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Jones & Roth is one of the largest CPA and Business Advisory firms with headquarters in Oregon.
Since 1946, we have been recognized as one of Oregon’s most trusted CPA firms. Our services span the areas of Tax, Audit & Assurance, Advisory, and Accounting & Payroll. Our CPAs also provide in-depth experience in over 10 specialty industries. Our goal is to have a positive impact in the lives of our clients, employees, and community.
The U.S. Department of Labor’s Employee Benefits Security Administration (EBSA) has completed an assessment of the quality of audit work performed by CPAs with respect to financial statement audits of employee benefit plans covered under the Employee Retirement Income Security Act of 1974 (ERISA).
The results of their study were alarming.
Nearly 40% of plan audits failed to comply with generally accepted auditing standards (GAAS), putting $653 billion dollars and 22.5 million plan participants and beneficiaries at an elevated risk of loss. In addition, the AICPA has determined that 21 % of practitioners in our study were not in compliance with required peer review requirements.
One notable finding was that firms that performed the fewest benefit plan audits had a 76% deficiency rate in complying with GAAS.
This report confirms what our Employee Benefit Plan Audit team believes to be true – a quality auditor is one who has extensive and specialized experience in the unique and highly technical aspects of Employee Benefit Plan audits.
The Jones & Roth Employee Benefit Plan Audit team performs more benefit plan audits than any other firm headquartered in the state of Oregon. Therefore, we hold a vigorous commitment to excellence, and our expertise covers common 401(k) plans, as well as unusual, highly technical plans such as defined benefit, 403(b), employee stock ownership (ESOP), profit-sharing, self-directed, health and welfare, and alternative investments.
Evan Dickens, CPA is a partner in the Bend office of Jones & Roth and the partner in charge of the firm’s retirement plan audit practice. Audits of employee benefit plans are his primary focus including 401(k), ESOP, 403(b), and health & welfare plans throughout the Northwest.
Let’s clear up some confusion between two income approaches — Capitalization of Earnings vs Discounted Cash Flow.
Which calculation relies on greater speculation? Does the court need some education? Is your appraiser not properly incorporating available financial information, or has the appraiser not asked all the pertinent questions?
These methods are not different methods, they are the same method.
The “Capitalization of Earnings” method (more appropriately called “capitalization of cash flow”) is the Discounted Cash Flow (DCF) method collapsed (using simplifying assumptions) to a single future year projection with a constant growth rate.
The “Capitalization” method relies on a projection of the cash flow one period into the future, then it assumes this projected cash flow will grow at a constant periodic rate. To arrive at the value estimate, the projected cash flow for the first year into the future is divided by the “capitalization rate.” The capitalization rate is the discount rate (the rate of return an investor requires for investing in a business as risky as the business being valued) adjusted for the expected constant growth rate. The formal name of this is the “Gordon Growth” Model.
The Gordon Growth Model states the present value of a perpetual annual stream of cash growing at a constant rate is:
V = D/(r – g)
V = present value of stream of cash flows
D = next period projected cash flow
r = investor (buyer’s) required rate of return, also called “discount rate”
g = annual growth rate in cash flow
The common name for the term “r – g” is “capitalization rate.” The constant growth rate can be positive, negative, or zero growth. When the constant growth rate, “g” equals zero (0%), the discount rate is equal to the capitalization rate.
We can prove the equivalency of the capitalization calculation and the DCF calculation mathematically, but we don’t wish to put you to sleep or cause your eyes to glaze over.
A simple calculation, for example, of the present value of the stream of annual cash (starting at $10,000) growing at a constant annual rate (such as 5% where the next year’s cash flow is $10,500, and the subsequent year’s cash flow is $11,025, and the following year’s is $11,576, and so on, with each year’s cash flow increasing by 5% from the prior year), is equivalent to the first year’s cash flow, $10,000, capitalized at the appropriate return adjusted for the constant growth rate.
The “Discounted Cash Flow” method allows the appraiser to incorporate more information about each period’s cash flows, resulting in projected cash flows that do not have a constant growth rate. When the appraiser has enough information to reflect non-constant growth rates for early periods, the DCF method allows the appraiser to incorporate this additional information, rather than relying on an assumption that is known to be incorrect.
At the point in time when a constant periodic growth rate going forward is a reasonable assumption, that next period’s cash flow is capitalized, valuing the cash flows from that point into perpetuity. The DCF allows the appraiser to incorporate information known that affects the cash flow of specific periods.
Often, investment in equipment is not a constant amount from year to year. When capital expenditure amounts are known for some immediate future periods (such as from the capital expenditure budget of the company being valued), using DCF, we can more accurately project cash flows and value them. We don’t need to simplify cash flows/capital expenditures to a constantly growing amount. “Simplifying” is greater speculation than incorporating specifically known periodic cash needs. DCF also allows us to accurately account for the pay down of long term debt in accordance with known debt terms, rather than assuming debt remains constant. Our estimate of the value of the projected cash flows is more accurate when we can incorporate more information into the model than a “constant growth” simplifying assumption.
Why do we care to explain the equivalency of the DCF method and the capitalization method? Why understand when the DCF is used instead of the Capitalization calculation? Here is a recent example of its pertinence.
In a recently litigated case, with appraisers representing each side, the Judge ruled that the analysis which used the DCF calculation was more speculative than the calculation using capitalization. As a result, the Judge accepted the capitalization calculation over the DCF calculation. Both appraisers had a similar starting point, year-end financials (income statements and balance sheets), and both appraisers made similar normalizing adjustments to the income statements.
