Jacob Courtright, Author at Whalen & Company, CPAs

Providing fringe benefits to employees with no tax strings attached

Jacob Courtright on October 18, 2022

Businesses can provide benefits to employees that don’t cost them much or anything at all. However, in some cases, employees may have to pay tax on the value of these benefits.

Here are examples of two types of benefits which employees generally can exclude from income:

A no-additional-cost benefit. This involves a service provided to employees that doesn’t impose any substantial additional cost on the employer. These services often occur in industries with excess capacity. For example, a hotel might allow employees to stay in vacant rooms or a golf course may allow employees to play during slow times.
A de minimis fringe benefit. This includes property or a service, provided infrequently by an employer to employees, with a value so small that accounting for it is unreasonable or administratively impracticable. Examples are coffee, the personal use of a copier or meals provided occasionally to employees working overtime.

However, many fringe benefits are taxable, meaning they’re included in the employees’ wages and reported on Form W-2. Unless an exception applies, these benefits are subject to federal income tax withholding, Social Security (unless the employee has already reached the year’s wage base limit) and Medicare.

Court case provides lessons

The line between taxable and nontaxable fringe benefits may not be clear. As illustrated in one recent case, some taxpayers get into trouble if they cross too far over the line.

A retired airline pilot received free stand-by airline tickets from his former employer for himself, his spouse, his daughter and two other adult relatives. The value of the tickets provided to the adult relatives was valued $5,478. The airline reported this amount as income paid to the retired pilot on Form 1099-MISC, which it filed with the IRS. The taxpayer and his spouse filed a joint tax return for the year in question but didn’t include the value of the free tickets in gross income.

The IRS determined that the couple was required to include the value of the airline tickets provided to their adult relatives in their gross income. The retired pilot argued the value of the tickets should be excluded as a de minimis fringe.

The U.S. Tax Court agreed with the IRS that the taxpayers were required to include in gross income the value of airline tickets provided to their adult relatives. The value, the court stated, didn’t qualify for exclusion as a no-additional-cost service because the adult relatives weren’t the taxpayers’ dependent children. In addition, the value wasn’t excludable under the tax code as a de minimis fringe benefit “because the tickets had a value high enough that accounting for their provision was not unreasonable or administratively impracticable.” (TC Memo 2022-36)

You may be able to exclude from wages the value of certain fringe benefits that your business provides to employees. But the requirements are strict. If you have questions about the tax implications of fringe benefits, contact us.

Ratio analysis: Extracting actionable data from your financials

Jacob Courtright on October 17, 2022

What do you do with your financial statements when your auditor delivers them? Resist the temptation to just file them away — they’re more than an exercise in compliance. With a little finagling, you can calculate key financial ratios from line items in your company’s financial statements. These metrics provide insight into historical trends, potential areas for improvement and how the business is likely to perform in the future.

Financial ratios are generally grouped into the following four principal categories:

Operating

Operating ratios — such as the gross margin or earnings per share — evaluate management’s performance and the effects of economic and industry forces. Operating ratios can illustrate how efficiently a company is controlling costs, generating sales and profits, and converting revenue to cash.

This analysis shouldn’t stop at the top and bottom of the income statement. Often, it’s useful to look at individual line items, such as returns, rent, payroll, owners’ compensation, interest and depreciation expense.

Asset management

Asset management ratios gauge liquidity, which refers to the ability of a company to meet current obligations. Commonly used liquidity ratios include:

Current ratio, or the ratio of current assets to current liabilities,
Quick ratio, which only considers assets that can be readily liquidated, such as cash and accounts receivable,
Days in receivables outstanding, which estimates the average collection period for credit sales, and
Days in inventory, which estimates the average time it takes to sell a unit of inventory.

It’s also important to consider long-term assets, such as equipment, with the total asset turnover. This ratio tells how many dollars in revenue a company generates from each dollar invested in assets. Management must walk a fine line with 1) efficient asset management, which aims to minimize the amount of working capital and other assets on hand, and 2) satisfying customers and suppliers, which calls for flexible credit terms, ample safety stock and quick bill payment.

Coverage

Coverage ratios measure a company’s capacity to service its debt. One commonly used coverage ratio is times interest earned, which measures a firm’s ability to meet interest payments and indicates its capacity to take on additional debt. Another is current debt coverage, which can be used to measure a company’s ability to repay its current debt.

Before a company that already has significant bank debt seeks further financing, it should calculate its coverage ratios. Then it should consider what message management sends to potential lenders.

