How thinking ahead can maximize value in transition

Entrepreneurs live for the challenge of launching and building their business. Growing an organization that solves problems, delivers new products and creates value can be an all-consuming passion. As an entrepreneur, building is in your blood. While building may come naturally, it isn’t the only thing that matters when it comes to getting value out of your business. In fact, the way you exit your business can have an even greater effect on what you get out of it, than the way you started it.

Smart Business spoke with Bob Belshe and Kevin Strain, audit partners at Sensiba San Filippo LLP, on how entrepreneurs can develop and implement exit strategies to maximize value and meet personal objectives.

Why do business owners need an exit plan?

The right exit plan can help you achieve both business and personal goals. Conversely, failing to plan for transition can create the need for difficult choices, loss of value and avoidable tax liabilities.

Successful business transitions require an understanding of the objectives and priorities of the business owner. Do you want to maximize value in a transaction? Are business continuity and legacy important? Every business is unique and every business owner has his or her own idea of success. Success requires more than just a great business. It also requires a great exit strategy.

When is the right time for exit planning?

Whether your eventual exit is one year or 20 years away, it’s never too early to think about your end game. Decisions made on day one can have huge implications down the road. Transition objectives should inform your decisions throughout the life of your business. An entrepreneur who wants to maximize value for an external sale within a five to 10 year window should make much different decisions than a business owner who wants to transfer ownership to employees. From corporate structure to investments to distributions and tax planning, the way you manage your business day to day must align with your end game.

What exit alternatives are available to business owners?

With the right planning, there are many different options for selling or transitioning a business. Initial public offerings, asset based sales, stock sales, management buyouts, employee stock option plans and private equity recapitalization can all provide different benefits in transition. While there are numerous ways to sell or transfer a business, there is usually a much smaller pool of alternatives that align with both personal and business objectives.

How can business owners develop the right exit strategy?

Planning the right exit strategy requires an understanding of your business, your personal and business objectives and knowledge of exit alternatives. The objectives of the owner will help prioritize maximizing the value of the business, facilitating retirement and financial security, controlling method and timing of exit, ensuring the survival and growth of the business, and reducing employee and family uncertainty. A good exit plan provides a solution that serves all priorities. Without an exit plan, business owners are often left to choose between value, timing and continuity.

What are common transition objectives?

Maximizing value at transition is a very common objective. In Silicon Valley, many entrepreneurs are also focused on job creation and the legacy of their organization. Having employees understand end-game strategy for management is very important as transition approaches. Communication can help eliminate uncertainty and provide security, keeping employees engaged and motivated. Business owners should not be afraid to have open conversations with their management team and employees.

What can business owners do today to plan for a successful exit?

Regardless of when you plan to sell your business, it’s never too early to plan for transition. Decisions made today such as business entity selection, ownership structure and tax strategy can have a profound impact on transition. Entrepreneurs should meet regularly with experienced advisers to develop, implement and review their exit plan.

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Why it’s important to start investing in your future leaders today

Regardless whether you are a manufacturer, distributor, consultancy or technology firm, your staying power and ongoing success will ultimately be determined by one single factor: your future leaders. Most business owners recognize the critical importance of leadership, yet many organizations still fail to develop the leaders they will need to face tomorrow’s challenges. What should businesses be doing now to groom tomorrow’s leaders?

Smart Business spoke with Michael Arklind, manager of learning and development at Sensiba San Filippo LLP, about strategies for leadership development that will bring value to any organization.

When should an organization start identifying and grooming future leaders?

It’s never too early to find and develop future leaders. Most companies don’t think about leadership until there is a pressing need. Unfortunately, by that point, it is often too late.

Start looking for leadership qualities during recruiting seasons and continue the process as soon as new professionals enter the organization. Leadership skills are just as critical to a company’s success as technical skills, so have a plan to identify and develop your professionals’ abilities in these areas.

How does the leadership development process begin?

Once you have identified a potential leader, you need to have a conversation with that individual and find out what he or she wants. There is no use trying to develop leadership skills in someone who has no desire to grow into a leadership role.

Next, you should work to build consensus among key management that you’ve found the right person. From there, the process becomes much more particular to the people with whom you are dealing. Determine what motivates each individual. Explore each person’s personal and professional goals and get each to take ownership of his or her own development.

