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SECTION Evaluating the Operations of the Business III entirely. In effect, the deferred taxes may be less when paid after the law changes instead of before. The rate, or the method of calculation of liability, could change. Of course, the reverse may also be true. • A tax deferral is, in effect, an interest-free loan from the federal government. It can be recognized as a valid financing source because there can be no more favorable rate than a zero interest rate for a loan. • Many tax options are under the company’s control. When one option fails to be favorable, it can change to another. Tax planning can have significant advantages. It can help conserve cash flow by deferring the payment of taxes. It can make available interest-free capital for the financing and purchase of new fixed assets or expansion. It can free up additional cash and make more disposable cash available for payout. Controlling Tax Liabilities When planning for treatment of tax expenses, consider these accounting methods and choices of accounting periods for controlling the amount of tax liabilities that may be incurred. Deferred Installment Sales A company may be able to defer income if it makes sales of personal property on an installment sales basis. An installment sale is defined for tax purposes as requiring two or more payments. Therefore, a company that sells personal property on a credit basis requiring only one payment in a certain period would not qualify for use of this deferral method. This deferral is permitted even if the overall method of accounting used is an accrual method. The company realizes a cash flow improvement by not having to prepay the tax on profits until they have been realized in cash payments. If you sell on installment sales contracts, do not fail to utilize this deferral method. 232 Taxes and Risk Management CHAPTER 8 Another consideration is the company’s credit policy. In establishing a credit policy, the firm should consider the tax advantages of certain installment sales. This deferral gets particularly beneficial if the company is experiencing an increase in accounts receivable. Typically, big-ticket-item retail stores, such as furniture and appliance dealers, can take significant advantage of installment sales deferment. By looking to the installment sales method of tax deferments, the company may not only have the benefit of deferring income taxes, but it may also provide an opportunity to charge slow-paying customers interest in consideration for extended payment terms. Bad Debt Method One company may choose to recognize its bad debts for tax purposes at the point where these debts actually become known to be worthless. Another company may set up a reserve and obtain a tax deduction based on an estimate of the debts that will be bad. The reserve method simply accelerates the tax deduction for bad debt, because the deduction is allowed in the year the reserve is established, based on the probability of some accounts going bad, rather than when the specific debt is determined to be bad. Accounting for Inventory Sometimes, by changing accounting methods, a company can eliminate short-term profits associated with inflation and the cost of inventory. In other words, if the company has significant inventory levels that were produced at lower costs and it is currently producing inventory at much higher expenses, by selling off the most recently made or purchased inventory items, the company will realize a profit only between the current selling price and the current higher costs. In doing so, the company retains, as a matter of bookkeeping, only old inventory at lower costs. This is a change from a first-in, first-out (FIFO) accounting system to a last-in, firstout (LIFO) system. 233 SECTION Evaluating the Operations of the Business III State Tax Considerations When locating offices and plants, a company with multistate operations should take into consideration the states in which legislation has been passed giving lower taxes for business. Lower state taxes can substantially reduce tax liability and will not inhibit the business from engaging in interstate commerce. Another important consideration is whether the state has a tangible personal property tax. In some states, on particular days of the year, tangible personal property located within the state will be subject to taxation. Many large companies (particularly airlines and railroads) ensure that the majority of their movable assets are not in states that levy tangible personal property taxes on the day of levy. Consideration of the Taxable Entity In planning the creation of a business, the principals should consider discussing tax liabilities associated with the various forms of business entities available. Consideration of whether to incorporate or enter partnerships, subchapter S corporations, or domestic/ international sales corporations should be reviewed. Each of these has particular tax liabilities. Some of them are associated with particular types of businesses and may not be applicable to the business in which you engage. Partnerships and subchapter S corporations can be useful to avoid double taxation, which arises because the corporation is taxed on its profits and again when the profits are distributed in the form of dividends. Again, there is an income tax liability associated with a receipt of the dividends by the owners. Partnerships and subchapter S entities, however, shift income from the entity to the shareholders’ or partners’ tax return. Tax losses, as well, flow directly through to the owners or partners. One of the criteria that should be considered when setting up the business entity is the relative tax rate for the individuals as compared to the corporate rate. The corporate rate may be higher than the rate at which the principals are taxed. 