July 11, 2017

In This Edition
Why You Should (Or Shouldn't) Pursue an Acquisition
Leasing Property to Your Business Might Trigger Undesirable Tax Consequences
Tax Calendar
Know Your Customers Before You Extend Credit

Why You Should (Or Shouldn't) Pursue an Acquisition
Like so many aspects of the national and global economies, merger and acquisition (M&A) activity tends to wax and wane. Nonetheless, billions of dollars continue to change hands annually, and an acquisition can be a great way to grow a business. So if one of these deals comes your way, it's important to carefully consider both the pros and cons.

Look at the Possibilities
Merging with, or acquiring, another company is one of the best ways to grow rapidly. You might be able to significantly boost revenue, literally overnight, by acquiring another business. Achieving a comparable rate of growth organically - by increasing sales of existing products and services or adding new product and service lines - can take years.  

An acquisition also might enable your company to expand into new geographic areas and new customer segments more quickly and easily. You can do this via a horizontal acquisition (acquiring another company that's similar to yours) or a vertical acquisition (acquiring another company along your supply chain).

In addition, you can realize synergies by acquiring the right type of company. Synergies are business characteristics and capabilities that complement and work well with those of your own company. The idea is to find an acquisition target that offers the right synergies so that the new combined entity will be stronger than either business would have been on its own.

Be Aware of Drawbacks
Although there are many potential benefits to acquiring another business, there are some potential drawbacks as well. For example, completing an acquisition is a costly process, from both a financial and a time-commitment perspective.  

Therefore, you should determine how much the transaction will cost and how it will be financed  before  beginning the M&A process. Also try to get an idea of how much time you and your key managers will have to spend on M&A-related tasks in the coming months - and how this could impact your existing operations.

A loss of control is another potential drawback to consider. Depending on the deal's structure, some degree of control may have to be shared with the owners of the business you're acquiring, especially if the owners aren't retiring but intend to be actively involved with the merged entity.  

It's also critical to try to ensure that the cultures of the two merging businesses will be compatible. Mismatched corporate cultures have been the main cause of numerous failed mergers, including some high-profile megamergers. For instance, if one company has a more formal and buttoned-down culture while the other is more casual and laid back, conflicts will likely ensue unless you plan carefully for how the two divergent cultures will be blended together.

Perform Due Diligence
The best way to reduce the risk involved in buying another business is to perform solid due diligence on your acquisition target. Your objective should be to confirm claims made by the seller about the company regarding its financial condition, clients, contracts, employees and management team.  

The most important step in M&A due diligence is a careful examination of the company's financial statements - specifically, the income statement, cash flow statement and balance sheet. Also scrutinize the existing client base and client contracts (if any exist) because projected future earnings and cash flow will largely hinge on these.  

Finally, try to get a good feel for the knowledge, skills and experience possessed by the company's employees and key managers. In some circumstances, you might consider offering key executives ownership shares if they'll commit to staying with the company for a certain length of time after the merger.  

Map Your Course
An acquisition is one way to expand and grow your company. But be sure to map your course thoroughly before heading down the M&A road. Our firm can help steer you in the right direction.

Contact: Jeff Tillema, CPA
Leasing Property to Your Business Might Trigger Undesirable Tax Consequences
If you own property and a business, there's an obvious temptation to lease that property to the business. Such an arrangement can make sense from many perspectives.

You're no doubt familiar with the property and its advantages to your company; the deal could be carried out quickly; and the money changing hands would stay between you and your company. And if you participate in other loss-producing passive activities, you may be hoping to offset the net rental income with those losses.

There's just one big problem: You'd risk triggering the "self-rental rule" and not achieving your desired tax outcome.

Self-Rental Rule in a Nutshell
Internal Revenue Code (IRC) Section 469 generally prohibits taxpayers from deducting passive activity losses (PALs).  

It typically applies to "flow-through" income and losses from partnerships, limited liability companies (if they've elected to be treated as a partnership for tax purposes), S corporations and trusts.  

The rules define "passive activity" as any trade or business in which the taxpayer doesn't materially participate. Rental real estate activities generally are considered passive activities regardless of whether the taxpayer materially participates. (There's an exception if the taxpayer qualifies as a real estate professional.)

A PAL is the amount by which the taxpayer's aggregate losses from all passive activities for the year exceed the aggregate income from all of those activities. A PAL can usually be used only to offset passive income, though there are a few exceptions.