Leverage

Leverage ratios can indicate a company’s long-term solvency. The long-term debt-to-equity ratio represents how much debt is funding company assets.

For example, a long-term debt-to-equity ratio of five-to-one indicates that the company requires significant debt financing to run operations. This may translate into lower returns for shareholders and higher default risk for creditors. And, because the company needs to make considerable interest payments, it has less cash to meet its current obligations.

Basis of comparison

Ratios mean little without appropriate benchmarks. Comparing a company to its competitors, industry averages and its own historical performance provides perspective on its current financial health. Contact us to help select relevant ratios to include in your analysis. We can help you create a scorecard from your year-end financial statements that your in-house accounting team can recreate throughout the year using preliminary financial numbers.

Tax and other financial consequences of tax-free bonds

Jacob Courtright on October 12, 2022

If you’re interested in investing in tax-free municipal bonds, you may wonder if they’re really free of taxes. While the investment generally provides tax-free interest on the federal (and possibly state) level, there may be tax consequences. Here’s how the rules work.

Purchasing a bond

If you buy a tax-exempt bond for its face amount, either on the initial offering or in the market, there are no immediate tax consequences. If you buy such a bond between interest payment dates, you’ll have to pay the seller any interest accrued since the last interest payment date. This amount is treated as a capital investment and is deducted from the next interest payment as a return of capital.

Interest excluded from income

In general, interest received on a tax-free municipal bond isn’t included in gross income although it may be includible for alternative minimum tax (AMT) purposes. While tax-free interest is attractive, keep in mind that a municipal bond may pay a lower interest rate than an otherwise equivalent taxable investment. The after-tax yield is what counts.

In the case of a tax-free bond, the after-tax yield is generally equal to the pre-tax yield. With a taxable bond, the after-tax yield is based on the amount of interest you have after taking into account the increase in your tax liability on account of annual interest payments. This depends on your effective tax bracket. In general, tax-free bonds are likely to be appealing to taxpayers in higher brackets since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, the tax benefit from excluding interest from income may not be enough to make up for a lower interest rate.

Even though municipal bond interest isn’t taxable, it’s shown on a tax return. This is because tax-exempt interest is taken into account when determining the amount of Social Security benefits that are taxable as well as other tax breaks.

Another tax advantage

Tax-exempt bond interest is also exempt from the 3.8% net investment income tax (NIIT). The NIIT is imposed on the investment income of individuals whose adjusted gross income exceeds $250,000 for joint filers, $125,000 for married filing separate filers, and $200,000 for other taxpayers.

Tax-deferred retirement accounts

It generally doesn’t make sense to hold municipal bonds in your traditional IRA or 401(k) account. The income in these accounts isn’t taxed currently. But once you start taking distributions, the entire amount withdrawn is likely to be taxed. Thus, if you want to invest retirement funds in fixed income obligations, it’s generally advisable to invest in higher-yielding taxable securities.

We can help

These are only some of the tax consequences of investing in municipal bonds. As mentioned, there may be AMT implications. And if you receive Social Security benefits, investing in municipal bonds could increase the amount of tax you must pay with respect to the benefits. Contact us if you need assistance applying the tax rules to your situation or if you have any questions.

SEC Chair Gensler warns about conflicts of interest

Jacob Courtright on October 10, 2022

Securities and Exchange Commission (SEC) Chair Gary Gensler spoke during a recent webcast to commemorate the 20-year anniversary of the Sarbanes-Oxley Act. Gensler recommended that the SEC take a “fresh look” at its rules on the issue of auditor conflicts of interest. He also asked the Public Company Accounting Oversight Board (PCAOB) to add auditor independence standards to its 2023 agenda.

Here’s why independence matters for public and private entities alike and what you can do to identify and minimize potential conflicts of interest.

SEC oversight

Enacted in the aftermath of the Enron and WorldCom accounting scandals, the Sarbanes-Oxley Act directed the SEC to create barriers between auditors and other parts of their firms. This caused many firms to spin off their consulting businesses into separate entities. “Over the past 20 years, however, many of these firms went on to rebuild them again. PCAOB inspections continue to identify independence — and lack of professional skepticism — as perennial problem areas,” said Gensler.

Under Rule 2-01 of Regulation S-X, when investigating auditor independence, the SEC considers whether an engagement:

Creates a mutual or conflicting interest,
Puts the auditor in a position of auditing his or her own work,
Results in the auditor acting as a member of management or an employee of its audit client, or
Puts the auditor in a position of being the client’s advocate.

