Many dealerships use an inventory accounting method known as LIFO to defer their income tax liabilities. However, using LIFO, which stands for “last in, first out,” requires some additional recordkeeping and may make your dealership appear less profitable to outsiders. So, it’s important to compare the pros and cons before deciding whether to use LIFO or not.
How LIFO Benefits Taxpayers
Manufacturers and retailers often opt for LIFO when they expect the prices of their products to increase regularly each year. The method enables dealerships to count the last vehicles that came onto their lot as the vehicles that were sold first. This contrasts with the “first in, first out” (“FIFO”) accounting method in which the first vehicles that came onto the lot are counted as the vehicles sold first. In addition to being used for new or used vehicles, the LIFO method can be applied to parts and accessories inventory.
Here’s a simplified example of how LIFO works: Suppose that ABC Dealership bought a 2014 vehicle in May for $10,000 and then bought the 2015 model of the same vehicle in October for $11,000. It sells one of these vehicles in November for $14,000.
If the dealership counts the vehicle it bought in May—the one that was “first in”—as the one sold, it would owe income tax on a profit of $4,000. But, if it counts the vehicle it bought in October—the one that was the “last in”—as the one sold, it would owe income tax on a profit of only $3,000.
The tax benefits of LIFO can accumulate, resulting in a LIFO reserve that can become substantial over time. In essence, you get an interest-free loan from the IRS over the length of time that LIFO has been used.
Potential Drawbacks of LIFO
While it might sound like using the LIFO method is a no-brainer for dealerships, some potential drawbacks exist. Perhaps the biggest negative is the fact that, if LIFO is used for income tax purposes, it also must be used for financial statement reporting, and dealerships usually want to increase net income on their financial statements. So publicly held dealerships may not choose LIFO, because they’re typically more financial statement–driven than income tax–driven.
LIFO also might not be the best inventory accounting method to switch to if you’re selling the business in the near future. That’s because the cost of making the LIFO election may not be recouped before you sell.
Another consideration: Upon the sale of a dealership, a dealer on LIFO will be required to recapture into income the amount of the LIFO reserve, if the sale transaction is an asset sale. If the sale transaction is a stock sale, the tax effect on the LIFO reserve is typically accounted for through the purchase price.
As mentioned, LIFO does require some extra work—notably, recording the LIFO reserve in your accounting records and performing annual LIFO valuations. Using LIFO is typically more beneficial when inventory is growing or staying steady. In times of decreasing prices or inventory reductions, LIFO liquidation may occur, and this will eat away at your LIFO reserve. The liquidation may cause your dealership to pay higher taxes in a particular year than it would have under FIFO or other accounting methods.
On the Chopping Block
For many years, there has been talk in Congress about eliminating LIFO. And it will remain an easy revenue-raising target for politicians—especially if Congress takes up serious tax reform.
Although, while it’s still an option, the LIFO inventory accounting method remains an effective tax deferral mechanism for many dealerships. If LIFO is eliminated from the tax code, those implementing this method would likely be permitted to gradually recognize the LIFO reserve as income over several years, rather than taking the hit in a single tax year.
Talk It Over
If you’re contemplating adopting or terminating LIFO, contact your LGT financial advisor. He or she can walk you through the potential benefits and pitfalls of changing your inventory accounting method.
Rather have your questions answered in person? Then join us at our June Controllers’ Roundtable in Galveston, Texas. Register here.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog. To reach a financial advisor at Lane Gorman Trubitt PLLC, call (214) 871.7500 or email email@example.com.
Not all financial statement preparation is the same
Do you know the differences between financial compilations, reviews, and audits? CPAs engage in all three types of financial statement reporting for auto dealerships and other businesses. But each endeavor has its own level of requirements, depth, and outcomes.
It’s important to understand that, depending on the level of assurance selected, CPAs perform procedures of varying degrees of complexity when evaluating a company’s assets, liabilities, revenues, and expenses. Here are descriptions of the three main types of CPA engagements.
Sticking to the Basics
Compilations (or “comps”) rely on data provided by the borrower. As such, the CPA provides no assurance that financial statements are free from material misstatement and conform to GAAP. Instead, the CPA simply reports on management’s financial information in a GAAP financial statement format. Footnote disclosures and cash flow information are optional and are often omitted from comps.
Comps may be appropriate for small or highly profitable dealerships where no outside lender requires a higher level of assurance. Comps also may be desirable for dealers who need assistance organizing their financial data and preparing a financial statement for interested parties such as prospective buyers.
