How ESOPs align shareholder and employee interest

As baby boomer business owners age, there is a pressing need to select their business exit strategy. One option is an employee stock ownership plan (ESOP), where the business owner sells the company — up to 100 percent of the stock — to the employees.

If you sell 30 percent or more, there are tax advantages that could mean that you end up with more after tax proceeds than selling to an outside party. This is nice, but often the bigger benefit is your legacy.

“If you sell to an outside third party, whoever buys it can do whatever they want with your business, and they may not maintain the employees or your business philosophy,” says Tim McDaniel, CPA/ABV, ASA, CBA, director of business valuations at Rea & Associates. “But with an ESOP, your business philosophy usually continues, and the employees continue to have jobs.”

At the same time, the employees get ownership, which motivates them to put in the extra effort and work as a team to build their own stock value. They have more pride going to work, and many long-term employees can retire with a nice nest egg if the company does really well, he says.

Smart Business spoke with McDaniel about which companies may be right for an ESOP.

Have ESOPs become more popular?

They haven’t exploded in popularity, but ESOPs are more popular today than they were a few years ago. In the past, the complexity intimidated business owners, and many lenders were reluctant to fund ESOPs. This has changed as knowledge about how ESOPs work has grown.

How are ESOPs different from employee stock option plans?

In an ESOP, which is most often an exit strategy, all employees own stock — although compensation and longevity will determine how much. An ESOP gives certain employees the right to buy stock. The key word is ‘certain.’ Usually, the company offers top-level employees stock as a short-term incentive.

What organizations are best suited to become ESOPs?

ESOPs are costly to establish because you need to hire an attorney, trustee and valuator. Therefore, they aren’t a good idea for companies without very much profit. A good rule of thumb is that you need at least $500,000 in ongoing profit for it to make economic sense.

In addition you need a strong management team. An ESOP is a leverage transaction and requires a bank loan. It’s important to have a leadership team that is able to manage the business and pay back the loan over time.

A stable workforce with little turnover is also important. The ESOP pays employees, usually over a period of five years, when they quit or retire; and it’s usually a large portion of their retirement plan.

Are there any disadvantages to ESOPs or risks that you should guard against?

Like any owner, the employees face the same advantages and disadvantages of owning a business — there’s higher risk and reward.

Some ESOPs replace other retirement plans for employees and if all of their retirement is in your company stock, they can be severely hurt if the company doesn’t do well or goes bankrupt. Don’t encourage this. You’ll want to allow for some diversification in the employees’ retirement.

The Department of Labor and IRS regulate ESOPs, so there will be more oversight from outside parties. Also, with new shareholders, some things like how much money you and the company makes is available to your employees. An ESOP might be your best exit strategy if you would like your legacy to continue and your employees to act like owners, and you don’t mind the additional oversight and cost.

Also, remember that you aren’t locked into an ESOP forever. If the ESOP no longer meets the needs that it was set up for, you can terminate the plan. But just like establishing an ESOP, it’s not cheap.

If this sounds like something that might work for your company, what’s the first step?

You’ll want to have somebody come in and do a feasibility study of what it actually would look like for your business. The study will determine what the value would be and what after-tax proceeds a business owner could expect. Then, you can determine whether to proceed, go another way or defer until your business is healthier.

Insights Accounting is brought to you by Rea & Associates

How key measures can detect and avoid fraud incidents in your organization

Fraud is ever present in today’s business world and many companies are concerned with the possibility of it occurring within their own organization. No matter how well you run your business or how well you may know and trust your employees, no organization is not susceptible to fraud.

Smart Business spoke with Michael Maloziec, Accountant at Cendrowski Corporate Advisors, to discuss how a company can prepare itself and prevent the possibility of fraud.

How large of an impact can fraud have on an organization? 