What is the single most important skill that a future leader must develop?

Without a doubt, it’s emotional intelligence. Leaders must know how to identify and manage their feelings. There is an extremely high correlation between emotional intelligence and top decision-makers. It’s also important to be able to recognize the emotions of others and to understand how these emotions can affect a situation.

When teaching emotional intelligence, start by teaching concepts, building an awareness of how emotion can cloud and affect decisions and actions. Also try to use real-world situations as teaching tools. Don’t tell anyone how they should have acted. Instead, develop critical thinking skills by reinforcing concepts and working with them individually until they find solutions on their own.

How can coaching and mentoring help leaders develop?  

Coaches and mentors are both important, but they play very different roles. Use coaches to help individuals become critical thinkers and problem solvers. Coaches also can help individuals develop specific skills that they will need to advance in their career.

Mentoring is a long-term process and is intended to support a professional’s overall development rather than building specific job skills. Mentors are critical to teaching emotional intelligence. They need to be advocates, so they usually aren’t direct supervisors. Good mentors build trust and create a connection with the individual with whom they are working that allows a deep level of openness and honesty, which is critical to an individual’s professional development.

To successfully develop future leaders, you must make leadership an organizational priority. Find potential leaders early, engage them in the process and proactively work to develop critical leadership skills. The future of your organization depends on it.

Michael Arklind is manager of learning and development at Sensiba San Filippo LLP. Reach him at (925) 271-8700 or [email protected].

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Networking like a pro

Elisabeth Fraser Au-Yeung, vice president of marketing, Sensiba San Filippo LLP

Elisabeth Fraser Au-Yeung, vice president of marketing, Sensiba San Filippo LLP

Networking is a critical best practice for business owners regardless of their company’s size. When you are just starting out, the effort you put in to making and nurturing contacts can directly impact your revenue and the future success of your business.

Smart Business spoke to Elisabeth Fraser Au-Yeung, vice president of marketing at Sensiba San Filippo LLP, about tips and tools that can help you become a polished and eloquent networking expert.

How can business owners prepare for a networking event?

Savvy networkers always have a plan in place before attending an event. A plan may include evaluating the event — is the event of high value to attend? What are your goals for attending? Will your target audience be in attendance?

Try to obtain a list of attendees and any sponsor firms prior to the event. Use the list to build a prioritized list of ‘target’ attendees you want to meet and speak with. You can take it one step further and create goals for each person you want to meet, as well as speaking points that you have thought out and practiced for when you meet that person. You can even search online for photos of the individuals you want to meet so you can more easily find and recognize them.

In addition, you need to have a few tools including business cards, a practiced and polished elevator pitch, and even marketing collateral that you can hand out. Have a pen so you can make notes on the back of the business cards you receive. Note any significant details that the person you met shared so when you follow up, you can mention this and make it a more impactful and personalized connection.

When you arrive, how do you start a conversation?

It can be more comfortable to arrive to an event early, as the room will be less crowded. Do not wait for someone to approach you. Be the master of your own destiny. Approach a person or a group and ask if you can join them. When you meet someone, make eye contact, have a firm handshake and smile. By doing so, you will look and feel more confident.

As you are speaking with people, listen to what they have to say and be cautious about interrupting. When it is your turn to speak, ask open-ended questions about the people with whom you’re speaking, such as what brought them to attend the event? What makes them passionate about their business or industry? What are they doing for the summer? People enjoy discussing the things they are passionate about, including their business and personal interests.

How should business owners ‘pitch’ themselves and their business?

When asked about your business, have a brief and easily understandable description of what you do. Be sure to incorporate into your description the ‘so what’ factor — what it is that makes you or your company different and why the person you are speaking with should be interested in hearing more about your business.

What are the most important tips for success in networking?

Networking is all about relationship building — having rapport and building chemistry over a period of time with people you meet. A relationship will not be built at just one event. It is something that needs to be nurtured.

Remember to ask everyone you meet for a business card. After the event, send an email and a LinkedIn invite to connect with them within 48 hours. Reference something you discussed by checking your notes on the backs of the business cards so your contacts have a recollection of your conversation. Make yourself ‘valuable’ by offering to send a white paper or thought-leadership piece. Follow up with your contacts every 30 days to keep in touch, and even offer to meet for coffee or lunch to further strengthen your relationship.

