The new revenue recognition standard doesn’t only affect publicly traded corporations and large privately held companies. It could have an impact on small businesses, particularly if they hope to obtain bank loans next year.
Some small businesses may find that because of the standard that takes effect for private companies next year, they will need to recognize revenue later than before. That means they could need larger loans than previously planned or they could fall short on loan repayments. While some financial institutions might be willing to amend the terms of a loan to increase lending limits or adjust payments, others might not be as flexible. For many small businesses, falling short on cash because of inadequate loans could have major consequences for growth, including the ability to pay their suppliers, as well as offer performance-based incentives such as bonuses and hire new employees.
“Private companies are starting to realize is it’s not business as usual,” said Mark Davis, national managing partner of Deloitte Private Enterprises. “When you’re dealing with a bank or a lender, whether it’s a commercial bank or a private lender, they’re in the business of looking to invest their dollars through a loan. They generally have confidence in what they’re receiving, and they build that level of integrity and confidence by their interactions with the company. The standard is very complicated, and one of the things that we recommend to our clients that either have a loan or plan to get a loan is that the banks are going to be looking for a level of confidence and comfort in what they’re getting from the company. They want to see that things are under control. They want to see that they have this standard understood, and they can explain to the bank or the lender what the impacts would be, whether that be on the current loan that they have or on a potential loan that they would look to get.”
Davis believes banks are going to want to know how their small business clients are implementing the revenue recognition standard.
“I think the bank will certainly have an interest in understanding how a company is dealing with it, whether they have it under control, whether they’ve evaluated it, whether they’ve hired somebody to do it for them,” he said. “If you’re looking to obtain a loan, I think that would be part of the conversation. They’re relying on what you give them from the financial statements. Many loans have financial covenants. That’s where the nuances of the standard can have an impact. The issue of covenants and whether you’re in compliance with them currently and will remain in compliance with them after the new standard is a big issue if you have a loan today. If you’re looking to enter into a new loan with somebody, it’s the same thing — how will those covenants be impacted by the new standard?”
Many banks will soon be dealing with another new accounting standard on current expected credit losses, also known as the CECL standard, but the revenue recognition standard is more likely to have an impact on small businesses that rely on bank loans. While small businesses like a mom-and-pop corner grocery probably won’t have to worry much about accounting standards, startup businesses in the technology industry could be facing some concerns.
“I think the standard affects companies more in certain industries than others, and certain businesses than others, like technology or media companies or companies that have long-term contracts or long-term construction contracts,” said Davis. “They’ll be affected whether they’re public or private. We’ve seen in the retail consumer business space much less of an impact in that space, but it really depends on the industry. Each industry has different issues that are affected by the standard. It really has less to do with public vs. private, big vs. small, and I think that’s why private companies have tended to wait to deal with it, because they’re of the view that it probably applies to public companies and may not affect them, when it reality it has nothing to do with public or private. It has more to do with the type of company.”
Startup companies that hope to go public eventually will need to be sure they can secure funding and their revenue recognition accounting is in order.
“If you look at a technology company that hypothetically is an emerging company looking to go public in a couple of years, and they do, say, software as service, hypothetically it could have an impact,” said Davis. “Let’s say they were recording revenue ratably over a period of time, over the life of the contract. Now they might have a different outcome. Let’s say someone had a $10 million two-year contract with a customer, and they were recording that revenue ratably over a two-year period. In each year they would have $5 million of revenue reflected in their financial statements. Let’s say they had covenants that were tied to that. Let’s say they had a revenue covenant in their debt agreement, and let’s say they had an EBITDA [earnings before interest, taxes, depreciation and amortization] covenant, both tied to that expectation of revenue being earned evenly. Now all of a sudden for whatever reason, let’s say a majority of that number doesn’t get recorded until that contract ends, so they may not achieve the revenue target and they may not achieve the EBITDA target, and they would have to go back to the bank in early ’19 to say, ‘We may not make our covenant.’ I would say a significant percentage of the time, a bank would say, ‘Yeah, we expected that. Let’s take a look at it and we’ll adjust the covenant and it won’t be a problem.’”