It’s also important to note here that effective for periods ending on or after December 15, 2015, CPAs in public practice may also be engaged to prepare financial statements for a dealership or other company. Similar to a comp, the preparation of financial statements in this manner affords no assurance that the financial statements are free from material misstatement. For more information about this type of service from your CPA, check out SSARS No. 21: Statements on Standards for Accounting and Review Services: Clarification and Recodification published by the American Institute of Certified Public Accountants or get in touch with an adviser at LGT.
Stepping It Up
Next are reviewed financial statements, which provide limited assurance that the statements are free from material misstatement and conform to GAAP. Like comps, reviews are based on internal financial data. Here, the CPA:
- Applies analytical procedures to identify unusual items or trends in the financial statements, and
- Inquires about these anomalies, as well as the company’s accounting policies and procedures.
Reviewed statements must include footnote disclosures and a statement of cash flows. But CPAs aren’t required to evaluate internal controls, verify information with a third party, or physically inspect assets—unless, through their analytics and inquiries, they’re uncomfortable that the numbers are accurate.
Going the Full Nine Yards
An audit provides a reasonable level of assurance that a borrower’s financial statements are free from material misstatement and conform to GAAP. The SEC requires all public companies to have an annual audit. Additionally, privately held dealerships also may require an audit as a part of the lending covenants established within their debt agreements.
Audited financial statements are the only type of report to include an expressed opinion about whether the financial statements are fairly presented in all material respects, in conformity with GAAP (or a special purpose framework).
Beyond the analytical and inquiry steps taken in a review, auditors perform “search and verification” procedures. Among other things, auditors obtain written confirmations for accounts receivable, physically observe year end inventory counts, and randomly test sales transactions by examining contracts and other supporting documents. They also consider the dealership’s internal control over financial reporting and may issue a report on internal control systems along with the audit report.
Although audits provide the highest level of assurance, there are no absolute guarantees against “creative accounting” or inadvertent errors.
Having an audit can provide a dealership with more than a reliable financial statement. Good auditors will share ideas for improving operations that they gathered throughout the audit process. For example, your auditor can help you determine whether a change in inventory accounting methods would be appropriate to help lower your taxes.
Auditors also may share their financial analysis tools. For instance, your auditor may use benchmarks to compare your store’s performance over time and against industry averages. In addition, auditors often use analytics to boost audit efficiency. These metrics can reveal much about your dealership’s strengths and weaknesses.
Making the Decision
A CPA at LGT is ready to discuss with you the purposes you have in preparing your financial statements. Together, you can decide which type of engagement will work best for your dealership. Contact one of our professionals today by sending us an email or giving us a call at (214) 871-7500. Would you rather have your questions answered in person? Join us at our June Controllers’ Roundtable in Galveston, Texas. Register here.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog. To reach a financial advisor at Lane Gorman Trubitt PLLC, call (214) 871.7500 or email firstname.lastname@example.org.
Many dealerships are riding the wave of an improved economy and the booming automobile industry, which experienced a record sales year in 2015. In the midst of these positive developments, however, there’s one potential risk dealerships should be aware of: internal fraud.
Traditionally, many stores have been susceptible to fraud due to their relatively small financial and accounting staffs, the large sums of cash kept on hand, a high volume of transactions, and their highly-marketable inventories. Growing sales and revenue can present even more opportunities for dishonest employees to embezzle funds.
Making Financial Information Timely
One of the best ways to mitigate fraud and embezzlement is to implement a system of strong internal controls. For most dealerships, this starts with making sure that accurate financial information is generated on a timely basis.
All dealership transactions—including vehicle sales, invoice payments, repair orders, and cash receipts—should be posted daily by the accounting department. This will make it easier to detect fraudulent activity early and take steps to stop fraud in its tracks before too much damage is done.
Another crucial internal control is segregating financial and accounting duties among multiple employees. In other words, the same employee shouldn’t make deposits and also reconcile the bank account, or both collect and deposit cash. Without this control, a financial employee could steal cash by voiding vehicle service orders and falsifying deposit slips, for example.
If your accounting staff isn’t large enough to segregate financial tasks, have your CPA firm complete some of these tasks, such as account reconciliation. Also make sure the owner is keeping a close eye on finances by periodically spot-checking the bank statements and other financial records. Even better, send bank statements to the owner’s home instead of to the dealership.
Installing Other Internal Controls
Here are a few more internal controls that can help your dealership mitigate fraud and embezzlement:
Keep an eye on electronic funds transfers (“EFT”s). Thieves are increasingly using wire transfers and ACH transactions to commit fraud, since EFTs can make it easier to hide their tracks. So review these transactions regularly and make sure all EFTs are supported by an invoice or other supporting vendor documentation.