Elisabeth Fraser Au-Yeung is a vice president of marketing at Sensiba San Filippo LLP. Reach her at (925) 271-8700 or [email protected]

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How business owners can protect their network from the inside and out

Jalal Nazeri, certified information systems auditor, Sensiba San Filippo LLP

Jalal Nazeri, certified information systems auditor, Sensiba San Filippo LLP

In this day and age, only a small number of businesses can function without a network of computers. Unfortunately, there are inherent risks to computer usage — hackers, viruses, worms, spyware, malware, unethical use of stolen passwords and credentials, unauthorized data removal by employees with USB flash drives, or servers crashing and bringing productivity to a halt. Owners of small to midsize businesses have to be cautious of cyberattackers, and depending on your industry, your business may be an easier target than larger businesses.

With cyberattacks on the rise, Smart Business spoke with Jalal Nazeri, a certified information systems auditor at Sensiba San Filippo LLP to discuss what business owners can do to protect themselves.

What is the first step toward protection?

The first task in creating a secure network is to draft a security policy, which, if carefully managed, can lower the risk of these threats.

When drafting a policy, consider every perceived threat, no matter how unlikely it may seem. Communicating and monitoring these policies regularly will lay the groundwork for compliance in defense of your network.

There are a number of core ideas to consider in implementing a policy. First, you will need to do a risk assessment to identify risks and determine the best methods to prepare for them. Then you will need to classify data by sensitivity level and develop access restrictions. Consider what the security requirements are of an authorized user and assess the possible risk, both logical and physical. In addition, create a plan to back up each user’s data. Finally, ongoing monitoring and maintenance of your risk assessment and the underlying policies and procedures is a must.

How do you manage employees’ usage of company computers?

An acceptable use policy is a common element to include in your security policy. The acceptable use policy restricts users by giving them guidelines on what they can and cannot do on your company’s network. Adding these restrictions can place an inconvenience on the end user, but it’s imperative to have them in place for the protection of your organization. The end user can be an organization’s weakest point.

Once a user reviews the policy and accepts the restrictions in place, it’s important that he or she sign the policy. Users should be made to re-sign the policy whenever it changes, and at regular intervals even when unchanged. Some companies set a six-month timeline, others vary. The value of the policy depends on the communication and monitoring of compliance. Without enforcement, its value is greatly reduced.

What are other tools businesses can use?

A few other key items a business can use are firewalls, content filters, encryption, virus protection, and accounts and passwords. Business owners need to maintain these tools, not just put them in place and forget about them.

Firewalls act as a barrier to the internal network, blocking unwanted traffic, while content filters restrict material delivered on the network and control what content is available to users on the Internet. Encryption is becoming more vital for transferring and storing data, whether it is for regulatory compliance or customer protection from theft.

Anti-virus software is a must on all your servers and workstations. A scheduled virus scan should never be missed, and always have automatic updates turned on.

Never use generic passwords or account names, and restrict users to using only their own login. Passwords should follow a complexity requirement, like the use of a mix of letters, punctuation, symbols and numbers, and should also have a limited lifetime and a rotation.

What is the value of taking these steps?

With small to midsize businesses, budget is always a major consideration in what is plausible in obtaining the most secured environment. With a good policy in place, identification of priority spending can be determined and can reduce the need for excess software and hardware.

Cyberattackers look to gain access to networks that have the least amount of resistance. A good security policy protects data against potential threats. Without one, the company may incur significant remediation costs, lose productivity and even lose clients.

Jalal Nazeri is a certified information systems auditor at Sensiba San Filippo LLP. Reach him at (925) 271-8700 or [email protected]

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How SOC reports provide assurance to stakeholders, customers

Jeff Stark, audit partner, Sensiba San Filippo LLP

Jeff Stark, audit partner, Sensiba San Filippo LLP

Service organizations are trusted with some of their customers’ most sensitive information. In order to thrive, these organizations need their stakeholders’ full faith that their internal controls safeguard both financial and nonfinancial information, and are designed and operating effectively. How can service organizations demonstrate that their control systems are protecting their customers? According to the American Institute of Certified Public Accountants (AICPA), Service Organization Control (SOC) reports are the answer.