While both appraisers interviewed management personnel, each requested and developed different information relative to the future of the business. One appraiser was provided with general information about the business, its history, and its organization chart and management responsibilities. From this basic information, that appraiser, relying on historical results, projected the cash flow for one year in the future and assumed (the “simplifying” assumption) a constant annual growth rate going forward.
The other appraiser was provided with explanations as to why revenues and income had been increasing (opening new service locations), what was expected of revenues and income per location after opening a new location (revenues growing for about 18 months then leveling), and future plans for opening additional locations (only one more would be opened). Capital expenditures were significantly increased when a new location was opened. Previously locations were not opened in a consistent manner, some were opened within months of each other, some more than a year apart. The most recent location opened was within the immediate market area of a currently opened location, and some revenues would be cannibalized between the two locations.
As you can imagine, the appraiser who had the detailed historical information regarding location openings and planned openings, historical revenues and expense (and capital expenditures) by location, expectations of new opening (cannibalizing revenues between locations), etc. understood that cash flows over the next 24 to 36 months were not going to grow in a constant manner.
Each location would “grow” distinctly different, and capital expenditures would not be consistent. The appraiser who had relied on a general description of the business, its history and overall operations, reviewed only total annual revenue/income growth, calculated a total entity growth rate, and it seemed somewhat consistent from year to year (this appraiser was unaware of the impact of openings of the separate locations on the revenues and income that was driving growth).
Based on a lack of information, this appraiser used a capitalization calculation, relying on the simple constant growth rate. The appraiser that took the time to understand why growth was happening, what management expected regarding its locations in the future, when it was going to need additional capital expenditures, had collected significant objective information which allowed that appraiser to understand annual cash flows would not grow in some constant manner until beyond year 3 or more.
The appraiser with the detailed understanding of operations did not need to rely on a “simple” assumption. The “Simple” assumption, constant growth, was really the sign of the more speculative valuation, an appraiser not performing appropriate due diligence.
The Judge, clearly believed that the less variables in the analysis the less speculative the valuation. The “Simple” assumption only required next year’s projected cash flow, the constant growth rate, and the “discount rate”/required rate of return. This is a pretty simple analysis, but it omitted incorporating significant and known objective operational plans.
The appraiser with greater information developed a significantly less speculative valuation. The number of variables which must be quantified does not determine which method is more speculative. More often than not, the calculation which relies on fewer variables is the more speculative analysis.
Has your appraiser speculated by simplifying, taken a short cut, or do you need to educate the Court?
Last year a break valued by many charitably inclined retirees was made permanent: the charitable IRA rollover. If you’re age 70½ or older, you can make direct contributions — up to $100,000 annually — from your IRA to qualified charitable organizations without owing any income tax on the distributions.
Satisfy your RMD
A charitable IRA rollover can be used to satisfy required minimum distributions (RMDs). You must begin to take annual RMDs from your traditional IRAs in the year in which you reach age 70½. If you don’t comply, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t. (An RMD deferral is allowed for the initial year, but you’ll have to take two RMDs the next year.)
So if you don’t need the RMD for your living expenses, a charitable IRA rollover can be a great way to comply with the RMD requirement without triggering the tax liability that would occur if the RMD were paid out to you.
You might be able to achieve a similar tax result from taking the RMD payout and then contributing that amount to charity. But it’s more complex because you must report the RMD as income and then take an itemized deduction for the donation. This has two more possible downsides:
• The reported RMD income might increase your income to the point that you’re pushed into a higher tax bracket, certain additional taxes are triggered and/or the benefits of certain tax breaks are reduced or eliminated. It could even cause Social Security payments to become taxable or increase income-based Medicare premiums and prescription drug charges.
• If your donation would equal a large portion of your income for the year, your deduction might be reduced due to the percentage-of-income limit. You generally can’t deduct cash donations that exceed 50% of your adjusted gross income for the year. (Lower limits apply to donations of long-term appreciated securities or made to private foundations.) You can carry forward the excess up to five years, but if you make large donations every year, that won’t help you.
A charitable IRA rollover avoids these potential negative tax consequences.
Have questions about charitable IRA rollovers or other giving strategies? Please contact us. We can help you create a giving plan that will meet your charitable goals and maximize your tax savings.
You can only deduct losses from an S corporation, partnership or LLC if you “materially participate” in the business. If you don’t, your losses are generally “passive” and can only be used to offset income from other passive activities. Any excess passive loss is suspended and must be carried forward to future years.
Material participation is determined based on the time you spend in a business activity. For most business owners, the issue rarely arises — you probably spend more than 40 hours working on your enterprise. However, there are situations when the IRS questions participation.
To materially participate, you must spend time on an activity on a regular, continuous and substantial basis.
You must also generally meet one of the tests for material participation. For example, a taxpayer must:
1. Work 500 hours or more during the year in the activity,
2. Participate in the activity for more than 100 hours during the year, with no one else working more than the taxpayer, or
3. Materially participate in the activity for any five taxable years during the 10 tax years immediately preceding the taxable year. This can apply to a business owner in the early years of retirement.
There are other situations in which you can qualify for material participation. For example, you can qualify if the business is a personal service activity (such as medicine or law). There are also situations, such as rental businesses, where it is more difficult to claim material participation. In those trades or businesses, you must work more hours and meet additional tests.
Proving your involvement
In some cases, a taxpayer does materially participate, but can’t prove it to the IRS. That’s where good recordkeeping comes in. A good, contemporaneous diary or log can forestall an IRS challenge. Log visits to customers or vendors and trips to sites and banks, as well as time spent doing Internet research. Indicate the time spent. If you’re audited, it will generally occur several years from now. Without good records, you’ll have trouble remembering everything you did.
Passive activity losses are a complicated area of the tax code. Consult with your tax adviser for more information on your situation.
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