I’m considering giving my manager an option to buy stock in my company. My thought is it wouldn’t cost me anything right now and it would give him incentive to stick around and help grow the value of the business. And, if things work out and he exercises the option, it could raise some funds for us, make him an owner and give him more reason to stick around and work hard. Does this make sense? Any tax issues I need to consider?

Answer:

If you can get comfortable with this person becoming an owner1; you make a condition that he must be employed to exercise the option; you can work out the valuation methodology so it’s clear and fair and will not give rise to disagreement; and the employee has (or should have) the cash that will be needed to exercise the option, it’s a great idea.

Let’s say you grant him a three-year option to purchase 10,000 shares issued from treasury, i.e., from your company, at the price of $3 each. There are currently 200,000 shares outstanding, all held by you, and so he could gain a 4.76% ownership interest. If the $3 per share reflects the current fair market value per share, there’s no tax due when the option is given — neither to your company (grantor) nor your employee (grantee).

Now let’s say in three years you value the stock at $5 per share and he exercises this option for all 10,000. He pays the company $30,000 (which does not trigger any tax; the amount is added to the company’s capital account) and the company gets a $20,000 tax deduction for the $20,000 of “value” it gave to the employee. Unfortunately, this “gift” amount is considered compensation to the employee at the time he exercises the option. Therefore, he must pay tax on this amount at his ordinary income rate. However, if the employee later2 sells his shares for a profit, he will enjoy capital gains tax treatment on the gain.

=========================

1. ^{We recommend making any stock issued “nontransferable” and “non-pledgeable” as collateral for a loan. Further, institute an automatic buy-back provision such that, in the event the holder departs the employment of the company, the stock is valued at a set valuation methodology and the company buys back the shares.}
2. ^{At least one year after exercising the option.}

I received a call from a Chicago business owner (let’s call him “Chicago”) a few months ago. His little home health company was just a couple years old and doing less than $1 million in annual revenue and not yet earning a profit. He wanted some assistance with a transaction.

Cool.

Chicago explained that a buyer by the name of U.S. Medical Home (USMH) of Washington, D.C. was interested in acquiring his company for $2 million. The buyer’s representative was a guy named Mike Keselica. His email address showed him as president of Health Management Group, Inc. with offices in Washington, D. C. and Providence, Rhode Island.

The letter of intent (LOI) terms were confusing to the seller. Sure enough, the deal called for $2 million in cash to be paid to the seller. All good so far. But then the terms went on to say the seller would immediately return the entire amount to the buyer in exchange for a promise to pay said funds back to the seller over a five-year term. No cash at closing! Not a cent until 365 days from closing!

According to the buyer, this structure was necessary to comply with some new tax laws that would be very advantageous for the seller.

Smelling a fish, I asked, “Have you paid them any money?”

Seventy-five hundred dollars for due diligence,” replied Chicago.

“What?” I asked.

“They came and did due diligence and said I needed to pay them for my part of it,” said Chicago.

“Who came?”

“Mike Keselica and Grace Kulik. But don’t worry – the terms of their LOI say if they don’t follow through and purchase they’ll return the seventy-five hundred.”

“Okay. Chicago, what I’m hearing you say sounds concerning to me, to say the least. I’m not sure about these guys.”
Still, there was a purported $2 million at stake so he asked me to withhold my judgment, talk to the buyer, and attempt to negotiate better terms. Surprisingly, the “buyer” agreed to a conference call with me. The “COO” was Grace Kulik. I called a bit early and a gentleman answered the line, “Health Management Group.” It was Mike Keselica. Hmmm.

The rest is just amusing. To conclude, they would not agree to any other terms (any that required any payment of cash at closing). Chicago, of course, could not agree to that so he asked for his money back. Naturally, the buyer said they were under no obligation to refund as they offered to purchase for $2 million. The seller is the one that backed out.

If it’s too good to be true…

If there’s a sizeable up-front fee required …

If the buyer or broker uses the need for confidentiality to restrict whom you can talk to…

If the terms are confusing or convoluted …

These are all reasons to be skeptical of the deal you’re being offered. And if you’re unsure about a business transaction, ask a successful and experienced business or legal professional for help. The best way to avoid scams is to exercise your own due diligence.

Caveat Venditor! Let the seller beware!

• the business use of the home is for the convenience of the employer, and
• no part of the home is rented from the employee by the employer

If the business use of the home is merely appropriate or helpful, no deduction may be taken. To qualify for exclusive use, you must use a specific area of your home only for your trade or business. The area used for business can be a room or other separately identifiable space. You do not meet the requirements of the “exclusive use test” if you use the area in question both for business and for personal purposes. You do not need to meet the exclusive use test if you use part of your home for the storage of inventory or product samples, but to take a deduction for such use you must meet all the following tests:

• The sale of products is your trade or business.
• You keep the inventory or product samples in your home for use in your trade or business.
• Your home is the only fixed location of your trade or business (or, as an employee, it’s your only place of work).
• You use the storage space on a regular basis.
• The space you use is a separately identifiable space suitable for storage.