The latest Report to the Nations, which is a research study conducted by the Association of Certified Fraud Examiners, found that a typical organization loses 5 percent of revenues each year to fraud. Although that does not sound like a significant number, if applied to the estimated Gross World Product, this 5 percent equates to a potential global fraud loss of nearly $3.7 trillion. The ACFE also reported that the median loss cause by frauds in the study was about $145,000.

Where within an organization is the risk of fraud greater than others?

One of the most vulnerable areas to keep an eye on would be cash. Make sure this part of the business is well-controlled and there are a set of solid standards in place, such as segregation of duties. Organizations need to make sure that more than one person has control of the bank account. The employee working on the bank reconciliation should not be the same person who is writing checks and making deposits. Additionally, the bank statement should be reviewed each month for any suspicious or unexpected activity. Having solid standards can help prevent many fraud schemes before they even develop. However, a fraud can only occur if it possesses three distinct elements.

What are these three elements of fraud? 

Every fraud situation will have each of the following three elements present: motive, rationalization and opportunity. These three elements are known as the fraud triangle.

Motive describes the compelling need for funds which drive the perpetrator. This could be anything from lifestyle needs or behavior such as a gambling addiction.

Rationalization describes the mindset of the perpetrator in which they rationalize their fraudulent acts and believe what they are doing is not a crime.

The last element of the fraud triangle is opportunity. Opportunity generally occurs because of a control lapse. Fraud deterrence focuses on removing one or more of these three causal factors of fraud. Motive and rationalization are generally dependent on personal situations in which the organization has very little control over. Since the opportunity element is controlled by an organization, this is often the most targeted aspect of fraud deterrence. Fraud is not a random occurrence and only happens in situations in which the conditions allow for the fraud to happen.

What are some ways organizations can prevent fraud? 

A recent study revealed that having a set of strong internal controls in place would be the most effective method of preventing fraud.  Internal controls close the door on opportunity. The presence of anti-fraud internal controls can contribute to the reduction of fraud by upward of 66 percent. Also, it is imperative that management review and enforce your company’s internal controls. Without enforcement, the internal controls will not stop the opportunity for fraud.

How can internal controls help an organization? 

Control activities help ensure a business process produces valid transactions, and that financial statements are accurate. To be valid, a transaction must conform to several standards such as being completely and accurately recorded, legitimate and recorded in a timely manner.

Additionally, monitoring controls are intended to ensure that transactions not conforming to these standards, raise red flags, and the transaction is quickly identified and corrected. The opportunity for fraud and financial misstatement exists where control procedures are not effective in achieving these standards.

What happens if you suspect fraud within your organization? 

If your company suspects a fraud has occurred, it might be helpful to retain a forensic accountant to investigate the matter. They can help your organization design anti-fraud control processes, which will mitigate future risks. Forensic accounts can also quantity the economic damages if a fraud has occurred.

Insights Accounting is brought to you by Cendrowski Corporate Advisors LLC

Plan sponsors are accountable for more than most realize

Sponsoring a 401(k) plan can bring tremendous value to your organization. Having a great benefit plan can boost the morale of your team members and improve your ability to attract and retain top talent. Managing your 401(k) plan, however, can get more complicated. In fact, many companies are failing to meet their basic responsibilities as a plan sponsor.

Whether you sponsor a large or small plan, your fiduciary responsibilities are the same. Both the Department of Labor (DOL) and IRS conduct examinations of 401(k) plan sponsors, so it’s critical to understand and meet your responsibilities.

Smart Business spoke with Suki Mann, senior manager at Sensiba San Filippo LLP, to learn more about the responsibilities of 401(k) sponsors.

What is the biggest misconception of 401(k) plan sponsors?

Many plan sponsors are overly reliant on third-party service providers, assuming that because they are paying someone else to manage their plan all of their responsibilities have been met. In reality, 401(k) sponsors frequently fail to meet their basic fiduciary responsibilities, and in doing so, fail to look out for the best interests of their employees and their organization. Failing to meet requirements can lead to larger investigations from the IRS and the DOL as well as more money coming out of your pocketbook.