Review adjusting journal entries. These are used by accounting employees to correct original posts. The general manager or owner should approve and sign off on all adjusting journal entries.
Monitor parts inventory. Conduct periodic random counts of vehicle parts throughout the year, rather than just conducting a year-end parts inventory. Also consider setting up cameras in your parts storage area to make it harder for employees to steal items they can then turn around and sell or use themselves.
Create a formal “approved vendor” list. All dealership vendors, from your paintless dent removal specialist to your wholesaler, should be documented on an official vendor list. Then check all disbursements (both paper checks and EFTs) against this list.
Watch out for payroll fraud. Segregate payroll duties (such as preparation, authorization, and disbursement) among multiple employees, and have the controller or general manager review final payroll before it’s disbursed. Also require the payroll clerk to take an annual vacation in which he or she is gone for at least one full payroll cycle.
Kickbacks are another fraud risk about which dealerships should be aware. Here, a used car manager might buy or sell vehicles at a price that’s unfavorable to the dealership and then receive a kickback from the wholesaler. In one instance, a manager was selling used cars wholesale at a loss to the dealership because he was a part owner of the wholesaler!
Testing Your Controls
Once you have implemented internal controls, it’s important that you test them periodically to make sure they’re working as intended. For example, when reviewing bank statements, trace a few transactions all the way back to their origin, and ask the bank for electronic debit and credit memos. If you own multiple stores, have controllers from different locations test the internal controls of one another’s stores.
Also consider establishing a fraud hotline that employees can use to anonymously report suspicions of fraud. Employee tips are one of the most common ways that fraud schemes are uncovered.
Do It Now
Don’t wait until your dealership is victimized to take action. Implement strong internal controls now to help protect against fraud and embezzlement. Your LGT advisor can help your dealership by performing an internal controls assessment and providing industry best practices.
50 Ways to Steal From A Dealership
In its Dealership Internal Control Manual, the National Independent Automobile Dealers Association has published a list of what it calls “50 ways to steal from the dealership.” Among these 50 dealership embezzlement schemes are:
- Stealing body shop and service department supplies to use for off-site repairs or sell for cash
- Inserting fictitious journal entries into dealership records
- Granting business to favored suppliers in exchange for kickbacks
- Not recording repair orders or other sales and pocketing the cash, and
- Paying fake (self-prepared) invoices with dealership funds and pocketing the money.
Implementing sound internal controls is the best protection against these and other fraud schemes. Ask your LGT advisor for help developing controls, if you need assistance.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog. To reach a financial advisor at Lane Gorman Trubitt PLLC, call (214) 871.7500 or email email@example.com.
Young adults entering the workforce may not consider factories and distribution facilities as the most glamorous places to begin a career. But owners of manufacturing companies know firsthand just how rewarding careers in this sector can be, both financially and intellectually. Some have found creative ways to breathe new life into their mature companies by enticing millennials—roughly defined as people born between 1980 and 2000—to join their workforces and take the first step into developing a career in the manufacturing sector.
Offering Value-Added Work Environments
As younger workers tend to have lower salary expectations, the importance and value placed on nonmonetary perks and benefits over cash is a key factor to hiring and retention. In fact, 45 percent of millennials prefer flexible work environments over pay, according to “The Cost of Millennial Retention,” a report published by research and consulting firm Millennial Branding and the career network Beyond.com. They want to choose when and where they work, rather than working traditional 9-to-5 jobs. Many young people also seek careers that provide a sense of personal fulfillment.
Examples of offerings that appeal to millennials include flextime arrangements, mentoring programs, and additional training and licensing opportunities. For example, a millennial worker may be incentivized by a year end bonus program that’s based on developing innovative solutions to lower costs and waste (lean manufacturing) or improve product quality (Six Sigma principles). It is important to regularly listen to the feedback from young workers to stay knowledgeable of what areas are of higher importance, such as wellness programs or flexible working hours.
Stay Ahead Of the Technology Curve
Millennials tend to be more technology savvy and innovative than previous generations, according to executive feedback reported in the 2014 Duke University/CFO Magazine Global Business Outlook Survey. Hiring workers with such attributes can give a manufacturer the creative edge it needs to outmaneuver competitors and stay current with technological advances.
Technology is an important part of the daily life of millennials—and they know how to use it to improve efficiency. Millennials are also likely to try to integrate intuitive devices and online services used in their personal lives into the workplace, such as tablets, video chat, social media, and cloud computing.
Managers can leverage millennials’ deep understanding of technology by involving them in purchasing decisions. Some forward-thinking manufacturers have even added millennials to their boards of directors to increase diversity and offer fresh, technology-driven perspectives on such issues as strategic investment decisions and data security.
