Cost of Capital: How Your Business Measures Up

The cost of capital is a key part of valuing a business under the discounted cash flow (DCF) and capitalization of earnings (COE) methods. A business valuation expert discounts the subject company’s future normalized earnings using the cost of capital.

The cost of capital — also called the rate of return, “hurdle rate,” or “capitalization rate” — is based on the perceived risk of the investment. Risky companies (or investments) warrant a higher discount rate and, therefore, a lower value (and vice versa).

The Basics

The term “cost of capital” refers to the expected rate of return that the market requires to attract funds to a particular investment. This amount can be found using the COE and/or the DCF methods. A business can be financed with 100% equity or a blend of equity and debt financing.

In general, debt costs less than equity. Why? Debt holders receive regular economic benefits (interest and principal payments). But equity investors receive dividends only at management’s discretion, and they must wait until a sale to receive any capital appreciation.

Cost of Equity

Several market-based rates can be used to estimate the cost of equity. It typically includes the following components:

A risk-free rate, based on a long-term government bond,
A market risk premium, based on historical returns for a stock index over the risk-free rate,
A market size premium, based on the relative size of the subject company compared to the S&P 500, and
A company-specific risk premium based on the subject company’s financial performance, industry and other attributes.

The cost of equity is used as the cost of capital when the subject company is financed 100% with equity financing — or when the valuation expert discounts earnings available to only equity investors.

Weighted Average Cost of Capital

Conversely, when discounting the earnings available to both equity investors and creditors, professionals apply a blended rate that incorporates the cost of equity and the cost of debt. This rate is often referred to as the weighted average cost of capital (WACC).

The cost of debt is fairly straightforward: It’s based on the interest rate that banks charge companies for borrowing money. Interest rates have been near historic lows in recent years, so debt can be an inexpensive form of financing. But there are limits to the amount of debt financing creditors will allow, and the cost of debt gradually increases as companies become increasingly leveraged.

In addition, interest payments are generally deductible as a business expense, which further reduces the cost of debt. But, going forward, when valuing larger companies, it’s important to factor in limitations on interest expense deductions under the Tax Cuts and Jobs Act. (See “Tax Law Changes Affect the Cost of Capital” at right.)

Capital Structure

When using WACC as the discount rate in a DCF analysis, an expert can choose various capital structures. What’s appropriate depends on the characteristics of the company and the standard of value being applied.

For example, an expert can apply the subject company’s historical or expected percentages of debt and equity financing. This may be appropriate when valuing a minority interest that lacks the control needed to alter the company’s capital structure.

Alternatively, an expert may choose an industry average capital structure. This is generally more relevant when valuing a controlling interest in the business.

What’s Right for Your Business?

Small differences in the cost of capital can have a major effect on the value of your business. Contact a credentialed business valuation professional to help you get it right.

The Tax Cuts and Jobs Act (TCJA) has altered the cost of capital for many companies. So, if your company has historically used, say, a 14% “hurdle rate” to evaluate investment decisions, you might need to adjust that figure going forward.

For example, in situations where a business uses its tax savings from the TCJA to pay off debt or repurchase outstanding stock, it could affect the company’s expected capital structure. That is, its blend of debt and equity financing.

Companies that transition to more equity financing (by paying down debt) could potentially increase the overall cost of capital. That’s because the pre-tax cost of debt is generally less expensive than the pre-tax cost of equity. Those that transition to more debt financing (by buying back stock) would likely reduce their overall cost of capital.

The TJCA also limits interest expense deductions for larger companies to 30% of qualified business income. This limitation could increase the cost of debt — because less interest expense would be tax deductible. However, companies with average annual gross receipts of $25 million or less for the three previous tax years are exempt from this limitation. The rules also allow certain real estate and farming entities to elect out of the limitation rules.

For more information about how the TCJA affects your company’s cost of capital, contact a business valuation professional.

Nonprofits are unique in that they sometimes obtain cash (or other assets) without providing an exchange of commensurate value. Accountants know that as contribution revenue. Sometimes it is hard to determine if a transaction is contribution revenue or exchange revenue, or how to account for it, especially in cases involving government grants and contributions. ASU 2018-08 Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made explains clearly when revenue is exchange versus contribution.

Who is paying and who is receiving goods or services?

The first step in ascertaining the accounting is determining who is paying the money and who, if anyone, is getting goods or services from the transaction. If the nonprofit gets funds from a payor and provides that payor direct commensurate value in return, that is an exchange transaction. An example would be when you purchase a training class from your membership organization − you pay the value of what you are receiving. If the nonprofit gets funds from a payor and no value is paid out to anyone at that time, that is clearly a contribution. If the nonprofit gets funds from a payor, such as the federal government, with the purpose of the nonprofit providing the goods and services to a third party, the general public or a subsegment thereof, that is also a contribution. When the general public, or someone other than the payor, receives the goods or services, it is a contribution.

Transactions that include both a contribution and an exchange

Sometimes transactions include both a contribution and an exchange portion. For example, many zoos, museums, etc. have membership structures where for a certain amount you can get a family membership which provides unlimited entrances to the establishment for a year. However, there is another membership level where the cost is more than the family membership, and the “additional benefits” are really just getting your name published as being a higher class of member or a donor. In these instances, we may need to bifurcate the revenue. We need to determine what value is actually received for a membership, potentially that could be the cost of the regular family membership. The value received for the membership is exchange revenue, and the additional amount paid is a contribution. This is common when there are multiple levels of memberships, in sponsorship agreements, fundraising events, and many other places. Once you know what portion is contribution revenue and what portion is exchange revenue, you can start accounting for it.