What are the fiduciary responsibilities of plan sponsors?

As a plan sponsor, you are responsible for managing the assets of your employees. Both the IRS and the DOL have published requirements pertaining to the fiduciary responsibilities of plan sponsors.

Commonly overlooked requirements include holding plan management meetings at least once per year to review the performance of the plan, quarterly statement reviews to look for any inconsistencies that could indicate fraud, and reviewing fees charged to both the plan and plan participants to ensure that they are reasonable. Your third-party provider can also help you understand your responsibilities. Just remember that hiring a third-party plan provider alone doesn’t ensure that you are meeting your responsibilities; in fact, reviewing their work is part of your fiduciary responsibility.

What are some of the common pitfalls found during DOL and IRS examinations?

Government examinations are not the best time to find out about problems with your plan. Understanding what problems are typically found during examination can help plan sponsors find and correct problems before they are revealed under examination.

Many sponsors fail to meet document retention requirements, mistakenly assuming that their third-party plan provider is keeping all documents. When participants take hardship distribution or borrow money from the plan, these activities must be documented and records should be retained.

It is also common for plans to fail to adequately define ‘salaries’ and ‘contributions,’ which leads to incorrect matching contributions that can create liability and interest for the plan sponsor.

Many smaller plans have nondiscrimination issues, where plan contributions are unfairly top heavy. Other plans have problems omitting eligible employees. It is critical that management notifies employees when they become eligible, and follow up on participation.

How can sponsors correct previous mistakes and become compliant?

The DOL voluntary fiduciary correction program generally provides plan sponsors with the opportunity to self-report and correct problems before fines are assessed. Both the IRS and DOL are generally much more lenient regarding self-reported corrections as opposed to problems found under examination.

Regardless of the size of your plan, you have a fiduciary duty as the plan sponsor. While larger plans require audits that often identify problems during the audit process, smaller plans also need to ensure that their fiduciary responsibilities have been met.

If you have questions regarding your fiduciary responsibility as a plan sponsor, visit the DOL or IRS website, or call a qualified adviser for a thorough review of your 401(k) plan.

Insights Accounting is brought to you by Sensiba San Filippo LLP

SHOP, drop, roll or self-insure: It’s not too late to examine all health insurance options and switch

The 2015 tax season will soon be in the rearview mirror. But that doesn’t mean businesses should stop evaluating health insurance options. Since the dawn of the Affordable Care Act (ACA), businesses have been trying to figure out what’s the best route to take when it comes to health care coverage. There are a handful of options — all with unique pros and cons.

“Health care insurance options are something all businesses should be evaluating continuously,” says Joe Popp, tax manager at Rea & Associates. “Just because a business decides one route is best right now doesn’t mean that it will be the most effective or efficient choice down the road.”

Smart Business spoke with Popp about five health insurance options — Small Business Health Options Program (SHOP), drop, roll, self-insure and private exchange.

What is the SHOP and who benefits?

The SHOP is the business portal to exchange insurance. Right now in Ohio, it’s available only to companies with fewer than 50 full-time equivalent employees.

It’s best for a company that is having trouble paying for coverage or doesn’t want to contribute a lot for insurance, and whose employees generally wouldn’t get a premium tax subsidy. The employer can put as much or as little toward insurance as it wants, but the employees still can pay with a pre-tax deduction.

The drop option is self-explanatory, but doesn’t it hurt the employees?

If a business drops health insurance coverage altogether, employees would have to buy insurance on their own. If the employee qualifies for premium subsidies or cost sharing they often get better quality coverage for a lower price than with their employer.

Dropping coverage may be the best option for companies whose employees would be eligible for premium subsidies, meaning relatively low income individuals or families with many children and relatively high income (single breadwinner families).

How does roll work?

You continue with your current coverage, even though it may be inefficient in the short term. Many people decided last December to renew early and roll over coverage to get another year of reduced ACA compliance and cost.