Recruiting and Mentoring
So how do you attract millennials to your workplace? Young workers today face a tighter job market compared to previous generations. But there’s an ongoing talent gap in manufacturing, especially high-tech niches. Proactive high school and college academic advisors are often instrumental in directing students toward careers in high-demand manufacturing sectors and recommending apprentice or internship programs.
Many businesses and schools work together in Project Lead the Way (“PLTW”) programs that start preparing students for science, technology, engineering, and math (“STEM”) careers as early as kindergarten. Today roughly 6,500 schools operate PLTW programs in all 50 states.
Manufacturing companies are a key partner in PLTW programs. By providing the face-to-face interactions while students are still developing career building decision, the industry has the opportunity to inspire the top talent to join the manufacturing world. For example, owners and managers may provide face-to-face guidance by mentoring students and teachers. Companies also have the opportunity to lend technology equipment to community colleges and high schools, and human resources departments may offer apprentice or internship programs to identify and provide early development for talented individuals.
Not only do PLTW programs offer opportunities for manufacturers to give back to local communities, but they also create a source of workers trained in STEM disciplines that they can draw from in the future. Often, money spent on these training programs may be deductible for income tax purposes—and, in some cases, may generate federal and state tax credits that could be refundable or carried forward to future periods.
Manufacturers and millennials can be a winning combination. Manufacturers should be able to stay current with young worker expectations and refresh the sector’s image by promoting flexible work options and personal development opportunities by investing in millennial-friendly technology and participating in PLTW programs. Contact your financial advisor to brainstorm creative solutions and maximize the tax benefits of attracting and hiring millennials.
Distributors Feel Their Own Labor Pains
Distribution companies are having trouble attracting and retaining reliable, experienced truck drivers, according to the American Trucking Associations (“ATA”). Last year, the average annualized driver turnover rate rose for both large truckload carriers and less-than-truckload companies. Although the driver shortage isn’t as dire as it was during the early 2000s, it’s expected to worsen as the economy heats up, regulatory oversight increases, and baby boomer drivers continue to retire.
For distributors with trucking fleets, this trend underscores the importance of offering drivers competitive wages and benefits. If you’re curious how your compensation packages measure up, the ATA released the results of a compensation study last December that revealed the median pay for drivers ranged from $46,000 for national, irregular route dry van truckload drivers to $73,000 for private fleet van drivers—and about 80 percent of truckload fleets offer paid holidays. The most common payment method was mileage-based, but three out of four fleets also pay hourly rates to some drivers. About 80 percent of private carriers offer 401(k) retirement plans and match employee contributions.
There’s more to compensation than just money, however. Trucking companies of all sizes that provide friendly, safe, flexible, and low-stress work environments may have the edge needed to attract and retain younger drivers.
In recent years, it appears that the trend of outsourcing to overseas suppliers and contractors may be losing some of its luster. Many businesses are returning to U.S. manufacturers—also known as “reshoring”—to obtain goods faster and at lower costs than foreign suppliers can offer. What’s more, “Made in the USA” tags and labels can win over domestic consumers who want to feel good about their purchases.
Complying with FTC Rules and Regulations
In order to make an unqualified claim that a product is “Made in the USA,” manufacturers must comply with strict regulations set forth by the Federal Trade Commission (“FTC”), the governmental body responsible for preventing deception and unfairness in the marketplace. These rules require that “all or virtually all” of the product is made within the U.S, with final assembly or processing taking place on U.S. soil. The FTC also considers other factors, such as how much of the product’s total manufacturing costs were spent on U.S. parts and processing and how far removed foreign content is from the final product. Complex labeling standards may also apply if an American flag or map is used on product packaging to imply the country of origin.
Although manufacturing and processing for a particular product may take place in several countries, and thus the product does not satisfy the criteria for an unqualified “Made in the USA” claim, a company can make a qualified claim in order for the product to be marketed as partially of U.S. origin. For example, a qualified claim may specify the percentage of a product’s domestic content or label a product as “Assembled in the USA” instead.
Compliance with these rules is essential, and qualified and unqualified claims for “Made in the USA” must be truthful and substantiated. Falsified claims are likely to attract an FTC investigation, which could lead to enforcement actions, negative publicity, or costly correctional expenditures. For example, violators may be required to modify product packaging to comply with the FTC regulations, which can be a pricey expenditure.