Accounting for exchange transactions

The exchange revenue portion uses the same accounting as for-profits use. The revenue is recognized when, or as, the goods and services (performance obligations) are transferred. Any money collected before the goods or services are transferred is deferred revenue (a liability). If the goods or services are provided before the cash changes hands, an account receivable is recorded at the time the goods or services transfer hands. All exchange revenue amounts are unrestricted (without donor restrictions), because there is no donor involved. Under the new revenue recognition standards, significant disclosures, including the total amount of exchange revenue, will be required.

Although the actual accounting for exchange revenue is likely to be straightforward, the new revenue recognition rules will take significant time and effort to implement. In order to obtain the disclosures, each revenue transaction cycle needs to be analyzed in detail. In many cases, this will be a significant amount of time and effort without any material change in the revenue numbers. The distinction between exchange and contribution revenue becomes more important this year, even if all the revenue is recorded in the same fiscal year, due to these disclosures. See Yeo & Yeo’s Revenue Recognition for Nonprofits eBook for more details.

Accounting for contributions

The contribution accounting isn’t quite so straightforward. We know that it is contribution revenue, but we need to determine if it is conditional or unconditional. If the contribution transaction has both a right of return (or right of release) and a barrier, then the contribution is conditional and no revenue is recognized until the conditions are met. A right of return or right of release means the contributor can request the funds be returned or doesn’t have to pay the nonprofit the funds unless the barrier is met. The barriers are measurable performance-related barriers, stipulations related to the purpose of the agreement (not administrative reporting tasks), or limited discretion by the recipient (such as having allowable cost requirements narrower than what the organization or program as a whole could do). This is a new definition; likelihood of a condition being met is no longer a criteria in determining conditional versus unconditional.

If the contribution is conditional, revenue is not recorded until it becomes unconditional (the contributor no longer has a right of return or right of release because the barrier has been met). If money is received before the contribution becomes unconditional, it is recorded as a liability (advance or deferred revenue). Conditional contributions require, as has always been the case, that you disclose the amounts of conditional contributions and what the conditions are. This means for federal grants, for example, you will need to know the total amount of grants that have been granted but the funds have not yet been earned (presumably have not yet been requested). The disclosure would indicate that there is $X of conditional contributions subject to 2 CFR 200 requirements.

If the contribution is unconditional, it gets recorded as revenue as soon as the contribution is made, regardless of whether it is yet collected. It is recorded at the present value of future cash flows. That means not only short-term contributions receivable, but also long-term ones, are recorded. If an organization promises unconditionally to give the nonprofit $100,000 per year for five years, the present value of the full $500,000 is recorded as revenue and a contribution receivable in the year the promise is made!

Donor restrictions

You also must determine if there are donor restrictions as to the use of the funds. If the funds are to support a specific time period or a specific program (which is narrower in scope than the mission), they get recorded as with donor restrictions. If there is a multi-year contribution receivable, there is an implied time restriction that the amounts are not to be used until the year in which they are to be received, so that would be recorded as with donor restrictions. If the amounts are to be invested in perpetuity and only the income used, that would also be recorded as with donor restrictions. Note that many of the conditional contributions from the federal government are also with donor restrictions; they can only be used for certain programs. However, the condition and the restriction may both be satisfied at the same time. Because of this, there is a policy election for contribution revenues where the restriction and condition are both met at the same time; this can be recorded in either with or without donor restrictions and this policy election is separate from other with donor restriction contributions that are met in the same year.

In summary:

All exchange revenue is considered without donor restriction, because there is no donor. All cash collected for exchange revenue before the money is earned is a liability (deferred revenue). Exchange revenue never results in net assets with donor restrictions, as there is no donor.
Contribution revenue, once unconditional, can be with donor restrictions or without donor restrictions. Contribution revenue is recorded as soon as it becomes revenue, and not when the corresponding expenses are paid. If the contribution revenue is with donor restrictions, the release from restriction will be recorded when the expenses have been made that release the restriction. Contribution revenue is only a liability if it is a conditional contribution that was received and the conditions have not yet been met.

This distinction will become more important when the revenue recognition standards, and the related disclosure requirement to say how much revenue is from contracts (exchange), are implemented.

Hiring an accountant for your nonprofit organization is different from hiring one for a traditional, for-profit business. Nonprofit accounting has many nuances, and you will need someone who understands the mission-driven challenges surrounding donors, resources and sustainability. Look for the following five considerations in hiring an accountant for a nonprofit organization.

1. Passionate

Everyone on your team should be passionate about the organization’s cause and mission. When people are inspired by the work they are doing, they are more likely to work harder for you. No matter their role, everyone’s goal should align with that of the organization. All organization decisions must be viewed through the lens of accomplishing the organization’s mission.

2. Understands Fund Accounting

It is important for your candidates to understand fund accounting, which is different from traditional accounting. With a focus on accountability rather than profitability, a nonprofit accountant needs to be aware that the organization’s stakeholders are concerned with proper utilization and allocation of funds rather than a bottom line.

3. Understands Nonprofit Reporting and Compliance

Nonprofit organizations are exempt from federal income taxes, which means that they face more scrutiny and reporting requirements than for-profit organizations do. Your accountant will need to be familiar with the various reporting and compliance requirements, such as Form 990, Michigan License to Solicit, payroll taxes, sales tax, audits, etc. Also, many nonprofit organizations are grant recipients and must report to grantors. Your candidates should have a base knowledge of those reporting and compliance areas that affect the organization. When you interview candidates, be sure to ask technical questions that will show the depth of their understanding and experience.

