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Is your construction company a C corporation? Beware of “unreasonable” compensation

Posted by Admin Posted on Nov 08 2022

Many construction businesses are structured as C corporations. If that’s the case for your company, you’re probably aware that C corporations usually prefer to classify payments to owners as tax-deductible wages because it lowers corporate taxes. However, as you’re likely also aware, if the IRS believes that an owner’s compensation is excessive and unreasonable, it may claim that payments are disguised dividends — and deny deductions for them. Earlier this year, in Clary Hood, Inc. v. Commissioner , the U.S. Tax Court found that a construction company owner wasn’t entitled to the deductible amounts he’d claimed in two tax years and that he was subject to a penalty. But there was some good news for the taxpayer. Deductions redetermined The company involved in the case primarily provided land grading and excavation services for construction projects in the South Carolina region. The owner founded the business with his wife and, together, they served as the sole shareholders and members of the board of directors. Using a multifactor test, the Tax Court found that the taxpayer failed to adequately establish how the deductible amounts being claimed for each of the two tax years were both reasonable and paid solely as compensation for the owner-founder’s services. However, the court didn’t deny the deductions. Rather, it redetermined the deductible amounts of compensation that the owner-founder could claim. The taxpayer could still deduct up to the redetermined amounts — which were less than what he’d originally claimed but still more than what the IRS was arguing for. The court noted various factors were most relevant and persuasive in reaching its conclusion. These included: The taxpayer’s distribution history, How the owner-founder’s compensation was set in the years at issue, and His involvement (day-to-day activities) in the business. The court also heard testimony from an expert, who included compensation for surety bond guaranties in his analysis and provided a well-reasoned salary comparison against industry standards. Penalty applied Another interesting aspect of the case was whether the owner-founder should be subject to the accuracy-related substantial understatement penalty for both tax years. To wit, the court didn’t uphold the penalty against the construction company and its owner-founder for the first of the two tax years. Although the taxpayer’s understatement was substantial for both years, the evidence demonstrated reasonable cause and reasonable reliance on professional advisors for the first year. Notably, the taxpayer showed that the company’s advisors were competent professionals with sufficient expertise to justify reliance and no inherent conflicts of interest. The owner-founder also provided evidence that the advisors were given all relevant information and that he relied on their advice. However, the court upheld the accuracy-related substantial understatement penalty for the second year. This is because the taxpayer provided almost no evidence regarding professional advice received in calculating the deduction amount. Although the owner-founder alternately claimed substantial authority for his position and the use of a certain test to determine the deductible amount, he failed to prove substantial authority to claim the amount. A strong defense As this case shows, the IRS will challenge deductions for owner compensation that it deems unreasonable. However, as the case also demonstrates, thorough documentation and expert advice can help owners of C corporations defend themselves. We can assist you and your construction company’s co-owners in determining reasonable compensation amounts. Clary Hood, Inc. v. Commissioner , No. 3362-19, March 2, 2022 (U.S. Tax Court) © 2022

Measuring residual value for the discounted cash flow method

Posted by Admin Posted on Oct 04 2022

When valuing a business using the discounted cash flow method, residual (or terminal) value is a key component. The International Valuation Glossary — Business Valuation defines residual value as “the value as of the end of the discrete projection period in a discounted future earnings model.”

Business valuation experts typically consider the capitalization of earnings method and the market approach when estimating residual value. Either (or both) may be appropriate, depending on the nature of the business, purpose of the valuation, reliability of the company’s financial projections and availability of market data.

Capitalizing earnings

The capitalization of earnings method is based on the assumption that cash flow will stabilize in the final year of the projection period. However, this is also the time period that’s subject to the greatest margin for error because it’s the furthest into the future.

Under the capitalization of earnings method, residual value equals expected future cash flow (the numerator) divided by a capitalization rate (the denominator). The long-term sustainable growth rate is used in the numerator to determine cash flow in the final projection period. Then it’s used again in the denominator because the capitalization rate equals the discount rate minus this growth rate.

Because it’s in both the numerator and the denominator, the long-term sustainable growth rate can have a significant effect on residual value. A minor change in this rate can have a major impact on business value.

