Taxes are a significant cost for any profitable organization. When business professionals discuss managing the risks associated with taxes, they are frequently referring to the tax implications of unfavorable audit opinions, improper recording of tax assets and liabilities on a firm’s balance sheet, or noncompliance with tax laws. Tax Risk Management (TaxRM), however, is much more than the sum of these elements.
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. TaxRM processes enumerate, analyze and mitigate tax-related risks associated with an organization’s strategy, operations and processes, says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Corporate Advisors LLC.
“Effective TaxRM can help an organization minimize its overall risk exposure, and it should be integrated into an organization’s enterprise risk management process,” says McGrail. “It is necessary for nonprofit and for-profit organizations.”
Three stakeholders can claim rights to the cash flow of any organization: debt holders, equity holders and the government. Besides minimizing risk exposure, TaxRM maximizes the amount of cash flow available to debt and equity holders.
Smart Business spoke with McGrail about TaxRM and how it can benefit organizations.
Who should be responsible for TaxRM?
Senior level tax managers, CFOs, audit committees, chief risk officers and heads of internal audit functions should manage TaxRM. As such, TaxRM processes holistically manage tax-related risks throughout the organization. These risks pertain not only to financial reporting and tax law compliance but also to the methods by which the organization generates profits for stakeholders. Wherever there are profits, there are most likely taxes, or at least compliance reporting requirements.
What are the foundational elements of an effective TaxRM process?
TaxRM is most effective when it is treated as a component of the organization’s overall enterprise risk management (ERM) process. Many ERM processes focus on the risk exposure associated with a company’s core services and operations. TaxRM, however, is infrequently integrated into an ERM process, in spite of the fact that the government can receive a significant portion of a company’s profits — in some cases upward of 40 percent of profits. Integration of TaxRM into an ERM process begins with the integration of the tax function in the organization as a whole. In many companies, the tax function is treated as an area of specialized expertise whose primary focus is tax compliance; day-to-day accounting and reporting functions are often carried out by personnel before being ‘thrown over the wall’ to the tax department.
For example, many companies make investment decisions using a net present value (NPV) based criterion: A project is accepted if its NPV is greater than zero when the company’s hurdle rate is employed. In calculating the NPV of a project, however, a flat, marginal tax rate of about 40 percent is often used. This rate may be significantly different from both the company’s effective tax rate and from the tax department’s best estimates regarding the net tax rate for the project, and could lead to suboptimal decision-making by organizational managers. A culture of tax awareness is also a necessary, foundational element of an effective TaxRM process. Cultures are not ‘implemented,’ per se; they are affected by the actions of an organization’s board of directors and senior management. A culture of tax awareness, then, is an element that must be fostered by these high-level individuals through their actions and through an emphasis on tax analysis. In the absence of a tax-focused culture, a TaxRM process will achieve suboptimal results.
Aside from a tax-focused culture, what are other foundational elements of a TaxRM process?
Another foundational element of a TaxRM process is a documented tax philosophy for the organization. This philosophy articulates the manner in which the organization will manage tax liabilities through acquisitions and dispositions, operations, accounting policies and financial reporting. There is a great deal of risk exposure surrounding each of these issues and, hence, a large amount of tax uncertainty. TaxRM processes are, therefore, focused on managing the variables associated with these issues and the requisite tax liabilities they generate.
A tax philosophy is more than an articulated statement, which relates that the organization will seek to minimize its tax liabilities. In fact, in properly structured environments, taxes can help companies minimize risks associated with their investments. For example, if a company experiences losses, it may receive refundable tax credits associated with this loss. These credits serve to minimize the firm’s risk exposure as the government has now borne a portion of the firm’s risk by providing for refunds of taxes previously paid or serve as credits against future tax liabilities.
Once a tax philosophy has been established, an organization can begin to implement working elements of a formal TaxRM process.
How can nonprofits also benefit from TaxRM?
Although nonprofits do not pay taxes on their core operations, a portion of their operations may be subject to unrelated business income tax (UBIT). For instance, although a hospital is a nonprofit organization, hospitals may pay UBIT on income earned in their gift shops if effective TaxRM processes are not in place. In this manner, an effective TaxRM process can help nonprofits minimize UBIT through careful and deliberate planning, affording the organization greater after-tax cash flow to fund its core operations and further its mission. As such, TaxRM should be a key element of ERM processes in nonprofits as well as for-profit corporations.