4. Resourceful

For many nonprofit organizations, funds can be tight. Look for a candidate who is resourceful and excels at solving problems. These types of candidates typically enjoy a challenge and will look for new ways to resolve issues and overcome barriers the organization may be facing. Sustainability and cash flow are of utmost importance for most nonprofits in their drive to accomplish their mission, and your accountant should share in the quest for efficiency, quality, and continuous improvement.

5. Strong Communication Skills

Your candidates should be strong communicators. When it comes time to relay accounting information, they will need to be able to discuss the financial information and reporting with people who may not understand nonprofit accounting. Having strong communication skills will help the candidates do this efficiently and effectively.

It may take extra time to recruit strong candidates. Look for someone who has these strengths along with other experiences and skills to help support your organization’s goals. Hiring the right person can help your organization’s ability to grow and thrive for years to come.

Learn more about the services Yeo & Yeo provides for nonprofits.

As you’ve probably heard, a new law was recently passed with a wide range of retirement plan changes for employers and individuals. One of the provisions of the SECURE Act involves a new requirement for employers that sponsor tax-favored defined contribution retirement plans that are subject to ERISA.

Specifically, the law will require that the benefit statements sent to plan participants include a lifetime income disclosure at least once during any 12-month period. The disclosure will need to illustrate the monthly payments that an employee would receive if the total account balance were used to provide lifetime income streams, including a single life annuity and a qualified joint and survivor annuity for the participant and the participant’s surviving spouse.

Background information

Under ERISA, a defined contribution plan administrator is required to provide benefit statements to participants. Depending on the situation, these statements must be provided quarterly, annually or upon written request. In 2013, the U.S. Department of Labor (DOL) issued an advance notice of proposed rulemaking providing rules that would have required benefit statements provided to defined contribution plan participants to include an estimated lifetime income stream of payments based on the participant’s account balance.

Some employers began providing this information in these statements — even though it wasn’t required.

But in the near future, employers will have to begin providing information to their employees about lifetime income streams.

Effective date

Fortunately, the effective date of the requirement has been delayed until after the DOL issues guidance. It won’t go into effect until 12 months after the DOL issues a final rule. The law also directs the DOL to develop a model disclosure.

Plan fiduciaries, plan sponsors, or others won’t have liability under ERISA solely because they provided the lifetime income stream equivalents, so long as the equivalents are derived in accordance with the assumptions and guidance and that they include the explanations contained in the model disclosure.

Stay tuned

Critics of the new rules argue the required disclosures will lead to confusion among participants and they question how employers will arrive at the income projections. For now, employers have to wait for the DOL to act. We’ll update you when that happens. Contact us if you have questions about this requirement or other provisions in the SECURE Act.

The Michigan State Housing Development Authority (MSHDA) and the U.S. Department of Agriculture’s Office of Rural Development (RD) released the allowable multifamily property management fees for 2020.

MSHDA

The maximum fees allowed by MSHDA for the 2020 calendar year are as follows:

Management fee per unit – $534
Premium management fee per unit – $82
This is slightly more than a one percent increase from the 2019 maximum fees of $527 for the management fee per unit and $81 for the premium management fee per unit.

See MSHDA’s 2020 Annual Budget Guide Policy

Rural Development

RD management fees vary from state to state based on the increase of HUD’s Operating Cost Adjustment Factor.

The fees in effect for 2020 can be found in the attachments to HB 3560-2, Chapter 3.

Highlights for Michigan include an approximate four percent increase from the 2019 fee of $52 to $54 per occupied unit per month beginning in 2020.

HUD

Multifamily projects subject to the U.S. Department of Housing and Urban Development (HUD) should review the guidelines in The Management Agent Handbook for requirements in determining allowable fee amounts to be paid with project funds.

HUD management fees are typically calculated using a fee per unit, per month calculation that is converted to a percent of the total rental income of a property. Management fee agreements may be open-ended or define a set period, such as three years.

For more information, please contact your Yeo & Yeo advisor.

Yeo & Yeo CPAs & Business Consultants has been named to Forbes’ Top Recommended Tax and Accounting Firms for 2020. Yeo & Yeo was listed as one of 112 firms nationwide recommended for tax services.

“Being named as a top tax firm in the country is a tremendous honor,” said David Jewell, Principal and leader of the firm’s Tax Service Line. “We are thankful for the trust that our clients have put in our tax professionals, and for the long-term relationships that we have with so many of them. We also thank our staff for their commitment and dedication to our clients and the firm, which has built our reputation.”

To create the list of America’s Top Recommended Tax and Accounting Firms, Forbes partnered with the market research company Statista to consider 1,800 survey responses from CPAs, enrolled agents, tax lawyers, accountants, and CFOs. Survey participants who worked for a tax or accounting firm could name a maximum of ten firms for both tax and accounting that they would recommend if their company were not able to take on a client. Also, survey participants who worked in a company on the client side were asked to name up to ten firms each in tax and accounting that they would recommend based on their professional experience over three years. The survey identified 227 firms, from the largest in the country to some of the smallest.

According to Statista, they’re all tackling the complexities of the ever-changing tax laws, such as the Tax Cuts and Jobs Act (TCJA), head-on. Yeo & Yeo offers several resources regarding the TCJA that can help families and businesses understand the sweeping changes.

See the complete list of Forbes’ Top Recommended Tax and Accounting Firms for 2020.