Smart Business spoke with Jeff Stark, audit partner at Sensiba San Filippo LLP, about SOC reporting and how it helps service organizations provide the broad spectrum of assurance their stakeholders require.

What are SOC reports?

SOC reports are standards created by the AICPA to allow for reporting on controls at service organizations. There are three types of SOC reports: SOC 1, SOC 2 and SOC 3. Together, they both replace and expand on Statements on Auditing Standards (SAS) 70 reports, giving service organizations the tools they need to provide the assurance their stakeholders require.

Though not widely known, SOC reports are becoming essential to the ongoing growth of the technology service sector as more businesses are outsourcing tasks and functions to outside service providers. Since the risk of the service provider becomes the risk of their stakeholders and customers, SOC reports provide much needed assurance, empowering service organizations to gain trust, while helping to protect their stakeholders from outside risk.

Why was SAS 70 replaced?

Since 1992, SAS 70 has provided service organizations with a vehicle to disclose control objectives and activities related to financial reporting. As the market changed, service organizations had a growing need to report on many nonfinancial control objectives. SAS 70, with its limited intended focus, was too often being used for purposes outside of financial controls.

In order to solve this problem, the AICPA issued Statements on Standards for Attestation Engagements (SSAE) 16, which replaced audit standards with attestation standards for internal controls over financial reporting. SSAE 16 standards became the basis for SOC 1 reporting, replacing SAS 70.

Additionally, the AICPA issued guidance related to attestation on controls relevant to the Trust Service Principles and Criteria including security, availability, processing integrity, confidentiality and privacy. This guidance became the basis for SOC 2 reporting, bridging the gap between market need for broad assurance reporting and the previously narrow financial focus of SAS 70.

How can an organization know whether a SOC 1 or SOC 2 report is right for them?

Whether an organization should obtain a SOC 1 or SOC 2 report depends entirely on the controls in question. Controls relating to information that could affect financial statements are covered by SOC 1 reports. SOC 2 covers controls related to nonfinancial information.

Payroll processors, employee benefit plan managers and banks commonly use SOC 1 reports. Data centers, Software as a Service providers and companies subject to industry-specific regulatory standards frequently benefit from SOC 2 reports.

Why should companies consider SOC reporting?

Service organizations that want to remain competitive need internal control attestation in a variety of areas. Many companies will not even consider working with an organization without assurance that relevant controls are well designed and operating effectively. In a highly risk-averse business climate, organizations can demonstrate effective controls with the appropriate SOC report.

Jeff Stark is an audit partner at Sensiba San Filippo LLP. Reach him at (480) 286-7780 or [email protected]

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How businesses on the selling end can plan for a merger or acquisition

Kevin Strain, audit partner, Sensiba San Filippo LLP

Kevin Strain, Audit Partner, Sensiba San Filippo LLP

Many of us have heard the saying, “By failing to prepare, you are preparing to fail.” While most business owners meticulously plan the ongoing management of their organization, far fewer prepare for a successful sale. If the sale of the company is a part of your exit plan, it quite literally pays to be prepared.

With merger and acquisition activity heating up, Smart Business sat down with Kevin Strain, Audit Partner at Sensiba San Filippo LLP to discuss what specifically businesses can do to ensure they are ready.

Why is it critical that businesses be prepared for an acquisition?

The current climate for acquisitions makes it more likely than ever that you’ll find yourself talking to a potential buyer. Acquisition activity has been ramping up since 2010, and is only expected to increase. Low interest rates and resurgent equity markets have left corporations flush with cash, and looking for opportunities.

Yet even in the current environment, the majority of deals still fail. More than 85 percent of prospective deals are never completed. Suitors come calling, but the process breaks down prior to execution, often because sellers are unprepared.

What is the first step a company should take to prepare?  

It is critical to identify and document the areas that drive organizational value. Every organization is different, and what makes you an attractive candidate for an acquisition depends on the nature of your business. Some acquisitions are technology buys, driven by intellectual property. Others are organizational or revenue buys, driven by the desire to add personnel or future earnings.

Regardless of what drives the marketability of your company, it is important to recognize the value drivers and document them. For example, if you hold technology patents, it’s essential that these are defended and documented.

What financial preparations should be made?

