Give or Take $600MM

I spent most of last week in audit training classes.  It’s no secret that the nuts and bolts of audit work are not exciting.  Unfortunately, the relevance of the task at hand was in the news.  I agree with  Lynne Turner, former head accountant at the SEC, on the missing money at MF Global.

 "It's like it just vanished into thin air and the fact that people today can't tell us where the $600 million went is not a good sign. The fact that they were held in custodial accounts that someone should have been on top of only further complicates the issue and makes it even more concerning."

Whether it was for meeting margin calls or going to a personal account in the Cayman Islands is still TBD, but that’s where the boring work that I was studying  is really important.  It may not be material for a new TV series, (CPA: Miami ??) but trained forensic accountants are the best chance for finding the needle in the haystack.

It’s important to note here that in a forensic engagement, where the task is finding the missing $600 million, the work is structured to find the needle.  However, in an audit, that level of detail work would cost too much money.  So the guys at PwC were just looking for potential misstatements that are material.  In accounting, something is material if it would cause a user of the financial statements to make a different decision about the company. 

In this case, MF Global had structured the sovereign debt deal so they could, in compliance with accounting rules, move the debt off their balance sheet.  Would investors have made a different decision if the debt were sitting in the liabilities section of the financial statements?  We’ll never know that, but FINRA regulators did find the accompanying disclosure of “off balance sheet arrangements and risk” inadequate. (My word, not theirs – I didn’t read the FINRA notice.) So with full disclosure it could have been just “caveat emptor” to investors.  You have to wonder about the judgment call to do a deal of that size and expect no one would care about the detail of a massive increase in leverage. 

Of course, the guiding light of that judgment was Jon Corzine.  One thing that’s always discussed in audit classes is how the person who is least likely to commit fraud is the one the auditors should be most worried about.   While Corzine doesn’t have the kind of financial motivation that say a bookkeeper has, clearly he sanctioned decisions that can only be described as rationalizing illegal behavior.  The fraud triangle is motivation, rationalization and opportunity.  Corzine had all three.  Who knows, this could be material for the first episode of CPA & Order….    

Dowsing for Dollars

This past week marked more conversations with people who say their business is picking up than I can remember in a while. This got me wondering if small business access to credit is picking up as well.  From what I can tell, it’s getting better, but not in the usual way.

Financing consultant, Multifunding pulled together a fascinating post on how banks’ number of loans of less than $1 million is much lower than the number of small business loans they report.  There are small businesses that get loans of more than a million dollars, but not that many.  (It’s worth noting that the smaller number is in regulatory reports and the larger number in press releases.)  This discrepancy between bank publicity on small business lending and regulatory filings is consistent across all the big name banks. 

On the other hand, people who provide alternative financing are so busy they can’t keep up.  So the banks say their small business loan portfolio is growing and the factors are busy, and the economy is slow!?  That would be impossible.  Business Week’s piece on small business funding through receivables (a.k.a. factoring) has pages of testimonials from small business owners who are growing their business thanks to alternative financing.  Not to say that this is all good news.  Factoring loans are expensive.  In addition, Factoring is essentially unregulated.  So it’s higher cost and higher risk.  This creates a potential vicious circle for small business credit scores where they are compressing margins, adding debt and therefore look even less attractive to banks.

Despite the outrage expressed by ”Occupy…” it’s hard to make the case that banks are aligned in a conspiracy against small business lending.  Banks with a successful small business loan portfolio make more money than banks that just hold cash in the vault.  The issue is that the analytics that used to signal the loan would be good; don’t work well in the current environment.  There are alternatives out there, like On Deck Capital, but my guess is the shortest route to losing your bonus as a banker these days is to try something new.  It was new analytics that short circuited the whole system.  I’m not saying I agree with this logic, but I do think it’s a dynamic driving behavior.

Factoring is clearly a much used source of working capital by an increasing number of businesses.  This starts to create a virtuous circle around increased liquidity and increased competition.  The growth in receivables financing infrastructure companies like the Receivables Exchange  adds weight to the idea that so-called alternative financing is becoming more mainstream.  While the world of finance doesn’t move at the speed of tech gadgets, traditional bank loans could be heading down the path of phones without a touch screen.  Seen any lately?

ABC's of Education Tax Benefits

Tax Code complexity has come up in a number of conversations this week, so that inspired the concept of a topic related to demystifying important yet unclear areas of the code.  This creates plenty of choices as, according to the IRS official count, the IRC  has 3.8 million words.  Tax credits for education caught my eye first. According to Saturday’s piece in the Wall Street Journal , IRS wordsmiths explain these benefits in an 84 page booklet.  I’ll try to stick with highlights.

The winner of all the tax benefits is the American Opportunity Tax Credit.  This covers up to $2,500 a year in qualified education expenses up to$2,500.  Anyone who goes to college more than half time is eligible (assuming you meet the AGI cutoffs < $90,000 for singles and < $180,000 for married filing jointly).  The best part about this credit is that up to 40% of it is refundable.  So if you don’t owe enough tax to get the credit as a reduction in taxes, Uncle Sam cuts you a check.  This benefit is set to expire in 2012 – so don’t budget for it past that year.  It’s been extended before, but you never know. Oops – one more exclusion – you can’t deduct education expenses the same year you get the credit.

