Acuity Advisors

Do you know the tax implications of your C corp.’s buy-sell agreement?

Private companies with more than one owner should have a buy-sell agreement to spell out how ownership shares will change hands should an owner depart. For businesses structured as C corporations, the agreements also have significant tax implications that are important to understand.

Buy-sell basics

A buy-sell agreement sets up parameters for the transfer of ownership interests following stated “triggering events,” such as an owner’s death or long-term disability, loss of license or other legal incapacitation, retirement, bankruptcy, or divorce. The agreement typically will also specify how the purchase price for the departing owner’s shares will be determined, such as by stating the valuation method to be used.

Another key issue a buy-sell agreement addresses is funding. In many cases, business owners don’t have the cash readily available to buy out a departing owner. So insurance is commonly used to fund these agreements. And this is where different types of agreements — which can lead to tax issues for C corporations — come into play.

Under a cross-purchase agreement, each owner buys life or disability insurance (or both) that covers the other owners, and the owners use the proceeds to purchase the departing owner’s shares. Under a redemption agreement, the company buys the insurance and, when an owner exits the business, buys his or her shares.

Sometimes a hybrid agreement is used that combines aspects of both approaches. It may stipulate that the company gets the first opportunity to redeem ownership shares and that, if the company is unable to buy the shares, the remaining owners are then responsible for doing so. Alternatively, the owners may have the first opportunity to buy the shares.

C corp. tax consequences

A C corp. with a redemption agreement funded by life insurance can face adverse tax consequences. First, receipt of insurance proceeds could trigger corporate alternative minimum tax.

Second, the value of the remaining owners’ shares will probably rise without increasing their basis. This, in turn, could drive up their tax liability if they later sell their shares.

Heightened liability for the corporate alternative minimum tax is generally unavoidable under these circumstances. But you may be able to manage the second problem by revising your buy-sell as a cross-purchase agreement. Under this approach, owners will buy additional shares themselves — increasing their basis.

Naturally, there are downsides. If owners are required to buy a departing owner’s shares, but the company redeems the shares instead, the IRS may characterize the purchase as a taxable dividend. Your business may be able to mitigate this risk by crafting a hybrid agreement that names the corporation as a party to the transaction and allows the remaining owners to buy back the shares without requiring them to do so.

For more information on the tax ramifications of buy-sell agreements, contact us. And if your business doesn’t have a buy-sell in place yet, we can help you figure out which type of funding method will best meet your needs while minimizing any negative tax consequences.

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Measuring “fair value” for financial reporting purposes

The balance sheet usually reflects the historic cost of assets and liabilities. But certain items must be reported at “fair value” under U.S. Generally Accepted Accounting Principles (GAAP). Here’s a closer look at what fair value is and which balance sheet accounts it affects.

Fair value vs. fair market value

Accounting Standards Codification (ASC) Topic 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition is similar in many respects to “fair market value,” which is defined in IRS Revenue Ruling 59-60.

The main difference is that fair market value focuses on the universe of hypothetical buyers and sellers. Conversely, FASB uses the term “market participants,” which refers to buyers and sellers in the asset’s or liability’s principal market. The principal market is entity specific and may vary among companies.

Hierarchy of value

Under ASC Topic 820, fair value is most often associated with business combinations and subsequent accounting for goodwill and other intangibles after the deal closes. Other examples of items that are reported at fair value include:

Impairment or disposals of long-lived assets,
Asset retirement or environmental obligations,
Stock compensation, and
Certain financial assets and liabilities.

When measuring fair value, the FASB provides a hierarchy of methods that may not necessarily apply to valuations performed for other purposes. GAAP gives top priority to market-based methods, such as quoted prices in active markets for identical assets or liabilities.

When market data isn’t readily available for a specific company, GAAP looks to quoted prices in active markets for similar assets or liabilities — in other words, comparable public stock prices or sales of controlling interests in comparable companies. The least desirable level of inputs under GAAP is unobservable data, such as cash flow or cost estimates prepared by management (which may be used to estimate value under the income or cost approach).

Changes in value

Decreases in the fair value of an asset (or increases in the fair value of a liability) may result from, say, poor company performance, changes in economic conditions and inaccurate estimates made in the past. Companies aren’t allowed to overstate the value of assets (or understate the value of a liability) under GAAP, so changes in fair value may lead to write-offs or restatements.