A detailed examination of financial records and projections should be expected during the negotiation process. If you haven’t had an audit completed recently, that should be the first step. If you have been through an audit, you need to be ready to provide the same information on relatively short notice. Make sure to keep the information that your auditors ask for current.

The focus of the financial review may also be driven by the type of acquisition. If a suitor is seeking to buy a future revenue stream, you need to be sure your projections are tight and defensible.

What pitfalls can derail the sale of a business?

Areas of potential risk can provide bargaining power to a buyer or stop the process in its tracks. Whether it’s an uncertain tax position, legal exposure or patent dispute, exposure can damage or kill a deal. Ideally, you’d like to resolve these issues. But if that’s not possible, put them on the table as soon as possible. It’s best for buyers to know where you stand sooner rather than later so the investment in the process is not wasted.

What else should business owners keep in mind?

Understand your own expectations and limits. You don’t want to be deciding where you are willing to bend during negotiations. That will weaken your ability to negotiate the best deal. Are you comfortable with an earn-out? How much guaranteed cash do you need? Are you willing to indemnify the buyer against any contingent liabilities?

Finally, it’s wise to find an experienced adviser to help you navigate through the process. The majority of business owners only sell a business once, so it’s important to get it right the first time.

Kevin Strain is an audit partner at Sensiba San Filippo LLP. Reach him at (650) 358-9000 or [email protected]

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Gaining the greatest value from your relationship with your accountant

Jerry Krause, audit partner, Sensiba San Filippo LLP

Jerry Krause, audit partner, Sensiba San Filippo LLP

Every business owner requires the services of outside accountants from time to time. On the surface, many CPAs seem similar. They list the same services, have the same accreditations and work in the same industries. But do they all deliver the same value? Is one CPA as good as the next? How can a business owner tell if he or she is truly getting the greatest value from a service provider?

Jerry Krause, audit partner at Sensiba San Filippo LLP, says delivering value to a business owner requires more than just technical expertise. “Serving a business owner is about much more than providing specific services or understanding accounting principles and tax codes,” says Krause. “Delivering value requires taking the time to understand the full picture of the owner’s business, personal and financial situation.” He says strong relationships are the foundation for value-added delivery.

Smart Business spoke with Krause about the best approach to building valuable relationships, where accountants could fall short, and what business owners should expect from a trusted adviser.

What should business owners expect from their accountant?

First and foremost, business owners should expect their accountant to be looking out for them. That means proactively identifying opportunities and avoiding problems. If an accountant is only providing the services a business owner is asking for, they aren’t doing him or her any favors. A trusted adviser is not an order taker. They listen to what their clients are saying and will be creative and proactive in finding solutions.

For the owner of a closely held business, an accountant needs to know more than just the business issues. Business decisions affect personal and family finances, so sound advice can’t be given without knowing the ramifications of what’s being advised. To properly advise business owners, accountants need to understand all of the factors involved.

What does it mean to be a trusted adviser?  

A trusted adviser will talk about more than just numbers and compliance. Conversations should be wide-ranging and include company operations, tax planning for the business and the owner, exit strategies, and estate planning.

Further, a good adviser must be willing to disagree with his or her client. Many business owners lack peers within their organization. Sometimes there can be great value in challenging a business owner’s perspective. When a good accountant anticipates that a client is about to make a mistake, he or she would be doing the client a disservice by not interjecting a solution.

What is the key to getting value from a relationship with an accountant?

Open communication is the most important factor for ensuring a successful relationship between a business owner and their accountant. The more open the communication, the better the service an accountant can provide.

The test of a good relationship is if there is an understanding that a business owner can call their accountant anytime. Business owners need to feel comfortable knowing their accountant is available to discuss whatever issues they’re facing. In order for that to happen, clients have to know their accountant is not going to charge them every time a call is made.

How can a business owner assess their relationship with an adviser?

Finding the right adviser is about fit and commitment. While a business owner needs a firm that has the right expertise and resources, it’s just as important to find an adviser who places high value in the relationship. Having an accountant with a high level of expertise doesn’t mean much if he or she doesn’t understand his or her client. It takes more than industry and technical knowledge to create a valuable relationship. It takes commitment and the willingness to invest the time to build understanding and trust.