The Further Consolidated Appropriations Act, 2020 was signed into law on December 20, 2019. This law retroactively removed the transportation fringe benefits tax for nonprofit organizations. Specifically, it struck out the wording that required transportation fringe benefit expenses (parking and transit passes) to be included in the unrelated business income definition.

Going forward, this means the only time a nonprofit needs to be concerned about calculating the amount of nondeductible transportation fringe benefit expenses is when the nonprofit already has another unrelated business. The transportation fringe benefit expenses are nondeductible for that unrelated business. In other words, they cannot be considered expenses on the 990-T. “Taxable expenses” will no longer be included on the 990-T.

This bill is retroactive. This means all the taxable transportation fringe benefits reported on the fiscal year 2017 or 2018 Form 990-T can be refunded to the nonprofit. Currently, the refund may be requested by filing an amended 990-T return. Even if no tax was paid, due to using a net operating loss carryforward, it may be beneficial to amend the 990-T return to get the net operating loss carryforward back to its original, larger amount. For organizations that paid interest and penalties for late payment on a notice, rather than on the return, it is not clear how those amounts will be refunded via an amended 990-T return.

We will keep you updated if the IRS provides any additional guidance on obtaining refunds for transportation fringe benefits or reclaiming net operating loss carryforwards that were used against transportation fringe benefits. If you would like Yeo & Yeo to prepare your amended 990-T return, please contact your Yeo & Yeo professional. Preparation of an amended 990-T would be a separate and distinct engagement with a separate engagement letter and fee.

If you save for retirement with an IRA or other plan, you’ll be interested to know that Congress recently passed a law that makes significant modifications to these accounts. The SECURE Act, which was signed into law on December 20, 2019, made these 4 new law changes that may affect your retirement plan.

Change #1: The maximum age for making traditional IRA contributions is repealed. Before 2020, traditional IRA contributions weren’t allowed once you reached age 70½. Starting in 2020, an individual of any age can make contributions to a traditional IRA, as long he or she has compensation, which generally means earned income from wages or self-employment.

Change #2: The required minimum distribution (RMD) age was raised from 70½ to 72. Before 2020, retirement plan participants and IRA owners were generally required to begin taking RMDs from their plans by April 1 of the year following the year they reached age 70½. The age 70½ requirement was first applied in the early 1960s and, until recently, hadn’t been adjusted to account for increased life expectancies.

For distributions required to be made after December 31, 2019, for individuals who attain age 70½ after that date, the age at which individuals must begin taking distributions from their retirement plans or IRAs is increased from 70½ to 72.

Change #3: “Stretch IRAs” were partially eliminated. If a plan participant or IRA owner died before 2020, their beneficiaries (spouses and non-spouses) were generally allowed to stretch out the tax-deferral advantages of the plan or IRA by taking distributions over the beneficiary’s life or life expectancy. This is sometimes called a “stretch IRA.”

However, for deaths of plan participants or IRA owners beginning in 2020 (later for some participants in collectively bargained plans and governmental plans), distributions to most non-spouse beneficiaries are generally required to be distributed within 10 years following a plan participant’s or IRA owner’s death. That means the “stretch” strategy is no longer allowed for those beneficiaries.

There are some exceptions to the 10-year rule. For example, it’s still allowed for: the surviving spouse of a plan participant or IRA owner; a child of a plan participant or IRA owner who hasn’t reached the age of majority; a chronically ill individual; and any other individual who isn’t more than 10 years younger than a plan participant or IRA owner. Those beneficiaries who qualify under this exception may generally still take their distributions over their life expectancies.

Change #4: Penalty-free withdrawals are now allowed for birth or adoption expenses. A distribution from a retirement plan must generally be included in income. And, unless an exception applies, a distribution before the age of 59½ is subject to a 10% early withdrawal penalty on the amount includible in income.

Starting in 2020, plan distributions (up to $5,000) that are used to pay for expenses related to the birth or adoption of a child are penalty-free. The $5,000 amount applies on an individual basis. Therefore, each spouse in a married couple may receive a penalty-free distribution up to $5,000 for a qualified birth or adoption.

Questions?

These are only some of the changes included in the new law. If you have questions about your situation, don’t hesitate to contact us.

A significant law, the SECURE Act, was recently passed that adds tax breaks and makes changes to employer-provided retirement plans. If your small business has a current plan for employees or if you’re thinking about adding one, you should familiarize yourself with the new rules.

The SECURE Act was signed into law on December 20, 2019 as part of a larger spending bill. Here are three provisions of interest to small businesses.

Employers that are unrelated will be able to join together to create one retirement plan. Beginning in 2021, new rules will make it easier to create and maintain a multiple employer plan (MEP). A MEP is a single plan operated by two or more unrelated employers. But there were barriers that made it difficult to setting up and running these plans. Soon, there will be increased opportunities for small employers to join together to receive better investment results, while allowing for less expensive and more efficient management services.
There’s an increased tax credit for small employer retirement plan startup costs. If you want to set up a retirement plan, but haven’t gotten around to it yet, new rules increase the tax credit for retirement plan start-up costs to make it more affordable for small businesses to set them up. Starting in 2020, the credit is increased by changing the calculation of the flat dollar amount limit to: The greater of $500, or the lesser of: a) $250 multiplied by the number of non-highly compensated employees of the eligible employer who are eligible to participate in the plan, or b) $5,000.
There’s a new small employer automatic plan enrollment tax credit. Not surprisingly, when employers automatically enroll employees in retirement plans, there is more participation and higher retirement savings. Beginning in 2020, there’s a new tax credit of up to $500 per year to employers to defray start-up costs for new 401(k) plans and SIMPLE IRA plans that include automatic enrollment. This credit is on top of an existing plan start-up credit described above and is available for three years. It is also available to employers who convert an existing plan to a plan with automatic enrollment.

