, if so, whether they include provisions to handle the tax allocations on a transfer of shares. Likewise, investigate the contractual obligations of the S corporation to distribute earnings or to make post-transfer distributions and not on its historical practices.

With sales of S corporations shares, the old adage of forewarned is forearmed is all too true.

Walter M. McGrail, JD, CPA, is a senior manager at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or wmm@cendsel.com, or visit www.cca-advisors.com.

Published in Chicago

In last month’s article, the concept of Tax Risk Management (TaxRM) was introduced. TaxRM is an enterprisewide process that is affected by a company’s board of directors, management and/or other personnel, and is designed to minimize tax liabilities and maximize compliance, each within the guidelines of tax laws.

Having provided a definition of TaxRM, this article focuses on elements of TaxRM processes and how they can identify opportunities associated with an organization’s strategy, operations and processes.

“TaxRM is most effective when it is treated as a component of the organization’s overall enterprise risk management (ERM) process,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC. “TaxRM should be a key element of every business’s ERM process.”

Smart Business spoke with McGrail about the types of tax risks that exist and how TaxRM processes can help mitigate those risks.

What is the function of TaxRM processes?

When professionals think about tax risks, they generally think of audits and financial reporting issues. TaxRM is about much more than these elements. Among other things, a TaxRM process should quantify the impact and likelihood of tax risks, manage tax risks to a level commensurate with the organization’s stated TaxRM strategy and quantify the benefits associated with proper tax strategy implementation. The last point is a central element of TaxRM: Proper tax strategy implementation can assist an organization in maximizing its after-tax earnings available to shareholders.

What types of tax risks exist?

Profitable organizations pay numerous taxes, including corporate income, sales, excise, payroll and withholding taxes. These taxes arise from decisions made in accordance with an organization’s strategy, operations and processes.

Tax risks are present within each of these elements due to uncertainty in the decision-making process and tax law changes. Among other things, tax risks might pertain to uncertainties in the application of tax law to numerous areas of the business; financial reporting decisions; acquisitions and divestitures; and asset purchases and sales.

Nearly every decision made by a for-profit corporation involves tax implications, and hence, tax risk. With some corporations paying upward of 40 percent of their profits in income taxes, the ramifications of tax risks can be highly significant and can negatively affect a business’s after-tax cash flow.

However, mitigation of tax risks can present numerous benefits to businesses while maximizing tax compliance.

Can you give specific examples of how TaxRM processes can identify opportunities associated with an organization’s strategy, operations and processes?

Let’s suppose an organization has a documented strategy stating that it wants to become a market leader in its industry. In order to achieve this goal, the organization must grow organically or acquire outside firms to increase its market share.

In some instances, the purchase of an external firm may provide significant tax benefits. For instance, if the acquisition is optimally structured from a tax standpoint, the target’s existing tax loss carry forwards may be preserved within the entity post acquisition.  TaxRM processes can also help guide organizational managers in their operational and process-level decision-making. For example, if an organization requires new machinery for manufacturing processes, leasing equipment may provide significant tax benefits when compared with capital expenditures associated with the purchase of a machine. However, the lease versus buy decision will hinge on numerous business-specific factors; it is not always optimal to lease equipment.

What are some prevalent risks that TaxRM processes can mitigate?

Business transactions, including asset acquisitions and divestitures, often present significant tax risks and opportunities for businesses. Involvement of the tax function or an external tax adviser in examining these transactions can yield significant benefits to the organization and potentially improve its profitability. This involvement might also save the business significant costs by ensuring a transaction is structured optimally from a tax standpoint.

For example, in some instances, business owners may desire to change the classification of their organization. If an organization that is taxable as a corporation elects to be classified as a partnership, this election will generally be treated as a full liquidation of the existing corporation and a subsequent formation of a new partnership. This classification change could thus cause the organization to realize harmful tax consequences, both immediately and in the future.

Involvement of the tax function or an external tax adviser in such decision-making can help managers make decisions in the best interests of the organization and maximize the after-tax cash flows of the business.

How can an organization achieve maximum benefits from a TaxRM process?

Again, in order to be most effective, a TaxRM process should be integrated into an organization’s ERM process. In this manner, tax risks can be evaluated simultaneously with other business risks, and the tax benefits and costs of an organization’s strategy, operations and processes can be regularly evaluated. Integrating TaxRM into the organization’s ERM process also signals to employees the importance the organization has placed on TaxRM. If employees can tangibly discern the organization’s emphasis on TaxRM, it is likely that they themselves will place greater emphasis on examining tax risks in their decision-making processes.

Walter M. McGrail, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or                                                 wmm@cendsel.com, or visit www.cendsel.com.

Published in Detroit
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