Touting the Benefits
The “Made in the USA” resurgence is a welcome boon to domestic manufacturing. Businesses and manufacturers can prepare by investing staff, inventory, and equipment to meet increasing demand for domestic-made products. In order to increase the demand for your U.S.-manufactured products, you may need to remind your customers about the benefits of using domestic manufacturers, including:
Cheaper, more reliable shipping. The United States offers lower labor, natural gas, and electricity costs than some other developed countries in Europe and Asia, including the United Kingdom, Germany, France, and Japan. Tariffs and high shipping costs can also make overseas production cost-prohibitive, and volatile foreign political environments may prevent products from shipping on time, leading to production delays.
Fewer business risks. Intellectual property theft and devaluation of the U.S. dollar are just some of the risks companies face when they outsource production to other countries. Additionally, important instructions—such as product specifications or shipping terms—may be lost in translation when communicating with foreign suppliers.
Safer products. News stories about contaminated plastic and pet food products from China have led to recalls, illnesses, and even deaths. Products made under the scrutiny of the U.S. Food and Drug Administration and Departments of Commerce and Agriculture are typically held to higher quality standards than many foreign-made products. Safer materials and products give businesses and manufacturers peace of mind that they are not exposing end-users to unsafe products—and themselves to liability claims.
Environmental concerns. The U.S. Environmental Protection Agency also requires manufacturers to adhere to strict environmental standards that limit emissions and pollutants. Other countries, including China and India, are currently making huge carbon footprints that will harm the environment for many years to come.
Humanitarian aspects. Citizens tend to feel patriotic when they support the U.S. economy and lend a helping hand in creating and maintaining jobs for American workers. They also take comfort in knowing that factory workers are not subjected to unsafe conditions, low wages, or other forms of exploitation that the U.S. Department of Labor and domestic labor unions protect against.
Whether you sell to businesses or consumers, you might consider implementing a marketing campaign that positions your products as American-made. This may include new advertising programs and repackaging your products with the “Made in the USA” label.
Preparing for a Comeback
As manufacturers and distributors budget for the coming years, they should consider whether the reshoring trend will attract more business, both domestically and abroad. Proactive businesses will position themselves as all-American and have extra capacity to meet the increasing luster of U.S.-manufactured products, and the increased consumer demand that will follow.
In the wake of the recession, states and municipalities are seeking to boost revenue by prioritizing the collection of taxes from out-of-state companies. Some states have even created new departments devoted exclusively to finding out-of-state companies that should be paying taxes but are not. For example, the Texas Comptroller’s Office has a department focused on such companies, known as the Business Activity Research Team, or “BART.” States are also taking advantage of cross-border agreements with other states’ departments of revenue to share information and are collaborating with federal customs agents. While it may be difficult to determine whether your activity in other states triggers a tax liability (i.e., if you have “nexus”), ignorance is no defense and the penalties for noncompliance can be steep, making this a critical issue for small businesses.
The concept of nexus is the degree of business activity in a state necessary to make your business subject to some or all of that state’s taxes. Further complicating matters, what establishes nexus for one type of tax might not establish nexus for another. For example, a physical presence is needed for sales tax nexus, but not necessarily for income or franchise taxes. Even determining what constitutes a physical presence varies by state.
For example, consider income taxes. If your company has income tax nexus in a state, you must file income tax returns and pay income tax in that state (with one major exception). A number of situations can trigger income tax nexus in a state, including but not limited to:
- Employing workers,
- Performing installations, repair, or warranty work,
- Leasing or owning property (including inventory),
- Attending trade shows,
- Leasing to customers, and
- Holding meetings or conducting training.
In addition to the above, some states consider nexus to be created simply by having sales to customers above a certain threshold amount (typically over $500,000), even without any physical presence. Since states vary so much, a nexus determination for one state may not hold true for another state.
The one major exception noted above relates to a federal law known as Public Law 86-272, which provides that no income tax filing responsibility is created, even if a business has nexus, provided that certain conditions are met.
Specifically, if a business sells tangible personal property, no income tax returns are due if:
- The business’s only activities in the state are the solicitation of sales and taking and accepting orders by employees or independent contractors from customers in that state, and
- Such orders are approved and fulfilled from outside that state.
Taxpayers need to be careful not to exceed the protected activities of Public Law 86-272; otherwise, they may create a corporate income tax filing. For example, sending employees into a state to perform installation or repair services, or having salespeople engaging in activities above and beyond solicitation, may create a filing responsibility.
Because states are being so aggressive in this area, and because there is no statute of limitations if a taxpayer has never filed any returns, it is important to know where you may have a filing responsibility and what the potential exposure could be (known as a “nexus study”). If a nexus study shows that you may owe state and local taxes, you may be able to take advantage of a voluntary disclosure program. Most states now offer such programs, which eliminate or lower penalties and interest on unpaid taxes and limit the look-back period. The Multistate Tax Commission offers a voluntary disclosure program that allows you to negotiate a favorable settlement agreement with multiple states through a single point of contact. It is important to note that such programs are only available if a business comes forward prior to being contacted by a state’s department of revenue.