To qualify under the regular use test, you must use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use.

If you use your home for a profit-seeking activity that is not a trade or business, you cannot take a deduction for business use. For example, if you are an investor and you use your home to regularly read financial periodicals and reports, conduct analysis, gather data, make trades, talk on the phone, and carry out similar activities related to your investments, you cannot take a deduction.

You can have more than one business location and still qualify for a home office use deduction as long as your home is your “principal place of business.” To determine whether your home is your principal place of business, you must consider:

• The relative importance of the activities performed at each place where you conduct business, and
• The amount of time spent at each place where you conduct business.

If, after considering your business locations, your home cannot be identified as your principal place of business, you cannot deduct home office expenses.

Figuring the Deduction

To take a home office deduction, you’ll need to figure the percentage of your home used for business. To find the business percentage, compare the size of the part of your home that you use for business to your whole house. Use the resulting percentage to figure the business part of the expenses for operating your entire home. For example, let’s say your home office is 240 square feet and your entire home is 1,200. Your business use percentage is 20%.

Next, identify the deductible expenses. They’ll fall into one of two categories:

1. Direct Expense — Expenses only for the business part of your home, such as paint and repairs to the business-only area of your home. These are 100% deductible.
2. Indirect Expense — Expenses for keeping up and running your entire home, such as insurance, utilities, real estate taxes and general repairs. These are deductible at the business use percentage of the home.

Expenses incurred to improve or enhance the non-business-use parts of your home are not deductible at all.

Depreciation Expense

If you own your home and qualify to deduct expenses for its business use, you can claim a deduction for depreciation. Depreciation is an allowance for the wear and tear on the part of your home used for business. You cannot depreciate the cost or value of the land. You recover its cost when you sell or otherwise dispose of the property. To figure your depreciation deduction, you need to locate the following:

• Month and year you started using your home for business.
• Adjusted basis and fair market value of your home (excluding land) at the time you began using it for business.
• Cost of any improvements before and after you began using the property for business.
• Percentage of your home used for business.

The adjusted basis of your home is generally its cost, plus the cost of any permanent improvements you made to it, minus any casualty losses or depreciation deducted in earlier tax years.

The calculation of the amount you can deduct in any given year is a bit complex. We suggest you give the above-noted data to your accountant and let him or her develop a depreciation schedule for you.

For more information about deductions for business use of a home, search for publication 587 at www.IRS.gov.

The “4-Week Avg. U.S. Net Imports of Crude Oil” graph shows the U.S. has recently become a net exporter of petroleum products. Such has generated a lot of publicity and surprise of late, but one must keep in mind that this is NOT crude oil.

As the “4-Week Avg. U.S. Net Imports of Petroleum Products” graph shows, the U.S. remains a massive net importer of crude, the raw material used to create petroleum products such as gasoline.

1. Immediately notify family, close friends, and attending physician;
2. Determine decedent’s expressed funeral and burial wishes, arrange for obituary and funeral arrangements, and order multiple death certificates;
3. Arrange care for pets, find and dispose of perishable property, secure residence and valuables, and forward mail;
4. Keep records of all payments for funeral and other expenses;
5. Locate safe deposit box, will, codicils, trust, and other estate-planning documents;
6. Locate life insurance policies, investment and bank account information;
7. Advise Social Security and other government agencies, as appropriate;
8. Investigate Social Security benefits; life insurance, union, veteran, and employee benefits; and business and retirement accounts;
9. Select and retain estate attorney;
10. Deal with fire, theft, liability, and auto insurance of the decedent;
11. Prepare inventory of assets, accounts and debts, and obtain valuations, if necessary;
12. Review credit cards for payment and cancellation; and
13. Arrange for final income tax return and estate tax return, as necessary.

The U.S. Government is the world’s largest buyer of goods and services – some $425 billion annually – with $200 billion of that purchased from private U.S. businesses. Are you getting your share?

Learn how to sell to the U.S. Government and you might find a significant source of new revenue. Those who have sold to the government say that, once you become familiar with doing business with the government, it’s not bad at all. It might take a little work to learn the ropes, but the prevailing lack of knowledge of how to do business with the government soon turns to your advantage.

The Office of Government Contracting (GC) is the agency that coordinates government purchases. To foster equality between large and small companies, each government agency establishes goals for contracts let to small businesses. Currently, the overall small business goal is 23 percent. This includes the specific goals of five percent to Women-Owned Small Businesses (WOSB), three percent to businesses owned by service-disabled veterans, five percent to small disadvantaged businesses (SDBs), etc. Each federal agency reserves specific procurements exclusively for small business participation. These transactions are called “small business set-asides.”