234 Taxes and Risk Management CHAPTER 8 The qualifications for subchapter S status change periodically. The Internal Revenue Service (IRS) can provide up-to-date information on revisions. Financing Considerations for Fixed Assets Rapid Depreciation Methods. When a fixed asset is purchased, accelerated cost recovery systems can be used, which at the same time increase cash flow. The law in this area changes frequently, and consultation with a good tax advisor will help you to understand how the depreciation deductions work and what is currently available. Investment Tax Credits. The laws regarding investment tax credits (ITCs) also change frequently. Congress permits and withdraws such credits as a means of altering tax revenue and/or stimulating the economy. A description of the normal situation when an ITC is available follows. An ITC affords the taxpayer an opportunity to reduce income tax liability by buying or constructing equipment or other qualifying properties. Property that qualifies for ITC normally includes tangible depreciable property, which typically must have a useful life of at least three years. Due regard must be given to the fact that usually no ITC is permitted for buildings or permanent structural components. In the case of leased property, a lessor for a qualifying piece of property may be able to pass the credit on to the lessee. The ITC or any portion may be carried back for 3 years or carried forward for 15 years. Unused credit for the current year generally is carried back for the earliest carryback year, and any other remaining unused credit is applied to each succeeding year in chronological order. Again, serious consideration should be given to consulting with a tax advisor in this area. The tax laws change on a regular basis, and before you make any capital decision, you should consider an ITC. 235 SECTION Evaluating the Operations of the Business III Leasing There are certain tax benefits to leasing, although the controversy surrounding these benefits still exists. Leasing may have these advantages: • The cash needed to purchase the property is available for other uses. • The lessor may pass through the ITC, if any, to the lessee for his or her use. This benefit probably will not be passed on without a corresponding payment to the lessor. • The lessor bears the risk of obsolescence or loss. • Lease payments may exceed depreciation and interest. In this respect, it may give the lessee a higher deduction in the form of immediate expense dollars. Cash Management through Tax Planning Compensation Plans. There are three types of compensation plans: basic, deferred, and pension- and profit-sharing funds. Funded and unfunded deferred compensation plans offer numerous advantages. For example, in the funded pension plan, the employer’s contribution to the fund is currently deductible as an expense. Any earnings generated internally by the trust fund are tax exempt. Finally, the employees are not taxed on an individual basis until after retirement. After retirement, the employee’s income should be less than he or she is receiving as an active employee. The employee gets the benefit of a lower tax rate at a later date. This is an income-deferred plan available to employees through the cooperation of their employer. There are firms and businesses that plan compensation packages, which can be very helpful in demonstrating different ways in which a company may save cash flow through the design of compensation plans. Employees’ Stock Ownership. Like compensation plans, many firms offer their employees participatory ownership plans. These plans offer two advantages. 236 Taxes and Risk Management CHAPTER 8 1. By giving the employees some participatory ownership in the firm, there is greater loyalty and greater concern for the firm’s well-being. Each employee has a vested interest in the success of the firm. As the firm grows and succeeds, so does the personal worth of the individual. 2. An employee stock ownership plan offers an employer a deduction without the payment of cash. However, when a stock purchase plan causes significant dilution of the ownership, the company may become subject to a suit called a derivative lawsuit by those owners who have had their percentage ownership decreased by sale of additional stock. This is generally associated with the issuance of new stock and is discussed more fully in Chapter 5. An employee stock ownership plan may use a profit-sharing or stock bonus format. There is a major advantage to a profit-sharing format: It allows distribution of benefits to employees in the form of cash or securities as well as employer stock. This may be an important consideration if the employer’s stock is not publicly traded or does not otherwise have a ready market. In a profit-sharing format, there are two basic limitations. 1. The employees’ contributions to the stock ownership plan trust may come only from current or accumulated profits. 2. The plan may not borrow funds on the basis of corporate majority stockholder guarantees to purchase employee stock. Risk Management A company may have the best business plan on Earth, execute it with precision, and end up with extraordinary profitability—only to lose it all because it failed to consider and guard against the risks to which every business is subject. This risk can range from the effects of weather, such as floods or earthquakes, to lawsuits, such as by competitors for patent infringement or employees for sexual harassment. In this section, we review the policies and procedures 237 SECTION Evaluating the Operations of the Business III that a company should adopt and follow to ensure that it has identified and protected itself against a wide range of risks. The first step in developing a risk management system is to have the board of directors formally review and approve a set of risk management policies, such as the one shown in Figure 8.1. These policies predominantly address the types and minimum amounts of required insurance coverage, although there should also be a policy regarding the completion and periodic review of a risk management plan. This policy forces the management team to not only obtain insurance from qualified independent insurance providers, but also (and more important) to create a risk management plan. This plan is designed to identify the major risks to which a company is subject, as well as specify how those risks may be mitigated. A very important point is that, when determining forms of risk mitigation, insurance should be considered the last resort. This is because insurance is designed to pay a company compensation for damages that have already been incurred, whereas a true risk mitigation strategy will prevent losses from ever occurring, so there would be no loss for an insurance company to cover. Accordingly, the steps outlined in this section to develop a risk management plan address only the need for insurance at the end of the process. Figure 8.1 Risk Management Policies 1. The company will obtain insurance only from companies with an A. M. Best rating of at least B++. 2. The company will create a comprehensive risk management plan, which will be reviewed by the board of directors at least once a year. 3. No insurance may be obtained from captive insurance companies. 4. The company must always have current insurance for the following categories, using the following minimum amounts: • $5 million for director’s and officer’s insurance • $10 million for general liability insurance • Commercial property insurance, matching the replacement cost of all structures and inventory Business interruption insurance, sufficient to support four months of operations Source: James Willson, Jan Roehl, and Steven M. Bragg, Controllership (New York: John Wiley & Sons, 1999), p. 1317. Reprinted with permission. 