Deloitte advises clients to be aware of the potential things that could go wrong with loans and debt covenants for small businesses.
“I tell clients that banks go through changes. They go through oversight changes, they go through leadership changes, they go in and out of different industries at different times, and they also look at a company when they get a chance to look,” said Davis. “Let’s say your business isn’t doing as well today as it was when you first got the loan. Or they say, ‘We’re not interested in that space any longer. We’re going to go in a different direction.’ All of a sudden, getting that covenant waived could get more complicated, and you might not get that covenant waived. We’ve been alerting our clients to that issue and why it’s become so important, regardless of whether it’s public or private.”
The new standard could also have an impact on whether companies can provide bonuses to employees and hire new workers.
“Cash is driven by the payment schedule in the contract, so you could potentially be getting the cash all throughout the contract, but with revenue recognition you don’t get to record it in the same manner,” said Davis. “If you go back to the example I gave you, maybe now half of the revenue would have to be deferred and recorded when the contract ends. So you’ve got the cash. It’s not a cash flow problem. It’s not a cash issue. It’s a financial statement, and it’s a reflection of the strength of the business from an income statement standpoint. So could it affect bonuses? Yes.”
The revenue recognition standard is a complex one for many small businesses to handle, and many of them will be turning to their accountants for help. “Another thing we’ve told people as to why this standard is more complicated than others is it’s a very far-reaching standard,” said Davis. “It goes outside of finance. It could touch human resources. It could touch your sales force. If your sales force is used to getting bonuses based on revenue earnings, and if now they have to wait two years to get their commission, a salesperson could be upset about that. There are so many facets that get impacted because lots of these things are tied to the financial statements: revenue or EBITDA. Bonuses could change. It’s really the timing of these things, the timing of when a bonus would occur. It could change. It’s not that the person will never get it. It’s that they may not get it the way they’ve been used to getting it. That gets people upset. Generally they don’t necessarily understand.”
Tax reform’s dizzying array of changes seemed to confuse preparers, lawmakers and the IRS alike. But amid all the new laws, which one stands out to clients?
As with the Tax Cuts and Jobs Act itself, answers can vary widely.
“Many are concerned with the non-deductibility of unreimbursed employee business expenses, along with other expenses that were subject to the 2 percent [AGI rule],” said Chris Hardy, an Enrolled Agent at Georgia-based Paramount Tax and Accounting.
“For individuals, it’s the lack of exemptions and particularly how that will affect taxpayers such as college students whom parents would normally claim but [who] still need to file their own return,” said EA Laurie Ziegler at Sass Accounting in Saukville, Wisconsin.
Burbank, California, CPA Brian Stoner finds clients chiefly concerned about two things. First, SALT limitations: “In California, almost every homeowner has way, way over $10,000 in real estate, state income taxes and personal property taxes,” he said.
And second, personal exemptions: “Especially if they have two or three dependents,” Stoner said, “but many will qualify for the Child Tax Credit because of a much higher income limitation or family credit on a lot of the dependents – so I have some good news for them.”
Client professions key
Many of Stoner’s clients are also in entertainment, paid by some of the large entertainment payroll companies. “Some are going to lose $30,000 to $60,000 in itemized [deductions] because unreimbursed employee business expenses are no longer deductible, plus financial advisor and tax preparation fees are also not deductible,” he said. “Many entertainment clients are looking into forming corporations as production companies to continue to deduct many of these expenses.
New York EA Phyllis Jo Kubey likewise has many clients in the performing arts. “While they’re freelancers, because of union contracts with many venues they’re treated as employees for some work, receiving a W-2, and as independent contractors, receiving a 1099-Misc for other work,” Kubey said. “Since they’re doing the same thing, they’re tremendously confused about what’s an employee business expense – no longer deductible under TCJA – and what’s a business expense related to their [self-employed] income [that is] deductible under TCJA.”
