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A Valuation Can Strengthen Your Buy-Sell Agreement

A solid buy-sell agreement can help closely held businesses avoid disruptions when a shareholder leaves the business. Arguably, the most critical provisions in a buy-sell agreement are those that address valuation-related issues. Incomplete or outdated valuation provisions can lead to costly, bitter disputes that hurt both individual shareholders and the company.

Here are some business valuation issues to consider when drafting a buy-sell.

What’s the appropriate valuation method?

The valuation provision of a buy-sell agreement describes how a departing shareholder’s business interest will be priced for purchase by the company or the remaining shareholders. Three common methods of valuing an interest include:

1.      Prescribed formula. Some buy-sell agreements call for a simple formula to establish the amount of the buyout. For example, a buy-sell might specify that “shares will be purchased at four times earnings before interest and taxes (EBIT) for the previous 12 months.” Usually, a valuation professional will suggest an initial buyout formula.

A drawback to valuation formulas is that they typically apply to historical financial results (not projected results) and may not reflect a business’s current value in today’s marketplace. Moreover, it’s difficult to account in a formula for all factors that can affect earnings in any given year — including discretionary, unusual or one-off expenses.

Earnings-based formulas also may be subject to misinterpretation or manipulation. For instance, shareholders might over- or understate expenses in anticipation of a buyout. Or they may disagree about what’s included in (or excluded from) “earnings.”

2.      Fixed price. An agreement also might specify a fixed price reached through negotiation by the shareholders, often with the input of a business valuation expert. This approach fosters collaboration and discussion among shareholders at a time when they aren’t yet facing a triggering event.

Like a formula, the main appeal of a fixed price often is its perceived simplicity. But a fixed price may not reflect the business’s value at the time of a triggering event. And both formulas and fixed prices might require periodic adjustments due to external factors (such as the recent Tax Cuts and Jobs Act) that can affect a company’s value and capital structure in ways not contemplated when the agreement was drafted.

3.      Outside opinion from a business valuation professional. Alternatively, a buy-sell agreement could call for an agreed-upon process, usually a formal business valuation, to guide the buyout when a triggering event happens. Objective, timely business valuations are likely to take into consideration current circumstances, thereby producing more meaningful results.

The agreement might provide for the retention of a joint valuation expert or require that both sides hire their own experts. In the latter situation, a third expert might be needed if the experts’ opinions don’t fall within a certain range of each other. The buy-sell agreement should specify who’s required to pay the valuation fees (the buyer, the seller or the company).

What are the valuation parameters?

Other relevant parameters to consider in the valuation provision of a buy-sell agreement include the appropriate level and standard of value, as well as the valuation date.

There are basically three “levels” of value: 1) minority, marketable, 2) minority, nonmarketable, and 3) controlling. In turn, these levels can affect the methods, assumptions and adjustments the expert uses — and, therefore, the final value.

For example, if an expert uses publicly traded (minority, marketable) stock prices to value a private business interest on a minority, nonmarketable level, it may be appropriate to apply a discount to reflect the time and effort required to sell private stock vs. an actively traded stock. Conversely, if valuing a controlling interest, the expert might apply a control premium or make adjustments that only a controlling owner could do to optimize the company’s earnings.

Likewise, the buy-sell agreement should specifically define the “standard” of value to prevent disputes during the buyout process. A business valuation expert can provide definitions for a variety of relevant standards, including fair market value, fair value, book value and investment value. Different triggering events or departing shareholders may require different levels or standards of value.

It’s also critical to specify the valuation date in advance. After all, a business’s value can change overnight. Using the date of the triggering event could prompt shareholders to time their departures to maximize their buyouts. It could also create financial reporting headaches if the buyout happens in the middle of the reporting period. So, many owners opt to value the interest “as of” the last day of the most recent fiscal year.

Choose wisely

When creating or reviewing a buy-sell agreement, there are no one-size-fits-all valuation provisions. The right choice depends on the shareholders’ objectives — and what’s right today might not be the right choice tomorrow. Contact us today for assistance with this matter. We would be happy to assist you. 