238 Taxes and Risk Management CHAPTER 8 A management team should use these 12 steps to create a risk management plan. 1. Appoint a risk manager. There should be one person in charge of a company’s entire risk management program. The reason for this is that, if too many people are involved, it is possible that some high-risk areas will not be addressed, simply because everyone involved thinks that someone else is addressing the problem. Also, this position should be a full-time one in a larger company and occupy a significant proportion of one person’s time in a smaller company, which ensures that a sufficient amount of attention is paid to the subject area. The risk manager’s job description should include the review of all corporate risks, estimating the probability of loss for each one, selecting and implementing the best methods for reducing the highestprobability risks, ensuring compliance with all governmental insurance requirements, supervising the work of the company’s designated insurance broker, maintaining loss records, and periodically reviewing the company’s performance under its loss prevention program. 2. Determine risk areas. This step involves a detailed review of all possible risk areas in a company. A considerable aid in completing this step is to use a checklist of insurable hazards, which is available from most insurers. Another approach is to review the past history of insurance claims that the company has filed, although this method will not cover any risks that have not yet been realized. If neither of these approaches is available, then at least review the company’s risks based on four key areas: facilities and equipment, business interruption, liabilities, and other assets. The review of facilities and equipment should include a detailed assessment of the risks to which each facility is subject (e.g., flooding, fire); the equipment review should take note of explosion and damage risks for each piece of major equipment. The business interruption review should focus on the amount of cash required to keep the business from going bankrupt during a business shutdown. A crucial review is that of liabilities to other parties that are caused by the company’s products, employees, or operations. 239 SECTION Evaluating the Operations of the Business III This review must include an examination of a company’s sales and purchase orders, contracts, and leases to see if there are any additional liabilities that the company has undertaken. Finally, there must be a review of a company’s cash, accounts receivable, and inventory to see if they are subject to an inordinate risk of loss for any reason. When the review is complete, all of these data should be summarized in preparation for the next step. 3. Identify risk reduction methods. Once the key risks have been outlined, they can be reduced. There are three ways to do so. The first is to use duplication, which means that a company can make copies of records to avoid the loss of original documents, or duplicate key phone or computer systems to ensure that there is an operational backup, or even set up duplicate fire suppression systems to reduce the risk of fire damage. The second way is to institute prevention measures. These can include safety inspections and safety training for employees, as well as the use of mandatory safety equipment, such as hearing protection, to ensure that identifiable risks are eliminated to the greatest extent possible. Finally, a company can segregate its assets, spreading them through numerous facilities, to ensure that losses will be minimized if damage occurs to a single location. All of these risk reduction methods must be documented for use in the next step, which involves their implementation. 4. Implement risk reduction methods. Implementing the risk reduction methods just outlined is not simple, because they usually involve either a capital expenditure (i.e., for a fire suppression system) that requires prior approval by senior management or some kind of training or inspection that requires the participation of multiple departments. Because of the additional time needed to complete some of these items, it is best to divide them into two groups—those that can be implemented at once without any further approval by anyone, and those requiring approval. The risk manager should implement the first group right away. The second group should be laid out on a project timeline, including expected completion dates, so the risk manager can methodically obtain approvals prior to implementing 240 Taxes and Risk Management CHAPTER 8 them. This approach will ensure that risk mitigation steps are completed in as efficient a manner as possible. 5. Schedule periodic risk reviews. Initially setting up a risk management plan is not enough. Although initially it may provide an adequate degree of risk mitigation, the types of risk will change over time, while the types of risk reduction activities being followed may fall into disuse. To keep these problems from occurring, it is important to schedule recurring risk reviews that delve into any changes in risks, as well as the degree to which current risk reduction systems are being used. The result of these reviews should be a report to management and the board of directors regarding any deficiencies in the risk reduction system, as well as recommendations for improvements. 6. Require insurance from third parties. We have just outlined a plan for reducing the level of risk in a company’s activities without the use of insurance. To take the concept one step further but without going to the expense of purchasing insurance as a form of risk coverage, it may be possible to force customers to pay for insurance coverage. A good example of this is in the rental business, where the renting company can require a customer to provide a certificate of insurance from the customer’s insurance agency, proving that the customer’s insurer will provide coverage for the specific equipment being rented. This approach allows a company to avoid paying for the same coverage itself, although there is some administrative hassle involved in obtaining the certificate of insurance. 7. Select a broker. Most insurance companies operate through brokers who are either their sole representatives or independent, and therefore represent numerous insurance companies to their clients. It is generally best to use an independent agent, since this person will work on the company’s behalf to search for the best insurance deals from among the most financially stable insurance companies. This person should be thoroughly conversant in the particular insurance needs of the company’s industry and be willing to provide in-depth advice regarding the company’s insurance needs. The brokers to avoid are those who overemphasize the need for additional insurance coverage when 241