Jerry Krause is an audit partner at Sensiba San Filippo LLP. Reach him at (650) 358-9000 or [email protected]

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How health care reform could impact your business

Bill Norwalk, tax partner-in-charge, Sensiba San Filippo LLP

Richard Leasia, shareholder, Littler Mendelson, P.C.

On Mar. 23, 2010, President Barack Obama signed the Patient Protection and Affordable Care Act of 2010 (PPACA) with the intention of providing comprehensive health care coverage to nearly all individuals. The law is being rolled out in phases and arguably the most significant aspect for employers is set for implementation on Jan. 1, 2014.

“We have found ourselves at the intersection of streets paved with good intentions and unintended consequences,” says Richard Leasia, shareholder at Littler Mendelson, P.C.

Effective Jan. 1, 2014, employers with 50 or more full-time or full-time equivalent employees will have to choose between providing affordable health insurance coverage to qualifying employees or paying a penalty. There is no per se requirement that all employers provide health insurance coverage and employers will need to evaluate the pros and cons of providing health insurance coverage or paying various penalties.

“Each business owner’s analysis should include not only the financial implications of one option over the other, but also issues of employee morale, competitiveness within the marketplace, tax implications and benefits, and potential internal compliance and monitoring requirements,” says Bill Norwalk, tax partner-in-charge at Sensiba San Filippo LLP.

Every company, regardless of size, will need to continue to decide whether and to what extent they will provide health insurance coverage for employees. While the PPACA mandate directly affects only those employers meeting the minimum threshold number of employees, small businesses, some of which are not legally required to provide health insurance coverage, may wish to do so as an incentive for employees, as a means of staying competitive within the market, and/or in order to take advantage of certain tax credits.

At a recent event hosted by Sensiba San Filippo, Littler Mendelson, ABD Insurance and Financial Services, and the Small Business Majority, panelists from each firm discussed the implications of health care reform

on small and medium-sized businesses.

Smart Business spoke with Leasia and Norwalk after the event to gather feedback and to have them answer questions about the basics of health care reform laws and what the laws will mean to businesses from a financial, tax, and legal perspective.

What are the legal implications?

Although the PPACA indicates in general terms what will be required on Jan. 1, 2014, many questions concerning the specific application of the law remain unanswered. A few of the open questions include:

1. When does an employee qualify as full-time or full-time equivalent?

2. What standard will be used when assessing whether the employer-provided health insurance coverage is ‘affordable’?

3. How do contractors affect the analysis?

4. What about seasonal employees?

5. What effect will the PPACA have on current city-specific mandated health care (e.g., San Francisco’s Health Care Security Ordinance)?

Unfortunately, answers to these questions will be dependent on yet-to-come regulations, but business owners should address them with their advisers.

What are the tax and financial implications?

Many business owners remain focused on 2014, but they should not lose sight of some very specific requirements that will be rolled out this year. These include, for example, an implementation of a $2,500 cap on employee contributions to health flexible spending accounts for plans beginning on or after Jan. 1, 2013; W-2 informational reporting for the 2012 calendar year was due for many employers by Jan. 31, 2013; additional notice requirements to employees; and beginning Jul. 31, 2013, there will be the imposition of certain temporary taxes for insured and self-insured group health insurance plans. Additionally, businesses should ensure that they are harnessing the full potential of the various tax credits currently available, including those available to small businesses that offer health insurance coverage to their employees. Now is the time to start planning with your tax adviser.

Throughout the coming year it will be imperative for businesses to examine their particular situation, learn how the PPACA affects their specific workforce, and prepare a plan for implementing the requirements that will go into effect in 2013, 2014 and beyond.

Richard Leasia is a shareholder with Littler Mendelson, P.C. Reach him at (408) 998-4150 or [email protected] Bill Norwalk is tax partner-in-charge at Sensiba San Filippo LLP. Reach him at (925) 271-8700 or [email protected]

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How unreported employment taxes could be putting your organization at risk

Claudia Necke-Lazzarato, tax manager, Sensiba San Filippo LLP

Business owners have long understood the importance of income tax compliance. Companies that understand the tax law and apply it correctly can save money and reduce the risk of surprises in the event of an audit. But recent focus on employment taxes by the IRS has caught even savvy business owners off guard, and in some cases, out of compliance.