These are only some of the retirement plan provisions in the SECURE Act. There have also been changes to the auto enrollment safe harbor cap, nondiscrimination rules, new rules that allow certain part-timers to participate in 401(k) plans, increased penalties for failing to file retirement plan returns and more. Contact us to learn more about your situation.

David R. Youngstrom, CPA, and Michael A. Georges, CPA, have been reelected to Yeo & Yeo’s board of directors effective January 1, 2020, announced Thomas E. Hollerback, president & CEO. They will each serve a two-year term.

David R. Youngstrom, CPA, principal, is the firm’s Assurance Service Line leader. He is responsible for all audits performed throughout Michigan and provides audit services for school districts, government entities, and for-profit businesses. He is a frequent presenter on audit topics at statewide conferences and also provides various consulting services. He is a member of the firm’s Government Services Group, the Education Services Group, and the Quality Assurance Committee. He has 24 years of public accounting experience.

In the community, Youngstrom serves on the Executive Committee of the Saginaw Valley State University Alumni Association, has served on the Freeland Community School District Board of Education for more than 10 years, and is past chairman of the United Way of Saginaw County. He is based in the firm’s Saginaw office.

Michael A. Georges, CPA, principal in the Ann Arbor office, joined Yeo & Yeo in 2014 and has 40 years of public accounting experience. He is a member of the firm’s Nonprofit Services Group. His areas of expertise include audit services for nonprofit organizations, government entities and school districts, as well as tax planning and preparation for individuals, small and medium-size businesses, and nonprofit organizations. He is a member of Michigan School Business Officials and the Southern Wayne County Chamber of Commerce.

In the community, Georges serves as a board member for the Grosse Ile Education Foundation, and the Child’s Hope Child Abuse Prevention Council of Out-Wayne County.

The Tax Cuts and Jobs Act created a new program to encourage investment in economically distressed areas through generous tax incentives. The Qualified Opportunity Zone (QOZ) program relies on investments in Qualified Opportunity Funds (QOFs) — funds that can provide wealthy taxpayers with some new avenues for estate planning.

3 big tax benefits

Investors in QOFs stand to reap three significant tax breaks:

They can defer capital gains on the disposition of appreciated property by reinvesting the gains in a QOF within 180 days of disposition. The tax is deferred until the QOF investment is sold or Dec. 31, 2026, whichever is earlier.
Depending on how long they hold their QOF investment, they can eliminate 10% to 15% of the tax.
After 10 years, post-acquisition appreciation on the investment is tax-exempt.

By incorporating QOFs in your estate planning, you can reduce both capital gains and transfer tax liabilities.

Estate planning implications

Proposed regulations make clear that a QOF investor’s death isn’t an “inclusion event” that would trigger tax on the deferred gains. In addition, most of the activities involved in administering an estate or trust (for example, transferring the interest to the estate or distributing the interest) won’t trigger the gain. But the sale of the QOF interest by the estate, the trust or a beneficiary would. Gifts of QOF interests also are generally considered inclusion events that make the deferred gains immediately taxable.

You could avoid this, though, by gifting your interest to a grantor trust. Both revocable living trusts and irrevocable grantor trusts qualify. However, transfers to the latter are completed gifts and therefore produce greater potential tax savings in situations where the income and gains of the trust are taxed to the grantor, in turn reducing the grantor’s estate by the amount of income taxes paid. (Note, though, that the termination of grantor trust status for reasons other than the grantor’s death is treated as an inclusion event.)

For example, you could transfer a highly appreciated asset to an irrevocable trust with no gift tax under the federal gift and estate tax exemption ($11.40 million for 2019 and $11.58 million for 2020). The trust could sell the asset and defer the gains into a QOF investment.

Another option for transferring QOF interests is the grantor retained annuity trust (GRAT), which allows you to make a gift to a trust and receive an annuity interest roughly equal to the fair market value of the gift. Any appreciation beyond the amount required to pay the annuity also passes to the beneficiaries without gift tax.

As part of a year-end budget bill, Congress just passed a package of tax provisions that will provide savings for some taxpayers. The White House has announced that President Trump will sign the Further Consolidated Appropriations Act of 2020 into law. It also includes a retirement-related law titled the Setting Every Community Up for Retirement Enhancement (SECURE) Act.

Here’s a rundown of some provisions in the two laws.

The age limit for making IRA contributions and taking withdrawals is going up. Currently, an individual can’t make regular contributions to a traditional IRA in the year he or she reaches age 70½ and older. (However, contributions to a Roth IRA and rollover contributions to a Roth or traditional IRA can be made regardless of age.)

Under the new rules, the age limit for IRA contributions is raised from age 70½ to 72.

The IRA contribution limit for 2020 is $6,000, or $7,000 if you’re age 50 or older (the same as 2019 limit).

In addition to the contribution age going up, the age to take required minimum distributions (RMDs) is going up from 70½ to 72.

It will be easier for some taxpayers to get a medical expense deduction. For 2019, under the Tax Cuts and Jobs Act (TCJA), you could deduct only the part of your medical and dental expenses that is more than 10% of your adjusted gross income (AGI). This floor makes it difficult to claim a write-off unless you have very high medical bills or a low income (or both). In tax years 2017 and 2018, this “floor” for claiming a deduction was 7.5%. Under the new law, the lower 7.5% floor returns through 2020.