Walter M. McGrail, JD, CPA, is a senior manager at Cendrowski Corporate Advisors. Reach him at (866) 717-1607 or firstname.lastname@example.org or visit www.cca-advisors.com.
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 Corporate Advisors. “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 Corporate Advisors. Reach him at (866) 717-1607 or email@example.com or visit www.cca-advisors.com.
Similar to for-profit corporations, nonprofits and charitable organizations (hereafter “nonprofits”) are highly susceptible to myriad risks. Faced with pressures created by today’s economic environment, nonprofits participate in a fiercely competitive environment. Barriers to entry for new organizations are low, and donors can easily shift their giving to alternate organizations. Additionally, nonprofits are generally staffed with employees and volunteers who are first committed to helping the organization achieve its mission. The achievement of this mission requires considerable resources, often leaving less than adequate time for these individuals to establish and/or maintain enterprise risk management (ERM) processes.
When properly implemented, “ERM processes can not only help nonprofits safeguard assets and their reputation, they can also allow the organization to capitalize on opportunities afforded by risk taking,” says Harry Cendrowski, managing director, Cendrowski Corporate Advisors. “In this manner, ERM implementation is similar to corporate strategy initiatives.”
Smart Business spoke with Cendrowski about the risks faced by nonprofits and the manner in which a nonprofit can develop and implement an effective ERM process.
How should a nonprofit develop an ERM process?
Risk management for nonprofits begins at the highest levels of the organization, with the board and C-suite executives. Before risk management processes can be devised and implemented, these individuals must work together to identify an overarching, balanced philosophy of risk. This philosophy should detail the risks the organization is willing to bear, as well as the expected reward for taking such risks. It should also be accepted uniformly among high-level individuals, for if it is not, downstream employees and volunteers will see a fractured view of not only the organization’s risk philosophy but also the vision by which the organization will achieve its mission. This may, in turn, lead these individuals to make decisions that are not necessarily in the nonprofit’s best interest and most certainly not aligned with its balanced risk philosophy.
Once a balanced risk philosophy has been established, the risks faced by a nonprofit should be enumerated and evaluated according to their potential impact to the organization and likelihood of occurrence. A priority should be placed on mitigating high-impact/high-likelihood events, as these risks pose the greatest threat to the organization. Mitigation might include the implementation of processes designed to detect and correct risks once they have occurred, or processes designed to prevent risks from occurring.
What mistakes do organizations make in establishing ERM processes?
Many nonprofits and for-profit corporations do not allow enough time for an ERM process to take hold within the organization. They sometimes rush implementation, which, in turn, causes a lack of process ownership at the employee or volunteer level. The implementation of an ERM process requires significant cultural change; this is not something that can be altered overnight. Cultural change is an indirect effect of other organizational changes and leadership behavior; it cannot be directly effected by leadership. However, once cultural change has been embraced, and a risk-focused culture has been adopted, employees and volunteers will be conscious about the risks associated with their jobs and the impact such risks may have on the organization.
How much time should leaders and the board allot for the implementation of an ERM process?
The amount of time required for an ERM process’s implementation varies for every organization. In addition to being a function of the organization’s size, it is also a function of the current state of the organization’s environment and the approach of its employees and volunteers. If these individuals have rarely had to think about risk, an ERM process will take a considerable amount of time to implement. ERM is very similar to corporate strategy in that changes can certainly take place, but they may require considerable time to implement. Short- and long-range ERM plans should be developed, complete with key milestones and roles and responsibilities for process managers. These plans should subsequently be monitored to ensure that the organization is progressing and that the ERM process is evolving as the organization intended. This will ensure that realized benefits of the ERM process are maximized.
What benefits can nonprofits realize from ERM processes?
ERM helps nonprofits maintain their relevance and capitalize on opportunities presented by risk. For example, when its goal of defeating polio was achieved, the March of Dimes made a conscious change to focus its efforts on preventing birth defects. Without this change — or the support of the change from its donor base — the organization would probably have become irrelevant to its donors. ERM also helps nonprofits mitigate perhaps the largest risk they face: reputational risk. Stripped of a once-sterling reputation, a nonprofit will find it extremely difficult to rebuild its image. This could have far-reaching consequences beyond the direct realization of a risky event.
For example, in a university setting, misappropriation or misuse of university endowment funds could have a significant impact on the organization’s overall reputation. Both Princeton and Yale University recently settled lawsuits in which the plaintiffs alleged the universities misused millions of dollars of endowment funds. The lawsuits harmed the reputation of the university not only in the eyes of existing donors, but also potential donors looking to make contributions, faculty, staff and even potential students.