 If graduate school or some other continuing education is what’s causing your tuition pain, then the Lifetime Learning Credit is your best shot.  While it’s available for undergraduate expenses, you can’t use it at the same time you get the AOTC, and it’s for a maximum of $2,000. The AGI cut offs are lower for this one (< $61,000 single, and <$122,000 for married filing jointly).  You also can’t take this credit if you’re taking a deduction.

Speaking of taking a tuition deduction -- you can do this if you are going to school for a line of work you’re already pursuing.  It’s up to $4,000 for AGI < $65,000 single, or < $130,000 married filing jointly.  This benefit expires after the 2011 tax year, so barring congressional action, this is the last year you can deduct tuition.  You will be able to continue deducting the interest on your student loans through 2012. 

If your employer is helping to pay your tuition, up to $5,250 can be excluded from your income, and there’s not AGI cap to worry about.  One other tax benefit that’s not subject to income thresholds is raiding your IRA for tuition help.  No early withdrawal penalties kick in, but you will have to pay tax on that money once it comes out. 

Finally a quick mention for tuition savings plans.  Coverdell Educational Savings Accounts allow you to put away $2,000 a year, and take out the proceeds to pay for education without paying taxes on any growth that occurs in the interim.  The proceeds must pay for education for someone under 30 years old, and there are AGI restrictions for these accounts.  529 plans are state specific, have no AGI limitations, and can be used to pay for anyone’s educational expenses.

A Case of Mistaken Identity

At last week’s Pittsburgh Business Times Biz-Mix event an unsuspecting entrepreneur was trapped into listening to my advice on why she should structure her new business as a pass-through entity.  I’m sure it was just what she wanted to talk about over cocktails at the Savoy.  In addition to vowing to be a more effective networker, this experience also made me think differently about tax reform.  If it's supposed to help small business, that would mean everyone is clear on what tax policies really benefit small companies and that's not the case. 

Even the IRS is getting that more clarity is needed in terms of defining what a business taxpayer looks like.  Tax Vox did a piece on the IRS overhaul of their small business count.  Using criteria that say a small business has combined income or deductions of at least $10,000 but no more than $10 million and operates in a businesslike manner, the number of small businesses in the US is now pegged at 20 million.  (Prior to the study it was 35 million).  This isn’t a story about the recession closing down businesses, it’s just cutting out businesses that are so small that they’re not really supporting anyone and also taking out businesses with small numbers of employees but lots of income.  Both those types of businesses don’t really care about things like health care tax credits or bonus depreciation.

One other item that came out of the research is only 27% of small businesses pay any wages at all.  This does bring up a recession related story.  According to a new Kaufman Foundation  study the truism about small business being the main job creator in the U.S. is true -- and that's not necessarily good news. When you net out businesses that don’t employ workers beyond the boss, the US has a decline in new business creation. According to the report new businesses in the US have historically contributed 3 million new jobs a year to the economy.  Starting in 2009, that number has fallen to 2.7 million per year.  Worse yet, the average start up staff in the 1990s was 7.5 people.  Today that same number is 4.9 jobs.  So fewer start ups and fewer jobs per business.  

My takeaway from all this is that tax reform for small business could really make a difference in helping the economy improve.  The key is paying attention to what helps businesses that grow into job creators and can scale to the point they make a difference.  This isn’t an impossible task given the available data, but it does require paying attention to more than just good sound bites. 

.. Be Thankful I Don't Take it All...

The Voluntary Worker Classification Settlement program reminds me of the Beatles song "The Taxman".  The issues surrounding worker classification are complex, expensive and filled with different taxes everywhere you turn.  Being wrong about them is easy and expensive. Worker Classification is all about whether a person is an employee or an independent contractor.   There are rules to define who is an employee and who is not.  But like everything else involving the tax code the rules are subject to interpretation. 

For purposes of assessing the amnesty program, let’s assume you know that you’ve been misclassifying employees as independent contractors.  There are plenty of reasons to do this.  Having employees is expensive.  First you typically pay half of their payroll taxes.   (This year it’s more than half because the workers are getting a payroll tax holiday.)  In addition, there is the employer portion of state and federal unemployment.  Then there is the cost of administering withholding the employee portion of the taxes and filing payroll tax returns, along with the required informational returns at the end of the year.  If an employee is an independent contractor all you have to do is the informational returns. 

Because the incentive to cheat here is high, the associated penalties are steep.   If you participate in the new program,  the IRS will charge you only ten percent of what you normally would have to pay.  They’ll also waive penalties and interest.  The Tax Mama Blogger does the math and the savings can be written using exponents.  But as we know Uncle Sam is not an overly altruistic guy, so you also have to agree to an extended statute of limitations on the assessments.

There are plenty of experts who say it’s unlikely you’d ever pay up the big numbers.  This is due to the Section 530 “Safe harbor” provision.  This portion of the Revenue Act of 1978 provides a “Get of Jail Free” card to employers who consistently and persistently misclassify workers.  Essentially this legislation says if you had a reasonable basis for thinking the person was not an employee and you treated everyone else in the same position that way, we’ll just leave it be.  There are exceptions to the safe harbor provision and the “reasonable basis” is a subjective standard, so it’s not bullet proof.  I should also mention that other experts  say you should give this program a serious look.  While Section 530 may offer relief for some, it’s not like you can be sure you qualify, and as discussed earlier, the cost of being wrong is high. 

The 2011 Obama budget proposal includes $25 million in funding to enforce worker classification laws and anticipates collecting another $7 billion in taxes as a result.  Small businesses that think they have an issue in this area should seek some help in deciding the best move in their specific case.