What is a small business? It’s likely you’ll qualify. Size standards are set for each six-digit NAICS code. Some are employee count thresholds. Some are annual revenue. Here are the size thresholds for a few:

GC administers several programs and services that assist small businesses in obtaining government contracts. They include the Certificate of Competency, the Non-Manufacturer Rule Waiver, and the Size Determination Program. The office also oversees special initiatives such as the Procurement Awards Program, the Annual Joint Industry/SBA Procurement Conference, the Women’s Procurement Program, and the Veteran’s Procurement Program.

Find out more and get started at http://www.sbaonline.sba.gov/contractingopportunities. Then, send your success stories to editor@thebusinessowner.com.

Leverable assets are ones debt providers will loan against. Generally, these are assets that generate cash flow and can be liquidated (sold) for cash, such as real estate, stocks, bonds, mineral rights, and equipment.

All things being equal, investors will maximize their use of leverage – relative to equity – because debt capital is less expensive.

Why?

1. Contributors of debt (lenders) demand lower returns than equity providers because debt has a senior claim on the assets and cash flow and is therefore less risky
2. The cost of debt (interest expense) is tax deductible

For these reasons, the use of debt (leverage) will boost the return to equity holders – so long as the assets earn a rate of return, i.e. return-on-total-capital (ROC), that exceeds the cost of the debt. Here’s a simple example.

Let’s say the investor has $100,000 to invest. He can purchase a $100,000 asset using all his equity or he can purchase an asset (or assets) of greater value and borrow the difference. Here’s the calculation of pre-tax and after-tax return-on-equity (ROE) at varied capital structures.

In the table below, we assume the assets held are generating a ten percent operating profit (ROC, which is the same as return-on-assets (ROA)) and the interest rate on the debt is 7%. As you can see, both the pre-tax and after-tax ROE rise as leverage increases.

Notice as well the differing values of the assets controlled by the equity holder (the top line). Leverage allows higher-value assets to be owned. As such, one should consider the possibility of changes in the market value of the assets over time. If we assume the assets in the above example rise in value by ten percent, the no-leverage scenario adds $10,000 to equity, for an equity value increase of 10%. In the highest leverage scenario, the rise in equity is $40,000, for an increase of 40%.

Wealth (equity) can be generated rapidly when leverage is utilized. Of course, it works the other way as well. Leverage adds financial risk.

Let’s look at what happens when the spread between the cost of debt and the return on capital shrinks. This can occur by either an increase in the cost of debt, decline in operating profit, or both.

In the table below, we assume the cost of debt rises to 10% and the ROC stays the same (at 10%). The investor gains nothing from the use of leverage (unless he assumes or can achieve a rise in the value of the assets held).

Returns are also impacted by changes in the operating profit (ROC or ROA). To demonstrate, let’s assume the cost of debt remains at 7% but operating profit grows to 15%. That’s a 50% increase on operating profit. Here’s the calculation of ROE at the varied capital structures.

As one can see in the example, when profit rises in a leveraged company, ROE rises at accelerated rates. The higher the leverage, the greater the rate of ROE increase. Again, it also swings the other way when profit declines. Further, if operating cash flow falls below the required debt service, the assets can be lost entirely. In this way, the use of leverage is risky and should be used with great caution. Assets that generate consistent earnings (or more to the point, cash flow) can support higher amounts of debt. Assets that generate unpredictable earnings should not be purchased with debt.

Owners of established and profitable companies will, in most cases, be able to utilize debt to boost equity returns, and do so with a manageable level of financial risk. How much risk is a function of the characteristics of both the business and the owner.

Today, with asset values depressed and debt at historical lows, every business owner should consider ways to take advantage. The first option is to refinance existing personal or business debt. The second is to acquire real estate, whether it’s the space occupied by your business, an investment property, or a new home. So assess your needs and wants, and look around for a good deal. They’re out there. Odds are, the economy will recover; assets will once again appreciate; moderate inflation will return; interest rates will rise to more “normal” levels; and you’ll be sitting pretty.

Lawmakers have aggressively used the tax code to try to get the economy back on track, and there are now more ways than ever to reduce your tax liability. But all of them take planning. You need to understand your opportunities and leverage the tax breaks available to you and your business. Business owners and managers have more tax concerns to worry about than most people. Don’t act first and think about taxes later. A little foresight can go a long way.