Smart Business spoke with Claudia Necke-Lazzarato, a tax manager at Sensiba San Filippo LLP, about changes in employment tax rules, increased IRS scrutiny, and what businesses should be doing to ensure compliance and limit their risk.

Why is employment tax compliance becoming more important?

Compliance has always been important. However, recently the IRS has shown an increased focus on employment taxes. With the economic slowdown, income tax revenue growth has slowed as well, and the IRS has increased its focus on employment taxes. These types of tax audits are definitely on the rise. This increase in IRS audits means an increase in risk for taxpayers. It is essential that business owners understand the importance of employment tax compliance. If it’s important to the IRS, it should be important to every business owner.

What are some common employment tax reporting mistakes?

Underreporting W-2 wages is the easiest way for businesses to fall out of compliance. Whether it’s wages that are improperly characterized as reimbursable expenses, or employees who are incorrectly designated as subcontractors, it is very common for a misunderstanding of tax law to lead to the underpayment of taxes.

Just this year, the IRS released a clarification on what qualifies as a reimbursable expense. This clarification created a requirement that employers have ‘accountable plans’ for reimbursement. The IRS also defined these ‘accountable plans’ for employee reimbursements, and according to the new ruling, they must meet the following three requirements:

• The reimbursed expense must be allowable as a deduction and must be paid or incurred in connection with performing services as an employee of the employer.

• Each reimbursed expense must be adequately accounted for to the employer with receipts or other proof of expense.

• Any amounts paid to employees in excess of expense must be returned within a reasonable period of time.

If all of these requirements are not met, reimbursements will not be treated as reimbursable expenses. Instead, these payments would be considered wages, and would be subject to withholding and employment taxes.

This means that flat value ‘expense allowances,’ which allow a set amount of funds to offset the costs of tools, automobiles and other business-related expenses, may now be reportable as W-2 income. To simplify internal reporting, many companies have historically provided fixed-value allowances for common expenses. Typically, these allowances would not meet the new requirements for ‘accountable plans.’

How do you determine if someone should be designated as an employee or a subcontractor?

Another very common mistake is mischaracterizing employees as subcontractors. If an employer incorrectly designates a worker as a subcontractor, it will fail to withhold tax for the employee and fail to pay the employer’s share of employment taxes. This can put both the employee and employer at significant financial risk.

To feel confident that they have correctly determined employment status, employers should know what questions to ask and who to speak with for clarification. Evaluate each contractor’s relationship with a few simple questions, then ask a CPA who is well versed in employment tax law if there is any ambiguity remaining. Look closely at who has behavioral and financial control in the relationship and answer the following questions:

• Is the work performed as part of a defined project?

• Who is supervising the work?

• Who provides the tools and supplies needed to complete the work?

• Who sets the schedule for the work?

If you still aren’t sure of the answer, find a CPA and ask for help. The IRS defaults to assuming an employee/employer relationship, so be certain you’re getting it right.

What are the consequences of underreporting employment tax?

Employment tax compliance isn’t just about having the right answer. There are real consequences for underpayment of taxes. The IRS has sharpened its focus on the reimbursement arrangement taxpayers have in place. In several instances, companies have a reimbursement arrangement that does not pass the requirements of accountability, from the IRS’s point of view. The IRS penalties can be very costly and time consuming to resolve, with companies having to pay all underpayments with interest, and in addition, pay an automatically assessed 20 percent penalty. Working with a CPA firm with IRS audit experience can help clients receive a negotiated reduced penalty and put a qualifying accountable plan in place.

How can business owners ensure compliance?

Understanding the importance of getting employment taxes correct is the first step. Rules and enforcement change frequently, so partnering with an experienced tax professional is a good idea.

A best practice to help remain compliant is to talk about the issue as much as possible and in a proactive manner, rather than taking the rearview mirror approach after an audit notice is received. When ongoing success is your primary objective, you need a tax professional who actively helps you to find opportunities and avoid potential problems.