Another wrinkle: Some clients think that they can deduct nothing anymore. “I have to keep reminding them what is and isn’t deductible for 2018,” Kubey said. “My clients are also confused, even with detailed explanations and 2018 tax projection worksheets I’ve provided, about whether they’ll still itemize deductions.” In New York City, where real estate carrying costs are dizzying, “even with the SALT limitation many will still itemize their deductions on what used to be Schedule A,” Kubey said.
Another major confusion for clients remains one pivotal detail of reform’s pass-through income deduction. “Lots of clients have expressed concern and confusion with the new 199A deduction,” said Jake Alexander, an EA and owner of Alexander Financial in Largo, Florida. “There’s been a lot of confusion for them establishing who qualifies for it, what it means if they do and how it will affect them.”
“Certainly for my small businesses, it’s 199A,” Ziegler added. “There are so many questions about how it works and who it includes, especially in light of the exclusion for certain professions.”
Recently proposed regs do attempt to narrow the scope of service businesses ineligible for the deduction. “Ineligible consulting business” has been limited to businesses that provide advice and counsel, for example. Experts say tricky areas remain when an activity rises to the level of a trade or business, and possibly banking when banks provide multiple services beyond lending and paying interest on deposits.
John Dundon, an EA and president of Taxpayer Advocacy Services in Englewood, Colorado, sees the most questions over the definition of a “specified service, trade or business,” which is key to the new pass-through income deduction. “The proposed regulations are less than fully clear, and many industries are not addressed or incompletely addressed,” he said. “As an example, the practice of law is deemed to be an SSTB, but what if all the lawyer did was trust administration, work that does not require a law degree? Is that lawyer performing duties [that are] an SSTB? Many think not.”
Post-reform, no matter their questions, “clients will need a lot of hand-holding from their tax pros as we go into the 2019 filing season for 2018 returns,” Kubey said.
The Internal Revenue Service released guidance Wednesday on the business expense deduction for meals and entertainment in the wake of the Tax Cuts and Jobs Act, which was supposed to eliminate deductions for expenses pertaining to activities generally considered entertainment, amusement or recreation.
The IRS said taxpayers can still deduct 50 percent of the cost of business meals if the taxpayer (or an employee of the business) is present at the meal, and the food or beverages aren’t considered to be “lavish or extravagant.” The meals can involve a current or potential business customer, client, consultant or a similar business contact. Food and beverages provided during entertainment events won’t be considered entertainment if they’re bought separately from the event.
Before 2018, a business was able to deduct up to 50 percent of entertainment expenses directly related to the active conduct of a trade or business or, if they’re incurred immediately before or after a bona fide business discussion, associated with the active conduct of a trade or business. That changed, however, with the passage of the tax code overhaul last December.
Section 274 of the tax code now generally disallows a deduction for expenses with respect to entertainment, amusement or recreation after passage of the new tax law. However, the Tax Cuts and Jobs Act doesn’t specifically address the deductibility of expenses for business meals.
The Treasury Department and the IRS plan to publish proposed regulations that will clarify exactly when business meal expenses are deductible and what constitutes entertainment. Until those proposed regulations take effect, taxpayers can rely on guidance in Notice 2018-76, which the IRS issued Wednesday in conjunction with the announcement.
Although the White House now acknowledges that Republicans will not be able to pass a second round of tax cuts before the midterm elections, House Speaker Paul Ryan has promised a vote on so-called Tax Reform 2.0 before then. But even if the politics are unsettled, the policy shouldn’t be.
Whether Tax Reform 2.0 is the first salvo in a protracted battle over tax policy or just an election-year gambit, this is a debate that cannot be avoided. New legislation will have to be passed to make many aspects of last year’s Tax Cuts and Jobs Act permanent. (The sunset provision, under which many features of the law change or expire in several years, was a gimmick designed to lower its impact on the budget deficit.)