Proper SOX Planning

By: David J. Gruber, CPA- Director of Risk Advisory Services

The Sarbanes-Oxley Act of 2002 (often shortened to SOX ) is legislation passed by the U.S. Congress to protect shareholders and the general public from accounting errors and fraudulent practice on the enterprise, as well as improve the accuracy of corporate disclosures.  Section 404 of Sarbanes-Oxley mandates public companies to issue an internal control report that contains management’s assertions regarding the effectiveness of the company’s internal control structure and procedures over financial reporting.  The steps leading to the company’s assessment can include:

· Documenting the company’s processes through narratives, flowcharts, and / or matrices

·  Identifying and documenting the key controls present to prevent financial statement errors

·  Evaluating the design of the key controls

·  Perform testing on the effectiveness of the key controls

·   Evaluating the results of the testing

Proper planning for Sox projects is the key to making them run smoothly and efficiently. This compliance work of documenting and testing the internal control structure can be an arduous task, and can be very time consuming for both the client and the SOX service provider.   Proper planning can ease the pain of of this work and help avoid any unnecessary bumps in the road.

Keys to proper planning:

·  Effective communication is often a key element in the proper planning and successful completion of a project.  Communication of the plan up-front, including timing and expectations, as well as ongoing communication of the progress during the project are essential to keep the project on track.

·   Well in advance of starting the project, hold a detailed planning meeting with all key personnel covering various topics such as:  changes in the business that could have an effect on the control environment (i.e. change in major customers, major acquisitions, etc.), changes in key personnel, discussion of the company’s risk assessment (have this document updated with the latest financial information prior to this meeting to allow for analysis), and changes in scope.

·   Plan the fieldwork around the work load of the client – avoid being on-site during the busiest times for the client, such as, month-end close, quarter-end filing deadlines, etc.

·   Properly plan the staffing of the project – ensure knowledgeable well-trained staff are ready and available to meet the client’s needs (i.e. plan for success and succeed in meeting the plan).

·   Do the little things well that will ensure the proper completion of the project with as little disruption to the client as possible.  One good example of this – during fieldwork, compile a list of questions / issues to discuss with client personnel and go over them all at once, instead of interrupting the client multiple times for each individual question.  Another example is to coordinate sample selections between the Sox service provider and the external auditor to minimize management and staff time in pulling information and answering information.

In short, proper planning can help your SOX project run as smoothly as possible to the benefit of all parties involved. Contact me directly for assistance with your planning and your SOX project. Shoot me an email now at DGruber@HolbrookManter.com or call me at 614.494.5300

Are you prepared to detect fraud?

By: Denise Smith, CPA, CGMA- Senior Accountant

How prepared are you and your company to detect fraud?  Fraud is defined as wrongful or criminal deception intended to result in financial or personal gain. Even if you have policies, procedures and programs to prevent or detect fraud, unfortunately you may still fall victim to fraud.  You and your personnel can be prepared to find and detect fraud by being aware of behaviors and signs.   

The Association of Certified Fraud Examiners publishes a report annually that lists, among other things – behavioral red flags that may indicate that someone is perpetrating a fraud:

·         Living beyond their means

·         Having financial difficulties

·         Having an unusually close relationship with a vendor or customer

·         Control Issues, unwillingness to share duties

·         Having a “wheeler-dealer attitude”

·         Going through a divorce or family problems

·         Irritability, suspiciousness or defensiveness

·         Addiction problems

·         Complaining of inadequate pay

·         Past employment related problems

·         Refusal to take vacations

·         Excessive pressure from within the organization

·         Social isolation

·         Complaining about lack of authority

·         Excessive family or peer pressure for success

·         Instability in life circumstances

·         Past legal problems

Other situations which may warrant looking further:

·         Missing documentation.  Do you have a hard time locating invoices or checks, etc.?

·         Do you have a large number of void checks or sales transactions? It is easy to make a mistake and need to void a transaction or check, but if you are seeing this on a regular basis – it may be time to ask a few questions.

·         Have you seen a large increase in purchasing or invoices being paid without a corresponding increase in sales?

·         Have you seen any duplicate payments to vendors?  If so, are you sure that all refunds have been deposited back to the company?

·         If you have a threshold for signatures on a check, are you seeing many checks falling just below this amount?

·         Are you receiving multiple complaints from customers about receiving statements for amounts that are not owed? It may be time to check up on some of these complaints.

Contrary to what you may believe, an audit, review or compilation of your financial statements by a CPA firm cannot be relied on to detect fraud.  That does not mean, however, that you cannot keep an eye on the red flags listed above, and give Holbrook and Manter a call to find out if we have some suggestions for tightening your internal controls or new procedures to try to detect fraud.