This is typically the best option for those with more than 50 employees who want to take a wait and see approach. With uncertainties in legal challenges, new requirements coming online in future years and the exchanges still in their infancy, choosing to delay a major change for a few years is a perfectly fine strategy.

What is the self-insure option?

The employer takes on the risk that an insurance company normally takes, up to a certain dollar amount, and gets a stop-loss plan over the top for a smaller premium. The employees still pay into a system, but often at lower amounts.

For the employer, some years you’ll ‘win’ and some you’re going pay a few large deductibles. As long as, on average, you come out better in the years when no one has high medical costs, the business as a whole wins. This is a good option for those with 100-plus employees as they can more effectively spread risk.

How does the private exchange operate?

Instead of using the federal government’s exchange, you access a custom exchange with a smaller set of providers. It’s best for employers with 100-plus employees.

Your company can set up a private exchange and employees pick what they want with a monthly stipend. The employer contribution might cover the bargain basement $6,000 deductible coverage, and if employees want better coverage, they pay in. It’s like shopping on Amazon.com with a gift card from the employer.

When do employers need to make a decision?

Before your next insurance renewal date, evaluate these options to see if one is more efficient. Think about it, talk to employees and run numbers to see what it could do for employer and employee costs. Do the groundwork now, even if you don’t end up making a change until next year or after.

Insights Accounting is brought to you by Rea & Associates

Equipment appraisal: When you may need one and what to expect from it

At some point in time, almost every business owner will be faced with the question -— what is your machinery/equipment really worth? Book value is rarely an accurate representation of what the equipment is really worth. The ones asking want to know the real value, one that is accurate and can be substantiated.

Knowing when this question might arise and what to expect when it does could enable a business owner to be prepared with an answer… even before being asked.

Smart Business spoke with Theresa Shimansky, a manager at Cendrowski Corporate Advisors LLC, about machinery and equipment appraisals.

When is it time to have a certified appraiser evaluate a business’s equipment?

There are more than 20 reasons why businesses may need a machinery/equipment appraisal. Some of the most common reasons for appraisals are mergers and acquisitions, business valuations, bankruptcy, financing and SBA lending, insurance, buy/sell agreements, property taxes and partnership dissolutions. A certified, reputable appraiser has the training, expertise and knowledge to provide a value that can be substantiated and reflects the true value of the equipment.

Are there different types of certified appraisal reports?

Yes, according to the Uniform Standards of Professional Appraisal Practice (USPAP) for personal property appraisals, section 8, there are two types of written appraisals; Appraisal Reports and Restricted Appraisal Reports. A Restricted Appraisal is one in which the client and intended user of the report are the same. However, if the intended user(s) includes someone other than the client under USPAP standards, the appraiser must use the Appraisal Report format. If anyone other than the appraiser’s client will be relying on the report, it cannot be a Restricted Appraisal Report.

How long does an appraisal take?

It will depend on several factors; first, how much equipment is being appraised. A large factory with thousands of pieces of machinery will take far longer than a small restaurant with only a couple of dozen pieces of equipment.

Other factors that can affect how long the appraisal will take are timing requirements — when do you need it, how many levels of value are being requested, and the type of equipment is it rare or can comparable items be easily found.

What will a certified appraisal cost?

Every appraisal has different requirements. The simplest answer is the cost will vary with the scope of work.

What can I expect during the process?

Expect the appraiser to view the equipment and document any pertinent information that will help to identify the equipment. The appraiser will ask about the make, model and serial number of the equipment, its condition, whether it has been properly maintained and if there are maintenance records and if the equipment has special features or upgrades. Appraisers may let clients know in advance what they will be looking at and any documentation they will need so that it can be available during the inspection.

Once the appraiser has documented the equipment. the research process begins. The appraiser will establish a value for the machinery/equipment and then write and certify the report.

Is the appraiser required to personally view the equipment?