To determine if your business activities establish nexus, contact a state and local tax professional at LGT.
Defending your business against tax audits
The IRS has many criteria they consider for selecting tax returns for examination. Here are some items that the IRS may target on a manufacturer’s 2015 tax return—and ways to help safeguard against an IRS audit.
- Owners Compensation
A privately held C corporation may try to overpay its owners in lieu of paying dividends to avoid double taxation. Conversely, an S corporation that’s not subject to corporate-level taxes might try to underpay its owners to minimize payroll taxes and, instead, make higher distributions. The IRS is on the lookout for both strategies and may compare your owner’s compensation to that of other manufacturers or distributors in your area.
How much should an owner get paid? There is no exact answer for every company. It depends on what unrelated third parties with the same responsibilities, education, and experience receive for performing the same functions. Outside sources, such as headhunters and various compensation surveys, can be used to substantiate your owner’s compensation level.
- Travel Expenses
Private business owners sometimes push the envelope when it comes to combining business and personal travel expenses. The IRS has strict rules on what qualifies as deductible business travel expenses.
For instance, suppose you attended the International Manufacturing Technology Show in Chicago last September. You visited the conference for two days but extended your stay a few days to visit family in the Chicago area—and your wife and kids tagged along. How much of the trip can you deduct as a legitimate business expense?
In order to deduct travel expenses, the primary reason for the trip must be business, rather than personal pleasure. To validate the business purpose of a trip, the IRS usually considers whether your business travel days—including travel days to and from the destination, working days, and standby days—exceed your personal travel days.
When this happens, you can usually deduct all your transportation costs, such as airfare, rental car fees and hotel costs, but not those incurred by the rest of your family. If the threshold isn’t met, you can’t deduct any travel costs, even if you conduct substantial business during your trip.
- Meals and Entertainment
Likewise, excessive meals and entertainment expenditures are likely to catch the IRS’s attention. You generally can deduct up to 50% of business-related meals and entertainment expenses incurred for the purpose of entertaining a client, customer, or employee.
Maintaining detailed records is the key to protecting your meals and entertainment deductions. Your company’s expense reimbursement forms should require the following information:
- Amount of the expense,
- Time and place,
- Business purpose, and
- Name and business relationship of any person entertained.
Hold onto records supporting the items claimed until the statute of limitations runs out. The statute of limitations usually runs out three years from the due date or the filing date, whichever is later. However, the IRS can go back more than three years if it suspects a substantial omission of income or a tax fraud.
- Net Operating Losses
When expenses exceed revenues, a C Corporation may incur a net operating loss (“NOL”). C corporations may elect to carry back (or forward) NOLs to offset income in other years. The IRS may ask your company to substantiate the loss, not only in the year it’s incurred, but also when a refund is claimed for an earlier (or later) year. So, proper record retention is essential with NOLs. IRS instructions recommend saving records until NOLs are fully utilized, plus seven years.
Tax Pros Lower Audit Risks
A small percentage of tax returns are audited by the IRS. Sometimes a business is randomly selected. But in many cases, high-risk or excessive deductions trigger an audit. The IRS keeps statistics on how much manufacturers under each industrial classification code typically deduct for each line item—but unfortunately, it doesn’t publish industry statistics to the general public.
IRS auditors often have a field day with do-it-yourself tax returns. An advisor at LGT who specializes in the manufacturing niche can evaluate your deductions line-by-line and help minimize your audit risks.
Managing IRS Inquiries
The IRS wants to make up for a tax gap that’s estimated at more than $300 billion. So, it’s become more efficient and targeted in its audit efforts.
If you receive a notice from the IRS in the mail, contact your tax professional immediately. He or she can help you respond to the notice or question, which is often all the IRS needs to satisfy its inquiry. A tax professional can manage your ongoing correspondence with the IRS. When an outside tax professional gets involved, it can limit your direct interaction with IRS agents.
Your tax advisor’s office may also serve as an offsite location for an IRS field audit. This may prevent an agent from inadvertently discovering other unrelated tax deficiencies while on your premises.
It is important to note that the IRS never initiates contact with taxpayers via telephone, social media, or e-mail. If you receive an e-mail, text, or phone call from the IRS, it may be fraudulent. Contact the IRS or Federal Trade Commission immediately.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog. To reach a professional advisor at Lane Gorman Trubitt PLLC, call (214) 871.7500 or email firstname.lastname@example.org.