If you’re paying college tuition, you may (once again) get a valuable tax break. Before the TCJA, the qualified tuition and related expenses deduction allowed taxpayers to claim a deduction for qualified education expenses without having to itemize their deductions. The TCJA eliminated the deduction for 2019 but now it returns through 2020. The deduction is capped at $4,000 for an individual whose AGI doesn’t exceed $65,000 or $2,000 for a taxpayer whose AGI doesn’t exceed $80,000. (There are other education tax breaks, which weren’t touched by the new law, that may be more valuable for you, depending on your situation.)

Some people will be able to save more for retirement. The retirement bill includes an expansion of the automatic contribution to savings plans to 15% of employee pay and allows some part-time employees to participate in 401(k) plans.

Also included in the retirement package are provisions aimed at Gold Star families, eliminating an unintended tax on children and spouses of deceased military family members.

Stay tuned

These are only some of the provisions in the new laws. We’ll be writing more about them in the near future. In the meantime, contact us with any questions.

President Trump signed the SECURE Act on December 20, 2019, as part of the federal government’s spending bill, and it will affect most retirement savers, as well as employers who offer retirement plans to their employees.

The SECURE Act legislation — which stands for “Setting Every Community Up for Retirement Enhancement” — puts into place numerous provisions intended to strengthen retirement security across the country. The Act includes a significant number of changes for both individuals with qualified retirement accounts, as well as employers who currently offer retirement plans to their employees.

Key provisions of the SECURE Act include:

Stretch IRAs eliminated – all funds from an inherited IRA generally must now be distributed to non-spouse beneficiaries within ten years of the owner’s death, with some exceptions for specified circumstances. Beneficiaries may no longer stretch inherited IRAs out over their expected lifetime.
Allows penalty-free withdrawals from qualified plans for the birth or adoption of a child.
Required minimum distributions (RMDs) must now begin at age 72, not at 70½.
No age restrictions on IRA contributions for taxpayers who continue to work into their 70s and have earned income.
401(k) eligibility for part-time employees who have worked at least 500 hours per year for at least three consecutive years and have attained age 21 by the end of the three years.
Allows expansion of access to multi-employer plans, allowing unrelated businesses to provide defined contribution plans at lower costs.
Section 529 plan distributions may now be used for costs associated with registered apprenticeships, and up to $10,000 of qualified student loan repayments (principal or interest).

Contact your Yeo & Yeo professional with questions about how these changes may impact your personal retirement and your business.

New Budget Bill Extends Many Expiring Tax Provisions

Congress passed the Taxpayer Certainty and Disaster Relief Act of 2019 as part of the Further Consolidated Appropriations Act on December 19, 2019, and on December 20, President Trump signed the bill into law.

The Act contains disaster relief provisions, repeals some of the tax provisions of the Affordable Care Act, and increases funding for the Internal Revenue Service. The Disaster Relief Act extends more than 30 expired tax provisions through 2020.

Key provisions extended through 2020 include:

Mortgage debt forgiveness on a principal residence in certain situations
The ability to deduct mortgage insurance premiums as an itemized deduction
Medical deduction for qualified expenses exceeding 7.5% of adjusted gross income (versus 10%)
Tuition and fees deduction as an “above-the-line” deduction
Work Opportunity Tax Credit (WOTC) for employers hiring from certain targeted pools of employees
Family and Medical Leave credit for employers meeting certain criteria and offering such benefits
Plug-in vehicle credit for certain qualifying vehicles

Provisions that were not included in the Act:

Reinstatement of unreimbursed employee expenses being deductible as an itemized deduction
Increase in the $10,000 cap on state and local tax deductions allowed as itemized deductions

Contact your Yeo & Yeo tax professional with questions about how these changes may impact your specific tax situation.

Yeo & Yeo is pleased to provide 2020 Tax Planning Calendars and other helpful tax planning resources.

What are the due dates for next year’s tax filings? When are the various tax payments due?

The 2020 Tax Calendar for Business and the 2020 Tax Calendar for Individuals and Trusts are valuable tools to help you plan for the deadlines.

What can you do now to save tax dollars?

Yeo & Yeo’s 2019 Year-end Tax Planning Checklist of action items may help you or your business save tax dollars. Please review the checklist and contact us soon if you would like help with deciding which tax-saving moves to make.

For more extensive information, visit Yeo & Yeo’s Tax Guide Online.

Yeo & Yeo honors employees for longevity, proudly recognizing 11 associates across the firm’s companies for milestone anniversaries at the firm’s annual holiday celebration held at Horizons Conference Center in Saginaw.

The following professionals were honored for 25 years of service.

Fred Miller, Vice President, Yeo & Yeo Technology, assists with the administration of YYTECH, works with clients as an Account Manager to support their technology goals, and works with the Business Applications team to implement solutions to meet clients’ business needs. He is a Boy Scout leader.

Rebecca Millsap, Managing Principal, Yeo & Yeo CPAs – Flint, leads the firm’s Estate & Trust Group and is a member of the Tax Services Group. Her areas of expertise include tax and business consulting, and assisting small businesses with financial reporting and strategic planning. Becky is the treasurer of the Rotary Club of Flint and serves on the Finance Council and Building Committee of Holy Family Catholic Church in Grand Blanc.

The following professional was honored for 20 years of service.