An appraiser does not need to personally view the equipment. The appraiser can rely on another party (including the client) to provide necessary documentation. This is considered a “desktop appraisal,” and the appraiser is required to disclose this within the report and in the report certification.

What should a business owner look for when choosing an appraiser?

When choosing an appraiser, a company shouuld only use a “qualified appraiser.” This individual, as defined by the IRS, has earned an appraisal designation from a recognized professional organization for competency in valuating property. Also, qualified appraisers regularly prepare appraisals for which they are compensated and demonstrate verifiable education and experience in valuating the type of property being appraised.

Accounting is brought to you by Cendrowski Corporate Advisors LLC

 

How financial reporting can help foster board member involvement

From time to time, nonprofit organizations may experience a lack of engagement of their board members during regular board meetings. There could be many reasons why board members are not engaged in meetings, but sometimes it’s up to an organization’s staff to find ways to involve board members more in the decision-making process.

Smart Business spoke with Ben Antonelli, CPA, a principal at Rea & Associates, to learn more about what nonprofit organizations can do to increase board member engagement during board meetings.

What are some possible reasons for decreased board engagement?

While a large majority of board members have a passion for their organization’s exempt purpose, they may not be as engaged when it comes to making financial decisions. Maybe the organization’s internal financial reports are not provided in a timely fashion, are too detailed or do not provide narratives to be reviewed prior to meetings.

In order for board members to make sound decisions, they need to be equipped with the right information.

How and when should board members be provided with information?

Board packets and presentations that include financial reports should be available to board members several days before the meeting. Sending out the packet the night before the meeting can put unnecessary pressure on the members, and may make it difficult for them to make educated, well-thought financial decisions during these meetings.

How much detail should be provided in the financial reports given to board members?

Nonprofit organizations should be mindful about the level of financial detail provided to board members. There may be times when they are provided with too much financial data on large spreadsheets. It may be difficult for board members to digest and analyze the information in the time leading up to and during the meeting.

Although detailed financial data should be available to board members upon request, financial statements reviewed during board meetings should be limited to summarized data. In addition (and this varies by organization and industry), relevant metrics or ratios should be given.

This report should show the increase or decrease in various metrics over time, usually multiple years. In order to be meaningful, organizations should use the same report format during all meetings so board members can become familiar with it.

What else should be included in board meeting packets?

  • Show an analysis of the actual budget versus the approved budget or operating plan. Most organizations operate with an approved budget or operating plan. If organizations do not have such a budget, it is critical to create one. For organizations with a budget, showing a comparison of the actual budget versus the approved budget for the past month and the year to date is useful.
  • Provide a brief narrative of financial results. In addition to financial data, a narrative explaining the organization’s analysis of the most recent financial results is also very helpful. Organization staff typically knows much more about the organization than the individual board members, so providing an explanation as to why the numbers are the way they are will help provide a level of context.
  • Disclose the basis of accounting if it is different from generally accepted accounting principles (GAAP). Many organizations that produce annual board-approved GAAP financial statements also produce monthly board reports on a separate basis. If an organization reports this way, a simple footnote or disclosure to the board stating that a different basis exists will help avoid any confusion at the end of the year.

An engaged board can help propel an organization forward, and likewise, a disengaged board can hold it back.

Organizations should give board members the tools they need to be active, strategic and valuable.

Insights Accounting is brought to you by Rea & Associates

There’s much to consider before bringing foreign employees to the U.S.

Foreign-based businesses are increasingly expanding their global operations into the U.S. As they do, they’re bringing talent with them from their home countries.

Most foreign businesses thoroughly prepare employees for the move. Many, however, do not convey the full impact of relocating their workforce, especially the resulting tax implications for employees.

Smart Business spoke with Lourdes Rabara, a tax professional at Sensiba San Filippo LLP, to learn about the challenges of transferring foreign workers into the U.S. She also discusses best practices business owners should implement as they plan their expansion.