It is important to note that what begins as the realization of a seemingly isolated risk may soon impact the organization as a whole — on many levels — if a functioning ERM process is not in place.
HARRY CENDROWSKI is managing director for Cendrowski Corporate Advisors LLC. Reach him at firstname.lastname@example.org or (866) 717-1607, or visit the company’s website at www.cca-advisors.com.
Business operations are subject to a number of risks from both internal and external factors. In addition, ownership interests in businesses are subject to risks, including market factors. How organizations and their owners address these risks can have a significant impact on the value of businesses and interests therein.
An enterprise risk management (ERM) process involves identifying risks relative to an organization’s objectives, assessing them for likelihood and impact, developing a response strategy and monitoring progress. A well-defined ERM framework can protect and create value for the organization and its owners.
“How a business addresses risk can have a significant impact on the value of a business,” says John T. Alfonsi, CPA, ABV, CFF, CVA, CFE, a managing director of Cendrowski Corporate Advisors LLC.
Smart Business spoke with Alfonsi about business risks and how they impact valuation.
Where is risk addressed in a business valuation?
The most common method of valuing a business is the ‘income approach,’ which requires a valuation analyst to project a business’s future cash flows, then calculate the present value of the sum of these cash flows by employing an appropriate discount rate.
When using the income approach, a valuation analyst must address risk in two primary areas: projected future cash flows and the discount rate. Effective ERM processes can help businesses increase value by affecting the estimates for these quantities.
How does risk impact projected future cash flow?
Projections contain risk: There exists a risk that the organization will not achieve the projected figures. As such, the process by which management projects future cash flows can impact a valuation analyst’s assessment of the business. A key risk in the process is information integrity, the quality of information generated through monitoring and data assimilation. Information integrity allows management to make well-informed decisions and should provide a valuation analyst with greater confidence in a business’s projections.
Valuation analysts can analyze information integrity by examining historical projections and assessing elements of the internal control environment. In analyzing historical projections, a valuation analyst should examine the variance between historical projections and a business’s actual performance. If a strong correlation exists, a valuation analyst can be highly confident in current projections, if the process employed by the organization in making projections remains constant. If a strong correlation does not exist, the analyst must examine the variance between past projections and actual performance to discern whether bias existed in past estimates and may exist in current projections. While valuation analysts are not experts in assessing internal controls, they can question management regarding how information integrity is maintained and business risks are assessed.
What about risks in the discount rate?
The discount rate is the yield necessary to attract capital to a particular investment, given the risks associated with that investment. A project with relatively high risk will require a relatively high yield to compensate an investor for bearing these risks. In determining the discount rate, there are two sources of risk to be quantified: systematic and unsystematic. Systematic risk is the risk one must bear for taking on a risky investment in the market, which encompasses all available risky investments, including public and private equities, real estate, foreign currencies, etc. However, systematic risk is estimated by calculating the return to public equities due to availability of data. The ERM process has little impact on systematic risk unless the business’s performance is heavily tied to market performance, as was the case with Lehman Brothers and Bear Stearns in their final days.
Unsystematic risk is sometimes broken down into two components, industry risk and company-specific risk. Industry risk reflects the risks identified with the industry in which a business operates. Company-specific risk encompasses all other risks, including (but not limited to) size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health. This last component of the discount rate is one that businesses can impact, and commensurately increase or decrease their valuation. Identifying and minimizing company-specific risks through an ERM process can positively impact the value of a business, as a company subject to less risk is more valuable than one subject to greater risks.
Are there risks that a business can manage and some they cannot?
Yes. Businesses cannot generally control systematic risk. They can, however, control company-specific risks. Successful identification, analysis and mitigation of company-specific risks through effective ERM processes can commensurately bolster a business’s valuation.
How can ERM processes mitigate company-specific risks and increase value?
An ERM process should quickly gather and assimilate high-quality information for use in the organization’s decision-making process, allowing the organization to rapidly assess the impact and likelihood of risks associated with changes in its internal and external environments. Early assessment and mitigation can help preserve value and capitalize on risky events when competitors do not react as swiftly to environmental changes. By capitalizing on risky events, businesses increase the chance of improving market share or maintaining an industry-leading position. ERM processes can also provide resilience to events including the loss of a leader or key customer. The ability to successfully mitigate risky events should be recognized by a valuation analyst through lower estimates for company-specific risks, leading to higher valuation estimates.
John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, is a managing director of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or email@example.com.