The Tax Cuts and Jobs Act contained three essential elements, two of which substantially strengthened the U.S. Tax Code and should be made permanent under any reform. The third one did not and should not.
The first two elements are the changes to the corporate and individual tax codes. America’s corporate tax rate is now commensurate with those of America’s economic peers, making the U.S. more competitive globally, and a change in the expensing of capital purchases will encourage investment. The individual code, meanwhile, has been simplified, and an increase in the standard deduction is essentially a tax cut for millions of Americans.
Together these two elements give U.S. businesses and taxpayers stronger incentives to save and invest. If made permanent, the Tax Foundation estimated last year, they could increase the total amount of capital invested in the U.S. economy by 12 percent.
The third element is the creation of a major new loophole in the form of large deductions for what are known as pass-through entities. These are essentially business structures, such as limited-liability corporations, that allow the owners to avoid paying corporate taxes and instead have their corporate profits added to their individual tax liability.
This kind of structure makes sense for sole proprietorships and other small businesses. Increasingly, however, driven in part by the U.S.’s relatively high corporate tax rate, it had been used by midsized and large businesses. Part of the rationale for lowering the corporate rate was to remove some incentive to form pass-through entities.
Unfortunately, the Tax Cut and Jobs Act also created a whole new incentive to classify a business this way. Under the law, an individual can claim a 20 percent tax deduction for any income classified as business income. That means high earners such as celebrities, financial professionals and surgeons have an incentive to form LLCs and claim this deduction, even when their services more closely resemble those of an employee rather than an entrepreneur.
It’s not as if members of Congress couldn’t have seen this coming. When Kansas included a similar loophole in its tax reform in 2012, it saw a 20 percent increase in the number of pass-through entities. This led to a $300 million decline in revenue, and Kansas officials essentially rescinded their tax reform in 2017.
Lowering marginal tax rates and encouraging investment are worthwhile goals. But the creation of a large pass-through deduction undermines those efforts, creating a tax loophole that is largely unavailable to middle-class taxpayers. It narrows the tax base, reduces long-term revenue projections and undermines the efficiency gains from the reform if the individual tax code.
As members of Congress consider tax reform — regardless of whether they actually vote on it — they should keep these larger goals in mind: reduce complexity and encourage economic growth. The pass-through deduction does neither.
U.S. companies anxiously awaiting guidance on how hard they’ll be hit by a new foreign levy in the tax overhaul will have to stay tuned for at least another two months.
The Internal Revenue Service proposed regulations on Thursday spanning 157 pages that provide some details on which assets are subject to the tax on GILTI, or global intangible low-tax income, and how to calculate it. But one of the most pressing questions — to what extent multinational companies can use foreign tax credits and business expenses to offset the levy — remained unanswered.
“It’s a very big deal that the FTC and expense allocation issues have been left out,” said Andrew Silverman, a Bloomberg Intelligence analyst who focuses on tax policy. The regulations are “not a great answer for companies who are essentially left in limbo.”
The rules provide a starting point for how to calculate what they owe, but without the additional information companies still won’t be able to get to a level of comfort to complete tax returns and file documents with the Securities and Exchange Commission, Silverman said.
Corporations don’t want to underestimate their GILTI liability because they could be hit with a penalty if they pay too little in their quarterly tax installments to the IRS. The deadline for two portions has already passed and the next payment is due Sept. 15. Treasury officials said during a call with reporters Thursday that the additional guidance will be coming in about 60 days.
The Republican tax overhaul slashed the corporate rate to 21 percent from 35 percent, and shifted the U.S. to a system of taxing its companies on their domestic profits only. Those changes required guardrails — like the tax on GILTI — to ensure multinationals pay at least something on their future overseas profits.
The piecemeal guidance process, and the lack of understanding about the ultimate amount of tax that will be paid until all the parts are finalized, underscore the complexity of the tax law’s international provisions.