What are some of the biggest challenges involved in relocating employees to the U.S.?

Expanding into the U.S. can be a complicated process for both the business owner and the employees. How the move is executed can lead to the successful growth of the firm, or if mismanaged, the failure of the company.

A critical step for business owners who are planning a move is to appoint a team of business advisers to assist them with the vast amount of preparation required. There are key areas of support business owners should provide to their employees. These include offering financial assistance and opportunities to meet with a tax professional, and talking with an HR professional to address cultural changes, language and workplace requirements. Business owners should ask their financial adviser to share referrals to other service providers with whom they have a trusted relationship.

What financial effects should be considered?

Business owners need to ensure that their employees have the financial tools to make the transition. As a best practice, business owners should have an equalization policy in place. This policy is specifically designed to ensure that each employee’s real income is equalized with the income they were receiving at home. That consideration takes into account all financial variables including changes in cost of living, taxes and more.

A financial adviser can help clients build plans that include understanding and calculating all of the financial effects of transplanting employees. This should ‘make them whole’ for any loss of income or expenses incurred because of the move.

What are the employee tax ramifications that employers should consider?

Tax compliance can be difficult for U.S. citizens. For foreign employees working in the U.S., compliance requirements can be overwhelming without proper guidance. Business owners should have resources available in advance to help their employees navigate the financial and tax implications.

Many factors can affect the tax situations of foreign employees. Considerations include how long they will be working in the U.S., marital status, the tax situation in their home country, foreign assets held and more. For example, if an employee will be working in the U.S. for more than 183 days, he or she may be treated as a resident of the U.S. That would mean worldwide income must be considered.

There could also be an issue of double taxation and the application of foreign tax credits. If an employee is involved in the ownership of foreign companies or holds substantial foreign assets, he or she may have additional reporting requirements.

Working in the U.S. can be challenging on many levels. Employers who desire happy, productive employees should make every effort to ensure the transition is as smooth as possible. Partnering with a U.S. based adviser that is experienced with the issues that affect foreign companies expanding into the U.S. is a great first step.

Insights Accounting is brought to you by Sensiba San Filippo LLP

What small businesses can do to prevent and detect occupational fraud

All things change, yet all things remain the same. The Association of Certified Fraud Examiners (ACFE) 2014 Report to the Nations on Occupational Fraud and Abuse (“ACFE Report”) is consistent with the organization’s prior studies, as to which entities are most likely to be victimized by fraud and measures that can be taken to effectively deter and detect fraud.

Businesses continue to be plagued with “occupational fraud,” the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.

“Occupational fraud can be classified into three broad categories: asset misappropriations, corruption and financial statement fraud,” according to Natasha Perssico, forensic accountant, and James Schultz, Principal, at Cendrowski Corporate Advisors LLC.

Smart Business spoke with Perssico and Schultz regarding the issues of fraud and steps that small businesses can take to reduce fraud.

How common is the occurrence of fraud in small businesses, and what impact can it have?

Small businesses having fewer than 100 employees are more frequently victimized by instances of occupational fraud, accounting for nearly 30 percent of fraud cases reported. The risk to small business as targets of fraud is compounded by the fact that many small business owners think they cannot afford to invest in fraud prevention and detection policies and procedures. In actuality, small businesses cannot afford to not implement fraud prevention and detection procedures. However, median losses for small businesses and large entities are quite close in dollar amount — $154,000 and $160,000 respectively. While a larger organization might be able to absorb losses and recover from a financial blow of this magnitude, a smaller business might not be able to recover.

What steps can be taken by small businesses to prevent fraud?