The SEC’s guidance applies to audit firms, covered people in those firms and their immediate family members. The concept of “covered people” extends beyond audit team members. It may include individuals in the firm’s chain of command who might affect the audit process, as well as other current and former partners and managers.

For example, an audit firm might not be independent if, at any time during the audit engagement, a former partner or professional employee is in an accounting or financial reporting oversight role at an audit client. Such an arrangement may be particularly problematic if the former partner has a buyout arrangement that’s contingent on the firm’s operating results.

AICPA guidance

Conflicts of interest are an area of concern for all organizations, not just public companies. According to the American Institute of Certified Public Accountants (AICPA), “A conflict of interest may occur if a member performs a professional service for a client and the member or his or her firm has a relationship with another person, entity, product or service that could, in the member’s professional judgment, be viewed by the client or other appropriate parties as impairing the member’s objectivity.” Management should be on the lookout for potential conflicts when:

Hiring an external auditor,
Upgrading the level of assurance from a compilation or review to an audit, and
Using the audit firm for a nonaudit purposes, such as investment advisory services and human resource consulting

Determining whether a conflict of interest exists requires an analysis of facts. Some conflicts may be obvious, while others may require in-depth scrutiny.

For example, suppose a company asks its audit firm to provide financial consulting services in a legal dispute with another company that’s also an existing audit client. Here, given the inside knowledge the audit firm possesses of the company it audits, a conflict of interest likely exists. The audit firm can’t serve both parties to the lawsuit and comply with the AICPA’s ethical and professional standards.

Diligence is critical

Before the start of audit season, it’s important to re-evaluate whether there’s been any change in circumstances this year between your organization and your audit firm that could create potential conflicts of interest. Examples include staffing changes, M&A activity and new service offerings. This is a matter our firm takes seriously and proactively safeguards against. If you suspect that a conflict exists, contact us to discuss the matter and determine the most appropriate way to handle it.

Investing in the future with a 529 education plan

Jacob Courtright on October 4, 2022

If you have a child or grandchild who’s going to attend college in the future, you’ve probably heard about qualified tuition programs, also known as 529 plans. These plans, named for the Internal Revenue Code section that provides for them, allow prepayment of higher education costs on a tax-favored basis.

There are two types of programs:

Prepaid plans, which allow you to buy tuition credits or certificates at present tuition rates, even though the beneficiary (child) won’t be starting college for some time; and
Savings plans, which depend on the investment performance of the fund(s) you place your contributions in.

You don’t get a federal income tax deduction for a contribution, but the earnings on the account aren’t taxed while the funds are in the program. (Contributors are eligible for state tax deductions in some states.) You can change the beneficiary or roll over the funds in the program to another plan for the same or a different beneficiary without income tax consequences.

Distributions from the program are tax-free up to the amount of the student’s “qualified higher education expenses.” These include tuition (including up to $10,000 in tuition for an elementary or secondary public, private or religious school), fees, books, supplies and required equipment. Reasonable room and board is also a qualified expense if the student is enrolled at least half time.

Distributions from a 529 plan can also be used to make tax-free payments of principal or interest on a loan to pay qualified higher education expenses of the beneficiary or a sibling of the beneficiary.

What about distributions in excess of qualified expenses? They’re taxed to the beneficiary to the extent that they represent earnings on the account. A 10% penalty tax is also imposed.

Eligible schools include colleges, universities, vocational schools or other postsecondary schools eligible to participate in a student aid program of the U.S. Department of Education. This includes nearly all accredited public, nonprofit and for-profit postsecondary institutions.

However, “qualified higher education expenses” also include expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private or religious school.

A school should be able to tell you whether it qualifies.

The contributions you make to the qualified tuition program are treated as gifts to the student, but the contributions qualify for the gift tax exclusion amount ($16,000 for 2022, adjusted for inflation). If your contributions in a year exceed the exclusion amount, you can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions. Thus, assuming you make no other gifts to that beneficiary, you could contribute up to $80,000 per beneficiary in 2022 without gift tax. (In that case, any additional contributions during the next four years would be subject to gift tax, except to the extent that the exclusion amount increases.) You and your spouse together could contribute $160,000 for 2022 per beneficiary, subject to any contribution limits imposed by the plan.

A distribution from a qualified tuition program isn’t subject to gift tax, but a change in beneficiary or rollover to the account of a new beneficiary may be. Contact us with questions about tax-saving ways to save and pay for college.

Author: Jacob Courtright

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