Tax advisers have been modeling the effects of the new law for their multinational clients, but because many of the new provisions are interconnected, and implementation may be governed by old tax regulations still on the books, they’re only able to estimate the amount of tax due.
That’s been a frustration for many publicly traded companies and their investors, who are anxious to understand how the new tax law affects them.
Companies are hesitant to record a tax hit for GILTI that they don’t think they should pay, so they’re waiting for the clarification in the regulations, said Brent Felten, managing director of international tax at accounting firm Crowe.
Still, Thursday’s regulations signal some good news could be ahead for multinationals. The rules indicate that companies can “gross up” their foreign income by the amount of foreign tax paid, a move that would result in a lower GILTI bill, said Mitch Thompson, a tax partner at Squire Patton Boggs.
“It’s taxpayer friendly,” Thompson said.
The GILTI levy effectively sets a 10.5 percent rate to apply to a company’s “excess” profits earned overseas through some of its foreign subsidiaries.
GILTI was intended to prod American technology and pharmaceutical companies into holding their valuable intellectual properties in the U.S. Currently, many hold their patents in subsidiaries in Ireland or other low-tax countries. The tax is intended to apply only in cases where a company’s cumulative overseas tax bill is below 13.125 percent, or 16.4 percent after 2025.
However, tax lawyers and accountants say quirks in the way the tax is calculated mean it will likely hit other companies, such as big banks with offshore operations, even when they already pay effective foreign tax rates above the threshold.
Bank lobbyists have urged the Treasury to come up with a fix that would lessen the pain from GILTI, saying an adjustment is needed to make the tax consistent with the intent of Republican lawmakers who wrote the legislation.
Pass-through entities such as partnerships and limited liability companies could fare even worse than corporations under the GILTI tax, but they won’t want to restructure their business without knowing how the foreign tax credit guidance will work, said David Shapiro, a partner at the law firm Saul Ewing Arnstein & Lehr.
That could create a rush of companies looking to reform as corporations after the regulations come out and before the end of 2018, Shapiro said.
Even after all of the GILTI questions are answered, companies will still be trying to figure out how they fare under the new international tax regime.
Treasury officials have said they plan to issue proposed regulations later this year on the other two major international provisions in the tax overhaul — a tax break encouraging companies to export U.S.-made goods, known as the foreign derived intangible income deduction, and the base-erosion and anti-abuse tax on payments corporations make to foreign subsidiaries.
The need to pay estimated taxes before receiving guidance has already caused headaches for some corporations that overpaid their repatriation taxes on profits accrued offshore since 1986. Some companies had overpaid to avoid penalties and were hoping for a refund. Instead, the IRS said in August it wouldn’t send the excess funds back and would apply them to a future installment of the repatriation tax bill.
“The more guidance you get from IRS and Treasury, the better, and the sooner you get it the better,” said Joe Calianno, a tax partner and international technical tax practice leader in BDO’s Washington office.
Despite the widespread belief that small businesses are a target for IRS audits, nearly a third of small-business owners think they overpay their taxes, according to a survey by B2B research firm Clutch of over 300 small-business owners and managers.
“If they think they’re paying too much, they’re questioning the accuracy of their tax return,” said Roger Harris, president of Padgett Business Services. “They’re somehow missing a deduction, or there are parts of the code they just don’t know about. If a business owner did their own accounting and bought a piece of equipment in October 2017, what’s the chance they knew the rules for the new 100 percent bonus depreciation?”
The small businesses in the survey listed unforeseen expenses (35 percent) as their top financial challenge, followed by the mixing of business and personal finances (23 percent) and the inability to receive payments on time (21 percent). Clerical errors in financial records, and outdated financial records, were both listed by 11 percent of respondents.
The majority of small businesses in the survey said they use the accrual method for tracking finances, although the smallest businesses, with fewer than 10 employees, were more likely to use the cash basis method.