Self-Employment Taxes & Spouse-Owned Businesses

If you own a profitable, unincorporated business with your spouse, you probably find the high self-employment (SE) tax bills burdensome. An unincorporated business in which both spouses are active is typically treated by the IRS as a partnership owned 50/50 by the spouses. (For simplicity, when we refer to “partnerships,” we’ll include in our definition limited liability companies that are treated as partnerships for federal tax purposes.)

For 2018, that means you’ll each pay the maximum 15.3% SE tax rate on the first $128,400 of your respective shares of net SE income from the business. Those bills can mount up if your business is profitable. To illustrate: Suppose your business generates $250,000 of net SE income in 2018. Each of you will owe $19,125 ($125,000 × 15.3%), for a combined total of $38,250. Fortunately, there may be ways your spouse-owned business can lower your combined SE tax hit.

Divorce yourself from the concept

While the IRS creates the impression that involvement by both spouses in an unincorporated business automatically creates a partnership for federal tax purposes, in many cases it will have a tough time making the argument — especially when the spouses have no discernible partnership agreement and the business hasn’t been represented as a partnership to third parties (such as banks and customers).

If you can establish that your business is a sole proprietorship (or a single-member LLC treated as a sole proprietorship for tax purposes), only the spouse who is considered the proprietor owes SE tax. So, let’s assume the same facts as in the previous example, except that your business is a sole proprietorship operated by one spouse. Now you have to calculate SE tax for only that spouse. For 2018, the SE tax bill is $23,172 [($128,400 × 15.3%) + ($121,600 × 2.9% Medicare tax)]. That’s much less than the combined SE tax bill from the first example ($38,250).

Show a lopsided ownership percentage

Even if you do have a spouse-owned partnership, it’s not a given that it’s a 50/50 one. Your business might more properly be characterized as owned, say, 80% by one spouse and 20% by the other spouse, because one spouse does much more work than the other.

Let’s assume the same facts as in the first example, except that your business is an 80/20 spouse-owned partnership. In this scenario, the 80% spouse has net SE income of $200,000, and the 20% spouse has net SE income of $50,000. For 2018, the SE tax bill for the 80% spouse is $21,722 [($128,400 × 15.3%) + ($71,600 × 2.9%)], and the SE tax bill for the 20% spouse is $7,650 ($50,000 × 15.3%). The combined total SE tax bill is only $29,372 ($21,722 + $7,650).

Explore all strategies

More-complicated strategies are also available if this plan does not fit your needs. Contact Holbrook & Manter to learn more about how you can reduce your spouse-owned business’s SE taxes.

Thousands of Ohio BWC rebate checks remain uncashed & are set to expire

Deadlines for Ohio employers to cash rebate checks issued by the Ohio Bureau of Workers’ Compensation are fast approaching. October is the month to make sure you get a hold of the funds owed to you as a part of $1.5 billion rebate issued by the BWC this summer.  The BWC began issuing the checks in late June and continued to do so throughout July, with the checks expiring at the 90 day mark. The Ohio Society of CPAs shares the following detailed information:

More than 5,500 rebate checks issued to Ohio employers by the Ohio Bureau of Workers’ Compensation remain uncashed.  The checks total $10.8 million and will expire in October, as part of a $1.5 billion rebate earlier this year. There are 44 outstanding checks expiring Oct. 3, worth $143,241, BWC said. On Friday, Oct. 12, 665 checks worth more than $2.2 million will expire, followed by 782 checks worth more than $1.5 million on Tuesday, Oct. 16; 1,291 checks worth more than $2.4 million on Thursday, Oct. 18; 1,611 checks worth more than $3 million on Monday, Oct. 22; and 1,154 checks worth more than $1.5 million on Wednesday, Oct. 24.

Should you miss your deadline, the BWC says they will reissue the checks but will further delay your access to the rebates.  BWC Chief of Fiscal and Planning Barbara Ingram shared this quote on their website,  “Employers can spend their rebates as they choose, whether that means hiring new employees, growing their business or investing in safety. They just need to get those checks to the bank quickly so they can begin putting their rebates to good use.”

Read more about the rebate checks and the upcoming deadlines on the Ohio BWC website at this link: goo.gl/NCxjfT



The dangers of waiting to ask your accountant that important question

By: Linda Lehman, Senior Assistant Accountant

Your business is constantly evolving; and with that comes changes to business practices, along with laws & regulations.  Maybe it’s starting a new product or service, a change in ownership, or an employee with an unusual withholding.

You are busy, and may decide to handle the situation the best you can to get by for now.  “I’ll make a note and then ask Holbrook & Manter about it at tax time.  I don’t want to spend the time or money on it right now”. 