Knowledge Is Your First Line of Defense
Inventory is one of the biggest assets on a manufacturer’s balance sheet. It’s also one of the hardest assets to measure and track. Thousands of transactions flow through the inventory account each year—and many of these journal entries require subjective estimates, such as overhead allocations, write-offs, and valuation adjustments. In addition, many employees have direct daily access to inventory or inventory accounting records, providing an ongoing temptation to steal or cook the books.
Case In Point
Consider ABC Manufacturing, a fictitious company that fell victim to a $300,000 inventory fraud scheme involving three trusted employees. Their scam was simple: the shipping clerk sent most finished goods to legitimate customers or company-owned retail outlets. But a few shipments to retail outlets were redirected to the home of the payables clerk. Later, the controller picked up the stolen goods to resell them on the Internet.
ABC’s retail outlets weren’t invoiced for shipments at the time of delivery. So there was no paper trail identifying what had happened to the redirected shipments. Without physical inventory counts, the perpetrators were able to pull the wool over the owner’s eyes for more than 18 months. Eventually, the shipping clerk became overwhelmed with guilt and confessed the scheme to the owner. With stronger internal controls, the scheme might have been detected sooner—or prevented from ever occurring.
Inventory is vulnerable to fraud because it’s eventually closed out to cost of goods sold (“COGS”). This is an expense account that winds up as part of retained earnings at the end of the accounting period. The formulas for computing COGS are:
Beginning inventory + purchases = goods available for sale
Goods available for sale – ending inventory = COGS
These formulas make sense for retailers or distributors that don’t add value to the goods they ship and, therefore, handle only finished goods. But they’re oversimplified for manufacturers that process raw materials into finished goods.
Manufacturers typically possess three types of inventories: finished goods, work-in-progress (“WIP”) and raw materials. WIP inventories include charges for raw materials, direct labor and overhead. Sometimes there are additional charges when the production of components are outsourced to a third party or another division of the company.
In addition, manufacturers can use a variety of techniques to account for finished goods inventories under Generally Accepted Accounting Principles. These include the lower of cost or market; first-in, first-out (“FIFO”); and last-in, first-out (“LIFO”). The more complicated a company’s inventory reporting process, the more opportunities employees have to commit fraud.
Motives and Methods
Small manufacturers often operate like families. Owners can’t fathom that a trusted “family member” would ever steal inventory. But it happens more often than you might think. When faced with a financial pressure and given an opportunity to steal, an employee may rationalize the theft of inventory.
For example, personal financial pressures or an addiction may entice an employee to steal inventory or overstate it—especially if he or she discovers a weakness in the internal accounting policies and procedures. The employee may rationalize the theft because he or she feels underpaid, underappreciated, or overworked by an owner who takes frequent vacations.
Whatever their motives, employees use a variety of techniques to steal inventory. The most obvious is directly taking items for personal use or resale. Physical controls are the best prevention tools here. To illustrate, warehouses should have a limited number of doors with 24-hour surveillance inside and outside of the facilities, including dumpsters, trucks, foliage, and parking lots.
Inventory fraud may also occur within the accounting department. For example, the controller or CFO may try to overstate inventory by artificially inflating inventory counts or values, recording false entries into the general ledger, or failing to write off old, obsolete, or damaged items. Moreover, the inventory account may become a “slush fund” for other internal fraud schemes. Inventory overstatements might be used to manage earnings or to meet financial covenants.
To Catch a Thief
Unearthing financial misstatements involving inventory overstatements is less straightforward than catching people who directly steal physical assets. A forensic accountant can help you by benchmarking financial statement trends, verifying source documents, and building a case that will help you prosecute fraudsters in your midst.
Assessing Your Fraud Risks
Global research company IBISWorld recently published its annual list of America’s riskiest industries for 2014 and 2015. Several types of U.S. manufacturers made the top 10 list, including apparel, computer, vacuum and small appliance, cigarette and tobacco, and recordable media manufacturers. Most of these have been in a state of decline due to changing consumer trends, overseas production, and technological advances.
Managers in these sectors may feel intense pressure to meet stakeholder expectations, which could drive them to commit fraud to hide weak financial performance. If you operate in a declining market segment, regularly assess your fraud risks and talk to your financial advisors. To speak with a professional who can offer advice on ways to mitigate your vulnerability to financial misstatement and theft by employees, call or email an LGT financial advisor.
Manufacturers and distributors who export products should consider the use of an interest charge domestic international sales corporation (“IC-DISC”) to reduce their tax burden. Here are some frequently asked questions about this strategy.