The self-rental rule in IRC Sec. 469 applies when you rent property to a business in which you or your spouse materially participates. Under the rule, any net rental losses are still considered passive, but the net rental income is deemed nonpassive. That means your net rental income can't be offset by other passive losses, yet net rental losses generally can offset only other passive income. This could have negative tax consequences if you're hoping to offset your self-rental net income with passive losses from other activities.

The Power of Grouping
You may be able to avoid the negative tax consequences of IRC Sec. 469's self-rental rule by "grouping." The regulations allow you to group your separately owned rental building with your business to treat them as one activity for purposes of the passive loss rules if they constitute an "appropriate economic unit."

The regulations determine this based on factors such as common ownership and control, types of activities and location. As long as you materially participate in the business - and the business isn't a C corporation - the rental activity won't be treated as passive for the purposes of income or losses.

To take advantage of this option, you must own both the rental property and the business. You could also use grouping if the rental activity is "insubstantial" (a term undefined by the regulations) in relation to the business activity.

Finding the Best Arrangement
Renting property to a business in which you materially participate can seem like a great idea. But doing so can turn out to be a lose-lose proposition when it comes to taxes - particularly for S corporation owners who may not understand the rules. Please contact our firm for help devising the most beneficial arrangement for your situation.

Contact: Greg Kenworthy, CPA
Tax Calendar
July 17 If the monthly deposit rule applies, employers must deposit the tax for payments in June for Social Security, Medicare, withheld income tax and nonpayroll withholding.
July 31 If you have employees, a federal unemployment (FUTA) deposit is due if the FUTA liability through June exceeds $500.

The second quarter Form 941  ("Employer's Quarterly Federal Tax Return") is also due today. (If your tax liability is less than $2,500, you can pay it in full with a timely filed return.) If you deposited the tax for the quarter in full and on time, you have until August 10 to file the return.
August 15 If the monthly deposit rule applies, employers must deposit the tax for payments in July for Social Security, Medicare, withheld income tax and nonpayroll withholding.
September 15 Third quarter estimated tax payments are due for individuals, trusts and calendar-year corporations.

If a six-month extension was obtained, partnerships should file their 2016 Form1065 by this date.

If a six-month extension was obtained, calendar-year S corporations should file their 2016 Form 1120S by this date.

If the monthly deposit rule applies, employers must deposit the tax for payments in August for Social Security, Medicare, withheld income tax, and nonpayroll withholding. 

Know Your Customers Before You Extend Credit
The funny thing about customers is that they can keep you in business - but they can also put you out of it. The latter circumstance often arises when a company overly relies on a few customers that abuse their credit to the point where the company's cash flow is dramatically impacted. To guard against this, diligently assess every customer's creditworthiness before getting too deeply involved.

Information, Please
A first step is to ask new customers to complete a credit application. The application should request the company's name, address, website, phone number and tax identification number; the number of years it's existed; its legal form and parent company, if one exists; and a bank reference and several trade references.  

If the company is private, consider asking for an income statement and balance sheet. You'll want to analyze financial data such as the profit margin, or net income divided by net sales. Ideally, this will have remained steady or increased during the past few years. The profit margin also should be similar to that of other companies in its industry.  

From the balance sheet, you can calculate the current ratio, or the company's current assets divided by its current liabilities. The higher this is, the more likely the company will be able to cover its bills. Generally, a current ratio of 2:1 is considered acceptable.

Check References and More
Next up is contacting the potential customer's trade references to check the length of time the parties have been working together, the approximate size of the potential customer's account and its payment record. Of course, a history of late payments is a red flag.

Similarly, you'll want to follow up on the company's bank references to determine the balances in its checking and savings accounts, as well as the amount available on its line of credit. Equally important, you'll want to find out whether the company has violated any of its loan covenants. If so, the bank could withdraw its credit, making it difficult for the company to pay its bills.  

After you've completed your own analysis, find out what others are saying - especially if the potential customer could be a significant portion of your sales. Search for   articles on the company, paying attention to any that raise concerns, such as stories about lawsuits or plans  to shut down a division.

In addition, you may want to order a credit report on the business from one of the credit rating agencies, such as Dun & Bradstreet or Experian. Among other information, the reports describe the business's payment history and tell whether it has filed for bankruptcy or had a lien or judgment against it.  

Most credit reports can be had for a nominal amount these days. The more expensive reports, not surprisingly, contain more information. The higher price tag also may allow access to updated information on a company over a period of time.

Stay Informed, Always
Although assessing a potential customer's ability to pay its bills requires some work upfront, making informed credit decisions is one key to running a successful company. Please let us know how we can help you with this or other financially critical business practices.

Doug Wendlandt Contact: Doug Wendlandt, CPA