Traci Cook, CPC, CPMA^®, Billing and Coding Consultant and Account Manager, Yeo & Yeo Medical Billing & Consulting, performs billing and coding reviews for physicians’ offices and advises them on how to maximize their reimbursement. She also provides training for billing and coding staff. She oversees the billing process for several accounts.

The following professionals were honored for 15 years of service.

Matt Dubay, Senior Systems Engineer, Yeo & Yeo Technology, provides support for YYTECH’s external clients. He implements and troubleshoots computer server environments such as Microsoft and VMware.

Chloe Eggleston, Receptionist, Yeo & Yeo CPAs – Saginaw, is the Ambassador of First Impressions, responsible for welcoming clients and visitors, and maintaining security and telecommunications. For 17 years she has been an advisor and board member for Young Champions, an organization that encourages young people to serve others.

Gus Hendrickson, Account Executive, Yeo & Yeo Technology, consults with businesses to help them achieve their objectives through the use of technology. Gus is engaged with organizations that make a positive impact on kids such as the CAN Council, READ Association, United Way, youth sports and scouting.

Jacob Sopczynski, CPA, Principal, Yeo & Yeo CPAs – Flint, provides audits for governmental entities, school districts and nonprofit organizations, as well as strategic tax planning for businesses and individuals. He is a member of the firm’s Manufacturing Services Group. He also serves clients as a consultant and specialist in the application of data extraction techniques. He is treasurer of the International Academy of Flint.

Eric J. Sowatsky, CPA, CGMA, NSSA^®, Principal, Yeo & Yeo CPAs – Saginaw, Eric leads the firm’s Agribusiness Services Group and the Saginaw tax department. At Bethlehem Lutheran Church & School, he is treasurer, finance committee chairman and a member of the athletics committee, and he sings in the church’s Boar’s Head Christmas Festival.

The following professionals were honored for 10 years of service.

Michael Evrard, CPA, Senior Manager, Yeo & Yeo CPAs – Kalamazoo, primarily works on audit engagements for nonprofit organizations and school districts, in addition to serving on the firm’s Audit Services Group and the Nonprofit Services Group.

Dan Featherston, Sales Support Specialist, Yeo & Yeo Technology, works with multiple YYTECH Account Executives to prepare quotes, proposals and other documentation. He researches new devices, including servers and computers, to find the appropriate device for each client.

Jesse Marenger, CPA, Senior Manager, Yeo & Yeo CPAs – Saginaw, is the Retirement Plan Audit Services Group Leader, specializing in auditing 401(k), 403(b), employee stock ownership, defined benefit pension, and health & welfare plans.

Consider how many capital asset purchases your municipality makes each year. The capital assets purchased and disposed of include everything from water and sewer system lines to copiers used in daily operations. Many governmental entities face the challenge of properly accounting for these purchases and sales. It is imperative to track and report them to the finance department to ensure that the capital asset balances presented in the government entity’s annual financial report are accurate and represent the actual capital assets the entity has in its possession. There are a number of common capital asset reporting issues encountered by municipalities.

It may be difficult for the finance department to report the capital asset balances accurately. Two common hurdles that a governmental entity may encounter are:

The capital asset listing contains assets that the governmental entity no longer possesses.
The capital asset listing is missing key information required to physically identify the asset.

Each of these hurdles is addressed below in more detail, with recommendations for overcoming them.

Disposal of assets

Capital asset listings for governmental entities are typically very large and contain assets from many years ago that are likely still in use, such as buildings or land. However, it is common for a capital asset listing to contain assets that may have been disposed of long ago, which were unidentified. This is partially because many governmental entities focus heavily on the capital assets that are being purchased each year as they require approvals and additional documentation that flows directly through the finance department. Also, disposal of capital assets does not always result in the governmental entity receiving proceeds; therefore, individual departments may dispose of capital assets (due to obsolescence, malfunction, etc.) without notifying the finance department.

To help mitigate the risk that disposed capital assets will not be removed from the listing, capital asset policies should be in place that include capitalization thresholds for each major capital asset category as well as detailed capital asset purchase and disposal procedures. Further, strong communication of these policies by the finance department to all other departments of the governmental entity is key to ensure that they are aware of the requirements and are adequately tracking their purchases and disposals throughout the year and reporting this information to the finance department.

Asset identification

Since most capital asset listings for governmental entities were set up many years ago, governmental entities may be challenged to know which description corresponds to which asset. Typically, this happens because the description is too vague. For example, a governmental entity purchases a truck for public works and labels it on the capital asset listing as “Truck.” While this description states what the asset being added to the listing is, it does not contain any other specific information such as a model number, vehicle identification number (VIN), etc. The description should contain enough detailed information so that any person in the governmental entity could physically verify that the asset exists from the information contained in the listing.

A best practice that could be incorporated into a governmental entity’s capital asset policies would be to require a serial number for the asset (such as a VIN), the fiscal year it was added to the listing, or some additional piece of information that would assist in identification. Assigning each purchase a unique capital asset number and tagging the actual asset is also encouraged as it provides another layer of identification.

By establishing clear policies and procedures related to the purchase and disposition of capital assets and communicating them to individual departments, the governmental entity will have a more accurate capital asset listing. Individual departments should be encouraged to review their capital asset listings periodically to help identify items that need to be removed. For federally purchased assets, Uniform Guidance requirements should be considered in the policies and procedures to ensure compliance with all grant requirements.