Applying the market approach

Another way to estimate residual value is to assume that the business could theoretically be sold at the end of the discrete period in an arm’s length transaction. Using the market approach, a business valuation expert considers comparable public stock prices and sales of comparable private businesses. Although the market approach sounds straightforward, it can sometimes be difficult to find comparable transactions, especially for small private companies.

Comparable market data also might serve as a sanity check. For example, a valuation expert might compare:

  • The implied pricing multiples from a residual value that’s been calculated using the capitalization of earnings method, and
  • Average pricing multiples from comparable transactions involving similar companies in recent years.

There may be cause for concern if, say, a company’s residual value generates a price-to-revenue multiple of 5.0 and comparable transactions during the last 12 months indicate an average price-to-revenue multiple of 1.2. The expert would need to explain the reason for such a discrepancy — or possibly adjust his or her analysis.

Need help?

Residual value can be a major part of the valuation puzzle, so it’s important to get it right. Like annual cash flows over the discrete projection period, residual value is discounted to present value to arrive at the value of a business under the discounted cash flow method. Contact us to develop a residual value that’s based on reliable projections and objective market data.

© 2022

Highlights from the latest ACFE fraud report

Posted by Admin Posted on Sept 16 2022

Preventing, detecting, and investigating occupational fraud requires a deep understanding of the types of schemes, potential financial losses, emerging threats and risk mitigation strategies. To that end, the Association of Certified Fraud Examiners (ACFE) has published its “Report to the Nations,” the preeminent source for occupational fraud statistics and trends, every two years since 1996.

The 2022 ACFE report covers 2,110 occupational fraud cases in 23 industries and in 133 countries. Surveyed organizations have lost more than $3.6 billion to fraud. The report can help your organization understand and mitigate fraud threats. Here are some of the highlights.

Three types

The ACFE divides occupational fraud schemes into three types:

Asset misappropriation. This includes cash theft, fraudulent disbursements, larceny and misuse of inventory and is the most common type of occupational fraud, accounting for 86% of cases. The median loss for these schemes is $100,000.

Financial statement fraud. The least common type of fraud (9% of cases), financial statement schemes generate the highest losses — a median loss of $593,000 in the 2022 report.

Corruption. This falls between asset misappropriation and financial statement fraud in terms of losses and frequency. In the 2022 report, corruption costs resulted in a median loss of $150,000.

Fraud experts who participated in the study estimate that the average organization loses 5% of revenue to fraud each year. This percentage can serve as a starting point for determining your risk of suffering financial harm.

Detection and the role of tips

According to the ACFE report, a typical fraud case generates losses of $8,300 per month and lasts for 12 months. Forty-two percent of frauds in the report were uncovered via tips, with more than half of those provided by employees. Forty percent of tips came via email, 33% via a web-based form and 27% from phone calls.

The volume of email and web-based tips exceeded the number of tips submitted via phone hotlines. However, organizations offering hotlines reduced the median loss of fraud by 50%, from $200,000 to $100,000. Those organizations detected fraud faster and reduced the duration of schemes by 33% — from 18 months to 12 months.

Antifraud controls

Almost half of the cases analyzed in the 2022 report were determined to occur because the organizations lacked adequate internal controls or managers had overridden existing controls. The report also highlighted a lack of management review and a poor “tone at the top” as primary control weaknesses contributing to fraud.

Not surprisingly, the ACFE found that the existence of antifraud controls can lower fraud losses and accelerate fraud detection. To help organizations understand the impact of internal controls, the ACFE details the effect of 18 common policies on median loss and median duration of fraud schemes. These include hotlines, surprise audits, codes of conduct, antifraud training and proactive data monitoring.

For example, when job rotation or mandatory vacation policies are in place, the median loss from fraud is $64,000. When neither control is in place, the median loss climbs to $140,000. Similarly, when organizations have job rotation or mandatory vacation policies in place, fraud schemes typically last eight months. This duration doubles to 16 months when those controls aren’t in place.

Learn from others

The ACFE report is relevant to organizations of every size and in every industry. Learning about the losses of others can help your company better assess risk and take steps to mitigate fraud. If there’s one overwhelming takeaway from the ACFE reports, it’s that internal controls are essential. Contact us for help assessing your control needs.

© 2022