Outside expertise

Auditors are specifically prohibited from providing valuation services for their public audit clients. Private companies may follow suit to prevent independence issues during audits. So, companies often turn to valuation experts who are independent from their auditors to make fair value estimates — and then their auditors can evaluate whether those estimates appear reasonable. Contact us if you have any questions about fair value, including how it’s estimated or when it applies.

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Bartering may be cash-free, but it’s not tax-free

Bartering might seem like something that happened only in ancient times, but the practice is still common today. And the general definition remains the same: the exchange of goods and services without the exchange of money. Because no cash changes hands in a typical barter transaction, it’s easy to forget about taxes. But, as one might expect, you can’t cut Uncle Sam out of the deal.

A taxing transaction

The IRS generally treats a barter exchange similarly to a transaction involving cash, so you must report as income the fair market value of the products or services you receive. If there are business expenses associated with the transaction, those can be deducted. Any income arising from a bartering arrangement is generally taxable in the year you receive the bartered product or service.

And income tax liability isn’t the only thing you’ll need to consider. Barter activities may also trigger self-employment taxes, employment taxes or an excise tax.

Barter in action

Let’s look at an example. Mike, a painting contractor, requires legal representation for a lawsuit. He engages Maria as legal counsel to represent him during the litigation. Maria charges Mike $6,000 for her work on the case.

Being short of cash, Mike agrees to paint Maria’s office in exchange for her $6,000 fee. Both Mike and Maria must report $6,000 of taxable gross income during the year the exchange takes place. Because Mike and Maria each operate a viable business, they’re entitled to deduct any business expenses resulting from the barter transaction.

Using an exchange company

You may wish to arrange a bartering deal though an exchange company. For a fee, one of these companies can allow you to network with other businesses looking to trade goods and services. For tax purposes, a barter exchange company typically must issue a Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions,” annually to its clients or members.

Although bartering may appear cut and dried, the tax implications can complicate the deal. We can help you assess a bartering arrangement and manage the tax impact.

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Fun fact: Which ancient culture accepted wild animals as tax payment?

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Benchmarking receivables

Accounts receivable represents a major asset for many companies. But how do your company’s receivables compare to others? Here’s the skinny on receivables ratios, including how they’re computed and sources of potential benchmarking data.

Starting point

A logical starting point for evaluating the quality of receivables is the days sales outstanding (DSO) ratio. This represents the average number of days you take to collect money after booking sales. It can be computed by dividing the average accounts receivable balance by annual revenues and then multiplying the result by 365 days.

Companies that are diligent about managing receivables may be rewarded with lower DSO ratios. Those with relatively high DSO ratios may have “stale” receivables on the books. In some cases, these accounts may be overdue by 31 to 90 days — or longer. If more than 20% of receivables are stale, it may indicate lax collection habits, a poor-quality customer base or other serious issues.

The percentage of delinquent accounts is another critical number. You may decide to outsource these accounts to third-party collectors to eliminate the hassles of making collections calls and threatening legal actions to collect what you’re owed.

Potential risks

Accounts receivable also may be a convenient place to hide fraud because of the high volume of transactions involved. When receivables are targeted in a fraud scheme, it’s common for there to be an increase in stale receivables, a higher percentage of write-offs compared to previous periods, or an increase in receivables as a percentage of sales or total assets.

In addition to creating phony invoices or customers, a dishonest worker may engage in lapping scams. This happens when a receivables clerk assigns payments to incorrect accounts to conceal systematic embezzlement. For example, a fraudster might steal Company A’s payment and cover it up by subsequently applying Company B’s payment to Company A’s outstanding balance. Then Company C’s payment is later applied to Company B’s outstanding balance, and so on.

Alternatively, a fraudster may send the customer an inflated invoice and then “skim” the difference after applying the legitimate amount to the customer’s account. Using separate employees for invoicing and recording payments helps reduce the likelihood that skimming will occur, unless two or more employees work together to steal from their employer.

Call for help

Like any valuable asset, accounts receivable needs to be managed and safeguarded. Auditors evaluate receivables as part of their standard auditing procedures, including performing ratio analysis, sending confirmation letters and reconciling bank deposits with customer receipts.

Contact us if you have any concerns regarding receivables midyear or your financial statements aren’t audited. In addition to surprise audits, we can customize an agreed-upon-procedures engagement that zeroes in on receivables.

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