Without realizing it, a year or more could pass between the time of the event in question, and meeting with us to prepare your return.  In that time frame, you may have been consistently mis-handling the issue for quite a long period.  Meanwhile, important deadlines may have passed which could cause penalties or prevent you from qualifying for certain opportunities.  It also takes extra time (and money) to correct the issue back to the time of the initial event-if it’s possible to do so.  By not addressing the issue immediately it could negatively impact relationships with clients, vendors, or employees.

Consider this hypothetical scenario:

Client XYZ met with Holbrook & Manter staff members recently to finalize their 2017 tax return.  When asked for copies of W2s issued to employees, we were told the individuals were contractors, not on payroll and therefore had no taxes withheld.  Further discussion with XYZ determined the individuals were, in fact, employees as defined by the IRS.  At this point the individuals had been misclassified for over a year, and in all likelihood, had filed their personal returns for 2017 without the proper W2.

Holbrook & Manter was able to help correct the errors, but it was costly for the client – penalties & interest were assessed, not to mention the professional fees incurred.  It created conflicts with upset employees who may have had to amend their personal returns, and incur penalties & interest of their own. 

At one point during the process of correcting the various issues this created, the client commented that they wondered if they were handling these individuals correctly when first bringing them on board.  Had they taken a few minutes to ask our advice before heading down the wrong path, a lot of time, money, and aggravation would have been avoided.  

 The best time to ask a question, or obtain advice, is NOW!

 Take a few minutes to give us a call or send an email with your question.  We can advise you on the proper course of action so the issue is handled appropriately.   

ESOPs Present Tax and Other Benefits

Wouldn’t it be great if your employees worked as if they owned the company? An employee stock ownership plan (ESOP) could make that a reality.

Under an ESOP, employee participants take part ownership of the business through a retirement savings arrangement. Meanwhile, the business and its existing owner(s) can benefit from some tax breaks, an extra-motivated workforce and potentially a smoother path for succession planning.

How ESOPs work

To implement an ESOP, you establish a trust fund and either:

  • Contribute shares of stock or money to buy the stock (an “unleveraged” ESOP), or
  • Borrow funds to initially buy the stock, and then contribute cash to the plan to enable it to repay the loan (a “leveraged” ESOP).

The shares in the trust are allocated to individual employees’ accounts, often using a formula based on their respective compensation. The business must formally adopt the plan and submit plan documents to the IRS, along with certain forms.

Tax impact

Among the biggest benefits of an ESOP is that contributions to qualified retirement plans such as ESOPs typically are tax-deductible for employers. However, employer contributions to all defined contribution plans, including ESOPs, are generally limited to 25% of covered payroll. But C corporations with leveraged ESOPs can deduct contributions used to pay interest on the loans. That is, the interest isn’t counted toward the 25% limit.

Dividends paid on ESOP stock passed through to employees or used to repay an ESOP loan may be tax-deductible for C corporations, so long as they’re reasonable. Dividends voluntarily reinvested by employees in company stock in the ESOP also are usually deductible by the business. (Employees, however, should review the tax implications of dividends.)

In another potential benefit, shareholders in some closely held C corporations can sell stock to the ESOP and defer federal income taxes on any gains from the sale, with several stipulations. One is that the ESOP must own at least 30% of the company’s stock immediately after the sale. In addition, the sellers must reinvest the proceeds (or an equivalent amount) in qualified replacement property securities of domestic operation corporations within a set period.

Finally, when a business owner is ready to retire or otherwise depart the company, the business can make tax-deductible contributions to the ESOP to buy out the departing owner’s shares or have the ESOP borrow money to buy the shares.

Risks to consider

An ESOP’s tax impact for entity types other than C corporations varies somewhat from what we’ve discussed here. And while an ESOP offers many potential benefits, it also presents risks such as complexity of setup and administration and a strain on cash flow in some situations. For help determining whether one may make sense for your business, contact Holbrook & Manter today. 

Ohio Residency Changes for Tax Purposes

By: David J. Herbe Jr., CPA, MAcc- Tax Manager

The state of Ohio has issued an information release in regards to a change in the way they look at residency of a taxpayer. This is effective for tax years starting January 1, 2018. Below is a list of criteria that must be met to be considered a nonresident of Ohio. 

Providing irrebutable presumption that the taxpayer is of non-Ohio domicile (essentially the burden of proof to provide the state that the taxpayer is a nonresident).

