“I have set my rainbow in the clouds, and it will be the sign of the covenant between me and the earth.”
“The financial statements look great this year. Our profits have never been higher,” thought John, a successful entrepreneur, as he reviewed his 11-month financial statements. Then the reflexive thought kicked in. “I need to do something so I don’t get killed with taxes.”
John met with his CPA and came up with a plan to reduce his income taxes. Once the year ended, John filed his tax returns (with very little due) and his CPA prepared the company’s financial statements.
Then John was reminded of the “rainbow” contained in his loan agreement with the bank.
John had agreed to certain conditions, or “covenants”, when he got his loan from the bank. And, just as God sent the rainbow as a promise to never flood the earth again, John’s banker was quick to point out the sign of his covenant… the loan agreement he had signed.
Banks use loan covenants to control their risk when making loans. Examples of non-financial covenants include:
Financial statement submission deadlines,
Restrictions on additional borrowing,
Monthly aging reports for receivables and payables
Financial covenants can catch business owners by surprise. They are often measures of cash flow, liquidity, leverage, and the ability to pay. Examples include:
Free Cash Flow(cash flow)
Debt Coverage Ratio(ability to pay)
The potential trap, however, is that tax-motivated decisions can unwittingly put a business out of compliance with its covenants. When planning tax-saving strategies, careful thought needs to be given to the financial statement impact of those strategies.
EXAMPLE: Acme Co. has taxable income of $50,000 for the year. The owner wants to eliminate 100% of the taxable income by incurring additional expenses of $50,000 before the end of the year. The following table shows the company’s picture before and after the tax-planning moves.
Acme was in a favorable position with all four loan covenants before the tax-planning move. However, by spending $50,000 to save income taxes, the company is now out of compliance on every one of them.
So, what do you do if you’re in this position?
Calculate the projected covenants. Before acting on your tax strategies, have your CPA measure the financial statement impact. This may entail some work outside the normal tax-planning process, but it might be time well spent in order to avoid a call from your banker.
Consider other options.Instead of paying cash, you might ask your vendor for payment terms or finance it with a short-term loan. Each of those options may have different impacts on your covenant measures.
Talk to your banker.He might be able to waive certain covenants if the tax strategy makes economic sense. Ask bankers what frustrates them in a lending relationship and you’ll often hear, “We don’t like surprises.”
Consider paying the taxes. This might sound like heresy, but it may be the best strategy. Cash and capital are precious to a growing company and the tax cost may be a good trade-off for retaining assets.
As you ponder your year-end moves, don’t lose sight of the big picture. Your ultimate goal is to grow the value of your business, not to minimize taxes. Of course, if you can accomplish both, go for it. Just don’t forget about that rainbow.
Martin Fox, CPA/ABV, CVAis a principal with Grimbleby Coleman CPAs, Inc., a full-service accounting firm in Modesto, California. He is accredited in business valuations and focuses his time on working with owners of small businesses to improve cash flow and values.
Debby Baker, an Experienced Senior Associate at Grimbleby Coleman CPAs, recently traveled as part of the official delegation to the International Toastmasters Convention in Kuala Lumpur, Malaysia.
Baker, who has worked for Grimbleby Coleman for the past 10 years, joined Toastmasters seven years ago on the advice of a friend. Toastmasters members meet and work to improve both their speaking and leadership skills in 14,650 clubs throughout 126 countries.
Baker says before she joined Toastmasters, her lack of confidence during presentations had begun to take a toll on her personally and professionally. The group was key to improving her outlook, and she has thrived in the organization: In June, Baker was elected Lieutenant Governor of Education and Training for District 33.
District 33 is responsible for the Central Valley, Southern California and Southern Nevada, home to 205 Toastmaster clubs with more than 3,000 members. The top three officers from every district are invited to the International Toastmasters Convention, which earlier this year took place in Kuala Lumpur, Malaysia. Baker journeyed to Malaysia on behalf of District 33, something Baker never predicted or imagined herself doing for a public speaking club.
“I have grown exponentially as a Toastmaster,” Baker said. “Not only have I become confident while giving a speech to hundreds of people, but I am also practicing what I am learning within the organization, at work, and many areas of my life. Toastmasters has made the difference for me.”
Learn more about Toastmasters International District 33 on their website: http://d33.toastmastersdistricts.org/
Clive has, in his words, been with Grimbleby Coleman since dirt and describes his role as president, cheerleader, and bottle washer. That makes sense, since he bought the practice from his father, Roy, in 1982. At the time, he had one employee, Claudia.
Before his entrance into business ownership, Clive received a BS in accounting from CSU Sacramento and an MBA from Golden Gate University, followed by time with Coopers & Lybrand and John Waddell Accountants.
When he's not running the practice, Clive keeps himself actively involved in a number of community organizations. See the list on his resume. It will make you tired!