“Actually, use of the cash method versus the accrual method has nothing to do with number of employees but with revenue,” said Harris. “In fact, the Tax Cuts and Jobs Act increased the ability to use the cash method for businesses with up to $25 million in annual revenue. Cash accounting is available to many businesses, and many small businesses prefer it because it’s simpler. They like taxable income to track as closely as possible to their checkbooks. In fact, most of our clients would be happy with a simple profit and loss financial statement: Money in minus money out equals money left, or what some of them call ‘my money.’”
“But the accrual method creates expenses that sometimes aren’t yet paid and sometimes defers costs that are already paid, and defers them into the future,” he continued. “In that case, taxable income can vary dramatically from using the cash method.”
“The cash method is easier for everyone to understand,” he said. “Money in is income, money out is expense, and what’s left is your money, which is what you pay taxes on.”
Most use a hybrid method — accrual for income because they have inventories, and cash for expenses, according to Harris.
“If I asked what method of accounting they use, most small-business owners would just stare at me,” Harris said. “But if I explained it to them and they made a pick, most would choose cash. I would be stunned if I asked a small-business owner without giving a choice, and anyone said ‘accrual.’ Most of them wouldn’t even know the term. If you go to the coffee shop in your building and ask the owner what method they use, they won’t know what you’re talking about.”
“In a classroom or to an accountant, the accrual method is favored,” said Harris. “But in the eyes of most owners, if they don’t have the money it’s not income, and if they haven’t paid money, it’s not an expense.”
Surprisingly, the survey found that more than a quarter — 27 percent — of small-business owners and managers said they do not have a separate bank account for their business. Naturally, established businesses are more likely to have separate bank accounts than start-ups. Nearly 80 percent of small-business owners of five years or more said they have separate accounts, compared to 68 percent of small-business owners of two years or less.
Source: accountingtoday.com Written by: R. Russell
The Internal Revenue Service and the Treasury Department said Wednesday that payments under state or local tax credit programs may be deductible as business expenses, permitting a workaround for businesses to the $10,000 limit on state and local tax deductions in the Tax Cuts and Jobs Act.
However, the IRS and Treasury are still not giving individual taxpayers the ability to make charitable contributions to state-run funds as a way to circumvent the limits on the SALT deduction in the new tax law. Last month, they issued proposed regulations aimed at stopping blue states like New York, New Jersey and Connecticut that have authorized such funds, and other high-tax states that have been considering them (see IRS moves to block New York, New Jersey plans to bypass SALT deduction cap). But they left open the possibility of allowing business taxpayers to use them (see IRS short-circuits SALT deduction charitable workarounds to new tax law, but leaves others open for now). Connecticut started such a program earlier this year, and New York is considering one (see Some high-tax states aim to provide businesses workaround for SALT limits).
The IRS said Wednesday that business taxpayers who make business-related payments to charities or government entities for which the taxpayers receive state or local tax credits can generally deduct the payments as business expenses, but it has to qualify as an ordinary and necessary business expense. In response to inquiries from taxpayers, the IRS clarified that the general deductibility rule is unaffected by the recent notice of proposed rulemaking concerning the availability of a charitable contribution deduction for contributions pursuant to such programs.
“The business expense deduction is available to any business taxpayer, regardless of whether it is doing business as a sole proprietor, partnership or corporation, as long as the payment qualifies as an ordinary and necessary business expense,” said the IRS. “Therefore, businesses generally can still deduct business-related payments in full as a business expense on their federal income tax return.”
The Treasury issued similar reassurance on Wednesday.
“The IRS clarification makes clear that the longstanding rule allowing businesses to deduct payments to charities as business expenses remains unchanged under the Tax Cuts and Jobs Act,” said Treasury Secretary Steven T. Mnuchin in a statement. “The recent proposed rule concerning the cap on state and local tax deductions has no impact on federal tax benefits for business-related donations to school choice programs.”
The clarification won't affect corporations, which aren't subject to the $10,000 limit on state and local tax deductions in the new tax law, but it would apply to pass-through entities such as partnerships.