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 email@example.com, or visit www.cendsel.com.