Claudia Necke-Lazzarato is a tax manager at Sensiba San Filippo LLP, a regional CPA firm based in the San Francisco Bay area. Reach her at (925) 271-8700 or [email protected]

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How to take a risk-focused approach to SOX compliance

Bill Philippe
Senior Audit Manager, Sensiba San Filippo LLP

In April 2012, President Barack Obama signed into law the Jumpstart Our Business Startups Act. Meant to encourage initial public offering activity, certain provisions of the act impact the application of Section 404 of the Sarbanes-Oxley Act, which requires management to establish and maintain internal control procedures for financial reporting. So how do emerging growth companies cope?

Smart Business spoke with Bill Philippe, a senior audit manager at Sensiba San Filippo LLP, about SOX compliance and the JOBS act.

How would you define an emerging growth company and the requirements in question?

An emerging growth company generally has less than $1 billion in revenue in the fiscal year prior to its IPO and its status generally lasts for five years after its IPO. It is exempted from the internal control audit requirement of Section 404 of the SOX Act. In practical terms, this exemption from the audit requirement should reduce the cost of compliance for an emerging growth company, as its auditors will not be required to audit its internal controls over financial reporting (ICFR), thereby reducing the scope and focus of the annual audit process. However, emerging growth companies are not exempted from the management reporting requirements of Section 404 of SOX.

The most challenging aspect of SOX is Section 404, which requires management and the external auditor to report on the adequacy of the company’s ICFR. This is the most costly aspect of the legislation for companies to implement, as documenting and testing important financial manual and automated controls requires a significant sustained effort.

Under Section 404, management is required to produce an ‘internal control report’ as part of each annual exchange act report. It must affirm ‘the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.’ The report must also contain an assessment of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. To do this, companies generally adopt an internal control framework such as that described in Committee of Sponsoring Organizations of the Treadway Commission (COSO).

What should an emerging growth company do following an IPO?

During the five years following an IPO, an emerging growth company should take a risk-focused approach to SOX compliance by specifically identifying, implementing and monitoring those internal controls that enable management to certify the design and operating effectiveness of controls with confidence.

You want to develop a SOX implementation process that is designed with clearly defined goals and executed by an experienced team. You need to lay the foundation for your company’s regulatory compliance requirements as well as practice effective corporate governance now and into the future.

How does the post-IPO process break down?

Activities in the first post-IPO year are focused upon the identification of high-risk processes and the implementation of the documentation and monitoring activities necessary to support management’s annual reporting requirements under Section 404.

The focus in the second and third post-IPO years is on evaluating and understanding the company’s internal control priorities in light of the company’s growth. Monitoring activities necessary to support management’s annual reporting requirements continue.

In the fourth post-IPO year, add the additional objective of documentation and assessment of the moderate- and low-risk processes. Evaluation of  the company’s internal control priorities continues along with monitoring activities necessary to support management’s annual reporting requirements.

Monitoring activities necessary to support management’s annual reporting requirements continue in the fifth year, as do those needed to support the integrated audit work of the company’s external auditors.

What are the effects of the recent changes to the Internal Control – Integrated Framework?

On Sept. 18, COSO released Internal Control over External Financial Reporting: Compendium of Approaches and Examples.

It includes the Updated Internal Control – Integrated Framework, which reflects feedback from its recently closed comment period and the proposed Illustrative Tools: Assessing Effectiveness of a System of Internal Control.

The compendium illustrates how the principles set forth in the proposed updated framework can be applied in designing, implementing and conducting internal control over external financial reporting. It provides additional reference material for concepts discussed within the framework, including types of external reporting, suitable objectives, judgment, overlapping objectives, deficiencies in internal control and smaller entities.

The Updated Internal Control – Integrated Framework was initially made available for public comment in Dec. 2011, and incorporates the following major changes from the original 1992 framework:

  • The financial reporting objective was expanded to address internal and external, financial and non-financial reporting objectives.
  • An increased focus on operations, compliance and non-financial reporting objectives.
  • Codification of the 17 principles that represent the fundamental concepts associated within the five components of internal control.
  • Expanded discussion of the governance role of the board of directors and committees of the board.
  • The changes in technology and how they impact all components of internal control.

Companies should assess the impact that the expanded areas of focus in the updated framework will have on their current internal control processes and draft an implementation plan for any enhancements deemed necessary by internal stakeholders and those charged with governance.

Bill Philippe is a senior audit manager at Sensiba San Filippo LLP, a regional CPA firm based in the San Francisco Bay Area. Reach him at (650) 358-9000 or [email protected]

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