How does it work?
An IC-DISC is a separate entity that earns a “commission” on the operating company’s qualified export sales. Qualified export sales include sales made to domestic companies that then ship directly to a foreign customer provided no further manufacturing of the property takes place.
The commission is based on the greater of:
- 50 percent of net income on sales of qualified export property or
- 4 percent of gross receipts from sales of qualified export property.
These thresholds can be applied on a per-item basis or applied to the entire amount of qualified foreign sales. Finally, a properly executed IC-DISC isn’t taxable at the entity level. So, the operating company receives a deduction for the commission paid at ordinary tax rates and the IC-DISC pays no tax.
The IC-DISC then distributes all of its profits as qualified dividends and the owners pay tax on the dividends at the more favorable qualified dividend tax rates. Depending on the owners’ personal income levels, qualified dividend tax rates could be as low as zero or 15 percent—or as high as 23.8 percent (the highest federal capital gains rate of 20 percent plus an additional 3.8 percent of net investment income tax).
How much federal tax can it save?
To illustrate, let’s suppose Widgets, Inc. (a fictional S corporation) ships $2 million internationally and pays $80,000 in commissions to its IC-DISC. Assuming the owners qualify for the highest capital gains tax rate of 23.8 percent, they’ll owe federal tax of $19,040 on qualified distributions from the IC-DISC.
However, the owners also owe less tax on their S corporation earnings. Widgets can deduct $80,000 in commissions paid to the IC-DISC, resulting in a tax savings of $31,680, assuming that the owners are in the highest federal tax bracket of 39.6 percent.
The net savings is $12,640 ($31,680 – $19,040), or 15.8 percent of the commission charge. The savings could be higher using the 50 percent of net export income method if deductions are tracked on a per-item-sold basis.
What steps are required?
A properly executed IC-DISC strategy follows these procedures:
- Form the new IC-DISC entity under state law.
- Make the IC-DISC election within 90 days of formation.
- Offer only one class of stock with par or stated value of stock of at least $2,500.
- Maintain a separate set of books and records for the IC-DISC.
Taxpayers also can establish the IC-DISC in a domicile without state income tax to eliminate the need to file state income tax returns.
Potential for big return on investment
The potential tax savings can outweigh the costs of creating and administering an IC-DISC. If you export products, discuss this strategy with your tax advisor at LGT today to see if it is a cost feasible strategy to implement.
A recent Gallup poll shows that roughly three-quarters of Americans support a minimum wage increase. Factories and warehouses tend to employ a large number of entry-level and low-wage workers. So you may be considering a wage increase for your hourly workers. Here are some important questions to factor into your decision.
How do your wages compare?
Many cities and states already have minimum wage rates that exceed the federal rate, which has been set at $7.25 since 2009. Cities and local municipalities have been leading the charge, but California is poised to set a state-wide minimum wage of $15 by 2022 across all business sectors, and other cities and states are following in hot pursuit. Depending on where you’re located, you may already be required to pay above-average wages—or soon will be—so it may not make sense to increase wages at this time.
Also consider that a wage increase might make you less competitive globally. Right now, productivity-adjusted labor costs in other developed countries (including the U.K., Germany, and Japan) are 20 percent to 45 percent higher than U.S. labor costs on average, according to a recent study by the Boston Consulting Group. That gives U.S. manufacturers an edge over other developed nations.
The Chinese government’s 2011-2015 “five year plan” has increased the minimum wage by an average of 13 percent per year, according to a website run by the Chinese government. As a result, China’s cost advantage over the United States has been cut in half over the last decade. So, outsourcing to China is becoming less cost-effective, causing many companies to rethink their supply chain partners.
Let China serve as an example of what might happen if you increase your wages. It could ultimately make you less cost-effective than global competitors, thereby lowering your sales.
What’s the total cost?
When annualized, the federal minimum wage rate equates to $14,500 for a full-time employee, assuming 50 work weeks per year. Every $1 more you offer full-timers per hour translates into another $2,000 in wages over the next year. This doesn’t include hidden costs—such as higher payroll taxes, retirement plan contributions, or other perks—that accompany a wage increase.
Moreover, an increase in the wages paid to entry-level workers is also likely to trickle up the ranks to more experienced hourly workers and managers. It’s questionable whether you can pass along these incremental costs to customers without lowering your sales demand.
Do the benefits outweigh the costs?
A wage increase can be a great way to show support for your workers by enhancing their buying power and sense of self-worth. But budgeting for a wage increase goes beyond simply increasing direct labor costs for your lowest-paid workers. Contact an accounting professional at LGT to guide you through this tough decision.