A purchasing card (p-card) program can be a flexible and timesaving tool in the school district’s purchasing process. This specialized credit card allows authorized school district employees to purchase certain goods and services through any merchant that accepts such payments, including those purchases through the internet. The program can greatly streamline the purchasing process and possibly provide valuable rebates. It can reduce the administrative burden and costs related to check writing, provide faster payment to vendors, and reduce the paperwork typically associated with the traditional procurement process. To run an effective card purchasing program, the school district must establish appropriate policies and procedures from the onset.

Policy and Guidelines

The school district should create a board-approved policy outlining the basic governance of the p-card program. At a minimum, the policy should contain the following elements:

Issuance procedures – Include who is responsible for the issuance and monitoring of the credit card(s) and the groups of employees who are eligible to receive a card. Also, document that an employee is to return the card upon the termination of employment. A cardholder agreement should be obtained upon issuance of a p-card to a district employee. The agreement should include the elements of the policy and guidelines noted below and establish that the card is to be used for school business expenditures only. This agreement must be signed by the employee and maintained throughout the program.
Documentation – A detailed receipt of goods or services purchased, which includes an itemized list of costs, the date of purchase, and the purpose of the purchase must be provided for each transaction.
Payment – Include who will be an appropriate approver of payment and how that payment will be made.
Misuse and/or Unauthorized Use – Violations of the policy will include disciplinary action.

In addition to the above policy, the school district should establish more specific administrative guidelines related to the program. These guidelines should include the following:

Transaction limits – Establish both the formal credit card limits, as well as internal purchase thresholds. These limits should be appropriate to their position and likely spending. These limits should be reviewed annually.
Eligible goods and services – This will vary based on the needs and comfort of your school district. Typical allowable transactions include travel (conference registrations, hotels, transportation, meal expenses) and small supply purchases. Employees should be conscious of the school district’s tax-exempt status and provide the proper forms to the merchant to ensure no such tax is paid.
Lack of documentation – Consequences should be established for lack of documentation. Typically, reimbursement from the employee must be made, or a payroll reduction will be enforced.
Reconciliation – A standard reconciliation form should be established by the school district to ensure consistency among cardholders. Employees should be responsible for reconciling their account statements and providing appropriate documentation. Timelines should be established to ensure the timely payment of the balance.
The school district must maintain appropriate controls, following their purchasing policy, to ensure the success of the p-card program. They should provide ongoing training for both cardholders and supervisor and the above guidelines should be modified as the needs of the program change.

Audit

Internal audits should be performed regularly, and employees must be held accountable for failure to follow the established guidelines. Audits should be strategic and include a closer look at transactions near limits (look for split transactions), with unusual vendors, or those that contain key words that could contain a prohibited purchase. Other things to watch for include, is the employee providing reconciliations on a timely basis? Were transactions properly approved? Are any purchases for personal gain?

Reporting Requirements

As part of the annual budget/transparency reporting, MCL 388.1618 of the State School Aid Act requires all public schools to provide the type, credit limit, authorized individual(s), and authorized dollar limit(s) of all credit cards maintained by the school district. This report should be updated within 30 days of any changes made to a district credit card. If you have no credit cards, you must provide a line stating such.
A purchasing card program provides numerous benefits. With the proper internal controls, the program can provide valuable time and cost savings for a school district.

A common question that arises when preparing an estate or trust return is, can capital gains be distributed to the beneficiary? Most often, the answer is no, capital gains remain in and are taxed at the trust level. In many cases, this is the correct answer. However, let’s consider three exceptions to this general rule.

For an income item to be eligible to be distributed to the beneficiary, it must be included as part of distributable net income (DNI). DNI acts as a ceiling for the amount a trust or estate can take as a distribution deduction and as a ceiling for the amount of income that the beneficiary is required to account for on their personal income tax return. So how exactly is DNI calculated? Per Section 643(a), the general formula for DNI is:

Taxable income
+ Distribution deduction
+ Personal exemption
+ Tax-exempt income
+ Capital losses
– Capital gains
– Dividends allocated to corpus
= Distributable net income

As stated above, capital gains are normally allocated to trust principal and, therefore, are taxed to the estate or trust. Trusts and estates, in general, can result in higher taxes on capital gains than if the same capital gains were taxed at the individual level. So, to help save tax dollars, following is more information about the three exceptions where capital gains can be included in DNI and distributed to the beneficiary.

Exceptions That Allow Capital Gains to Be Distributed

Reg. 1.643(a) – 3(b) has specific requirements that must be met to allocate capital gains to the beneficiaries.

Prerequisites that must be met
1) Trust agreement and local law; or
2) A reasonable and impartial exercise of discretion by the trustee

Three methods available to allocate capital gains

Method 1: Capital gains allocated to income. This method is limited unless the trust instrument or state law allocates capital gains to income, which is unlikely in most instances, or the fiduciary has broad discretion to allocate capital gains to income.

Method 2: Capital gains are allocated to corpus but treated consistently by the fiduciary on the trust’s books, records and tax returns. This method requires consistent practice in allocating capital gains to DNI. This method is most common when a trust is in its first year of existence, as no precedent has been set for how capital gains will be treated. If the fiduciary, in their discretion, allocates capital gains to DNI in the first year, this sets the precedent for treatment of capital gains in future years. If a trust has been in existence for several years and capital gains have never been allocated to DNI before, the fiduciary cannot start doing so now.

Method 3: Capital gains are allocated to corpus but are distributed to the beneficiary or utilized by the fiduciary in determining the amount to be distributed. This method does not require a consistent requirement and appears to be the most flexible.

This article provides only brief information as to when capital gains could be allocated to a trust or estate beneficiary. If you would like more information, please contact a Yeo & Yeo professional, and we will be happy to discuss your situation.