All four criteria must be met:

1.       The individual(s) did not change their residence in or out of Ohio for the taxable year

2.       The individual files a statement with the state of Ohio that claims

          a.       They had less than 212 contact periods with Ohio for the taxable year

                       i.      A contact period is a time period of consecutive days when a resident stays overnight in Ohio away from their non-Ohio home. i.e. John was in Ohio Monday and Tuesday  this would be considered a contact period (one period). If John was in Ohio Monday and then left and came back to Ohio this would not be considered a contact period he is not staying overnight.

          b.      The individual has a home outside the state of Ohio for the full tax year

          c.       The individual doesn’t hold a driver’s license

          d.      The homestead exemption and/or owner-occupancy property tax was not claimed

3.       The statement can’t be false or misleading regarding the requirement above

4.       The statement must be filed on or before October 15th.

 One of the biggest changes that we found is the due date for the affidavit to be filed with the state of Ohio. The due date in prior years was May 30th; it has now changed to October 15th.

This will mostly apply to individuals who filed their tax return in Ohio as a resident last year but this year plan to file as a non-resident. It will also apply to individuals who have a home and spend a good chunk of time in Ohio but do not actually file or plan to file a tax return because they have no income sourced in the state. Really if there is believed to be a change in residency status that will raise any red flags with the Ohio Department of Taxation it may make sense to file the affidavit statement. It is a quick one page form that can be filed with the state department.

Should any questions arise concerning these new changes, Holbrook & Manter has plenty of experience in this area and would be glad to help!

Changes to the Home Mortgage Interest Deduction

A home is the most valuable asset many people own. So, it’s important to remain aware of the tax impact of homeownership and to carefully track the debt you incur to buy, build or improve your home — known as “acquisition indebtedness.”

Among the biggest tax perks of buying a home is the ability to deduct your mortgage interest payments. But this deduction has undergone some changes recently, so you may need to do some catching up.

Before the passage of the Tax Cuts and Jobs Act (TCJA) late last year, a taxpayer could deduct the interest on up to $1 million in acquisition indebtedness on a principal residence and a second home. And this still holds true for mortgage debt incurred before December 15, 2017. But the TCJA tightens limits on the itemized deduction otherwise.

Specifically, for 2018 to 2025, it generally allows a taxpayer to deduct interest only on mortgage debt of up to $750,000. The new law also generally suspends the deduction for interest on home equity debt: For 2018 to 2025, taxpayers can’t claim deductions for such interest, unless the proceeds are used to buy, build or substantially improve the taxpayer’s principal or second home.

Step carefully if you own a second residence and use it as a rental. For a home to qualify as a second home for tax purposes, its owner(s) must use it for more than 14 days or greater than 10% of the number days it’s rented out at fair market value (whichever is more). Failure to meet these qualifications means the home is subject to different tax rules.

Please contact Holbrook & Manter for assistance in properly deducting mortgage interest, as well as fully understanding how the TCJA has impacted other aspects of personal tax planning.

Should you Adjust your Estimated Tax Payments?

Bryan Davidson, CPA- Tax Manager

Have you switched jobs in the past year?  Did you start a business? Do you own interest in a pass-through entity?  These are all scenarios that you should consider when making your 3rd and 4th quarter tax estimates.  In addition to these individual specific situations taxpayers also need to consider the 2017 Tax Cuts and Jobs Act.  This legislation drastically overhauled the tax code for the first time in decades.  Many of the changes will directly impact your tax situation for 2018. 

Some of the highlights include:

1.       New income tax rates and brackets

2.       Standard deduction increased

3.       Personal exemptions suspended

4.       Child tax credit increased

5.       State and local (Sch A) deduction limited

6.       Miscellaneous itemized deductions suspended

7.       Domestic production activities deduction repealed

8.       New deduction for pass-through income

When you combine the individual specific changes and the tax law changes there’s a lot of room for adjustments. 

The typical tests that are applied when looking at estimated taxes (and underpayment penalties) are exception 1 and 2.  Exception 1 states you need to have 100% of your prior year tax paid in through either withholding or timely estimates.  If your AGI in the prior year was greater than $150,000 then you need 110% of your prior year tax paid in.  Exception 2 states you need 90% of your current year tax paid in through either withholding or timely estimates.  If you’re currently paying quarterly estimates it may be worth reviewing since the above mentioned items can both increase and decrease your overall taxes. Contact Holbrook & Manter today for assistance with this matter. We would be happy to assist you.