Small businesses owners will be relieved to know that there are many simple, effective and affordable practices that could be implemented by small business. Here are some key steps for owners to employ to minimize acts of fraud:

  1. Segregation of Duties. Many small businesses rely on one person to open mail, process payments, make bank deposits, pay invoices, handle petty cash and reconcile bank statements. Such unchecked access creates an opportunity for fraud and misappropriation of assets. Segregating accounting responsibilities so that no single individual controls all of the financial activity and reporting of that financial activity reduces the risk of fraud.
  2. Insist on receiving and reviewing bank statements first. You should have the original or a duplicate bank statement sent to your home address or a secure P.O. Box directly from the bank. Make it a regular habit to review bank statements for missing checks, checks that are out of order, checks written to unfamiliar suppliers or other unknown persons and checks made out to a third party but endorsed by someone in your company. Informing your employees that you review the bank statements independently of accounting personnel will also serve as a fraud deterrent.
  3. Review accounts receivables, cash receipts, and uncollectible accounts. Understanding trends and investigating changes in accounts receivables and cash receipts is a useful practice. Unexplained declines in cash receipts and increases in uncollectible accounts write offs could be a flag that misappropriation of cash is occurring before bank deposits. Sending customers account statements is a good procedure that can possibly reveal any discrepancies as customers will complain if the amounts said to be owed by them are erroneously overstated. Write-offs of uncollectible accounts should also require approvals.
  4. Educate employees about what behaviors are unacceptable and how to report suspicions of fraud. Employee tips play an important role in fraud detection. Employees should be informed that fraud is unacceptable, how fraud can negatively impact the organization, and how it can negatively impact the employees personally.

What are some positive results of implementing a fraud prevention program, and who can help in creating a good program?

For small businesses even simple procedures can make a large impact on the company’s image and financial health. Organizations with strong and frequently communicated fraud deterrence policies are better situated for early fraud detection and the mitigation of large losses due to long running frauds. Further, holding other operational issues aside, organizations with strong anti-fraud programs also benefit from a less risky image leading to greater shareholder, creditor, and employee confidence in the organization.

Organizations unfamiliar with fraud prevention and fraud risk assessment programs should rely upon qualified fraud experts in conducting and implementing these important processes.

Insights Accounting is brought to you by Cendrowski Corporate Advisors.

Should you start your own insurance company? Consider the benefits

Traditionally, business owners have turned to the insurance industry for protection against risks associated with their professions, including malpractice litigation and product liability. As a result, insurance companies have been able to charge high premiums for their services. But what if business owners started their own?

Smart Business spoke with Christopher Axene, CPA, a principal at Rea & Associates, to learn about captive insurance companies and how they can be used to help business owners lower their taxes while increasing wealth.

What is a captive insurance company and how can it be used as a tax planning tool?

Captive insurance occurs when a company or service professional purchases insurance coverage from an insurance company they also own and control, and this can be a desirable option for many business owners.

The captive insurance option allows business owners to pay insurance premiums to their own insurance company and claim the tax deduction associated with this expense as they normally would. But instead of paying another insurance company, they pay the premiums to themselves.

Furthermore, because of a provision in the tax law, the captive insurance company doesn’t pay taxes on the premium income it collects, as long as the premiums total no more than $1.2 million per year.

Another tax consideration for those interested in starting their own captive insurance company is that at the end of the coverage term, the unspent premiums can be reinvested and any dividends received will be taxed at a significantly reduced rate. The law says that captive insurance companies can deduct 70 percent of the dividends they receive from stock portfolio investments.

Is a captive insurance company still a valid safeguard against risk?

To be considered ‘insurance’ and a valid safeguard against risk by the IRS, the captive insurance company must meet two qualifying factors — risk shifting and risk distribution. Risk shifting means that risk can be shifted from the business to the captive insurance company.

Achieving risk distribution is a little harder because it means that the captive insurance company must be a part of a risk distribution system — a group of captives that share each other’s risks. Typically, the premiums one would pay into their insurance are used to safeguard their business against smaller risks. For larger issues, such as a malpractice claim, funds to help settle the claim would be pulled from the distribution pool.

How do I know if a captive insurance company is the right strategy for my business?

Business owners across all industries are eligible to establish a captive insurance company, but certain factors may make this strategy more desirable to larger companies. First, upfront costs should be considered. This would include any research conducted on the business, service fees and any legal considerations associated with setting up the entity. But once it’s established, there are service providers that are available to manage the captive, giving business owners the freedom to concentrate on their business.

Second, while a captive insurance company can help an owner realize significant tax savings and increase wealth, using this entity as a tax planning strategy is only possible if few (or no) claims are made against their business — at least during the first few years to give the owner time to reinvest the premiums they originally paid into the captive.

In other words, if an owner sets up a captive insurance company and is forced to make a claim in the first year or two, the owner may wind up diminishing the account and owing more than what the owner has, which isn’t an optimal outcome for anybody.

When done properly, a captive insurance arrangement can provide business owners with a cheaper insurance coverage solution. At the same time, when claims history is low, the profits of the captive can be reinvested for the owner’s benefit.

Insights Accounting is brought to you by Rea & Associates

Avoiding the pitfalls, reaping the benefits of a C-corp to S-corp switch

Most business owners understand the importance of selecting the optimal corporate structure and tax status for their companies, but fewer know about the process, benefits and potential pitfalls of converting an existing business from a C-corporation to an S-corporation.

Smart Business spoke with Jay Lee, a tax specialist at Sensiba San Filippo LLP, to learn more about S-corp conversions and to get an analysis of the benefits of potential S-corp conversions — looking at both short and long-term costs, benefits and roadblocks.

What are the most important considerations for a company considering an S-corp conversion?

Business owners should take a comprehensive, long-term approach when considering an S-election. They must determine whether they qualify for S-corp filing status. S-corps can have no more than 100 shareholders, who must be U.S. citizens or resident aliens, and can only have one class of stock. C-corps with international owners or several classes of stock will not qualify to make an S-election. Companies should consider current funding and potential future methods of funding before electing to be taxed as an S-corp.

Tax ramifications may be the next decision point. At the federal level, income from a C-corp is taxed twice — once at the corporate level and second at the shareholder level when dividends are paid. In contrast, income from an S-corp is taxed only once at individual income rates, while distributions to shareholders can generally be made tax-free. Some states, however, impose a corporate-level tax for S-corps. For example, California imposes a lower 1.5 percent tax to S-corps compared to 8.84 percent to C-corps, providing additional incentive for conversion.

What critical issues could drive the decision to convert to an S-corp?

While the tax benefits of filing as an S-corp may seem straightforward, converting to an S-corp may have some lingering corporate level taxes from activity as a C-corp. For example, there is a net unrealized built-in gains (BIG) tax that imposes a corporate-level tax to an S-corp when disposing assets within the recognition period, which was five years in 2014 and currently 10 years for conversions occurring in 2015 and beyond. The tax is assessed on the amount that the fair market value exceeds the tax basis of an asset at the time of conversion. Proper planning should be considered when converting to an S-corp, as disposing of certain assets such as inventory may be inevitable in the normal course of business.

Special consideration should be made for cash basis corporate taxpayers. Assets such as accounts receivables may not appear on the face of the balance sheet and can be overlooked as an asset subject to BIG tax once the receivables are collected. An uninformed taxpayer may unexpectedly be hit with the BIG tax for sales or services performed as a C-corp and taxed at the highest corporate tax rate of 35 percent because of the conversion.

The BIG tax is subject to the highest corporate tax rate of 35 percent if assets are disposed of within the recognition period after conversion. Companies should be aware of corporate-level taxes as they are considering the conversion in order to manage cash flows and to allow for proper planning to minimize the tax effects.

How should business owners approach this important decision?

The decision to convert from a C-corp to an S-corp should be a well-planned, strategic decision that considers both short- and long-term plans for the business. While tax considerations are important, current and future ownership, funding considerations and the business owner’s exit strategies are also critical.

Insights Accounting is brought to you by Sensiba San Filippo LLP