Although the year is winding down, it’s not too late to act. Below are several year-end tax strategies that may help you leverage new incentives or avoid a tax headache. But keep in mind that these strategies won’t work for everyone. Whether or not they help you will depend on your situation. The strategies also involve just a fraction of all the new tax incentives available for businesses and individuals. Make sure you talk to a tax professional to discuss your own situation and to uncover all the tax breaks that can help your business.

Expense business investments

In an effort to jumpstart business investment, lawmakers have expanded the ability of taxpayers to immediately deduct the cost of many types of investments in their businesses.

Legislation enacted in 2010 doubles a bonus depreciation tax benefit for property your business places in service before the end of the year. Under this provision, you can fully deduct the cost of eligible equipment on this year’s return if you place it in service by December 31. To qualify for bonus depreciation, the property you place in service must be new and generally have a useful life of 20 years or less under the modified accelerated cost recovery system (MACRS).

This tax benefit is generally only available for property placed in service before the end of the year (there are different rules for certain property with long production periods and most airplanes), but Congress could extend it. If no legislation is enacted, property placed in service in 2012 will qualify for regular bonus depreciation, which allows you to deduct half of the cost of the property while the rest is depreciated using normal rules.

Get your self-employment taxes right

Employees that earn wages generally split payroll taxes with their employers and these taxes are automatically deducted from their paychecks. Self-employed taxpayers instead pay their own payroll taxes as “self-employment tax,” which is levied against self-employment income. Self-employed taxpayers may then deduct half the cost of this tax (what’s normally considered the “employer” half) for income tax purposes.

Lawmakers provided a partial payroll tax holiday in 2011 that reduces the employee share of Social Security taxes from 6.2% to 4.2%. This rate cut also applies to the self-employment tax, lowering the combined rate from 15.3% to 13.3% for 2011 self-employment income under the $106,800 Social Security wage cap. This rate cut is considered to come from the employee’s share of employment taxes, so it does not reduce your above-the-line income tax deduction for self-employment tax. This deduction is still calculated as one-half of 15.3% of self-employment income, or 7.65%.

Become a “qualified small business”

Lawmakers have focused many new tax incentives on small businesses. Legislation enacted in 2010 presents a unique opportunity for companies that are considered a “qualified small business” (QSB) under tax rules. A QSB must be organized as a C corporation for tax purposes (and meet several other tests) and cannot have more than $50 million in assets.

Original issue QSB stock purchased before the end of 2011 will receive a full exclusion from capital gain. That means taxpayers who purchase this stock before the end of the year will never pay tax on any gain on the stock as long as they hold it for five years and follow all the rules. You can normally exclude only half of the gain on QSB stock held. The full exclusion offers an excellent opportunity for eligible enterprises to raise capital at a reasonable rate or provide owners with a tax efficient growth opportunity. And it’s not only for C corporations. Under QSB tax rules, partnerships may perform a conversion into a C corporation in which the converted partnership interests are treated as stock acquisitions that can qualify for the QSB stock gain exclusion. But be careful, because there are lots of other tax implications to consider when deciding on your business structure.

Smartly set your corporate employee-shareholder salary

If you own a corporation and work in the business, you need to think carefully about your salary structure. Your tax treatment will vary depending on how high you set your salary and whether your business is organized as a traditional C corporation, or an S corporation (in which corporation income is “passed through” and taxed at the individual level).

Payroll taxes that are levied against salary income include a 2.9% Medicare tax (1.45% for the employee and 1.45% for the employer). Distributions of corporate income are generally not subject to this tax. That means if your business is an S corporation, you will pay Medicare tax only on business income received as salary, not income received as a distribution. C corporations are different. C corporation distributions also escape Medicare tax, but are subject to a 15% dividend tax rate (even though the income is already taxed at the corporate level). So many C corporation owners will pay less overall tax on income received as salary (which is deducible at the corporate level).

But remember to tread carefully. You must take a reasonable salary to avoid potential back taxes and penalties, and the IRS is cracking down on misclassification of corporate payments to shareholder-employees.

Make up estimated tax shortfall with increased withholding

Although you don’t file your return until after the end of the year, it’s important to remember that you must pay tax throughout the year with estimated tax payments or withholding. People paid in wages generally don’t have to worry as long as their employer is withholding enough. But business owners or executives with other types of income often need to make estimated tax payments. You will be penalized if you haven’t paid enough.

If your adjusted gross income is over $150,000 in 2011, you generally can avoid penalties by paying at least 90% of your 2011 tax liability or 110% of your 2010 liability through withholding and estimated taxes. If you’re in danger of being penalized for not paying enough tax throughout the year, try to make up the shortfall through increased withholding on your salary or bonuses.

Paying the shortfall through an increase in your last quarterly estimated tax payment can still leave you exposed to penalties for underpayments in previous quarters. But withholding is considered to have been paid ratably throughout the year. So a big bump in withholding on high year-end wages can save you in penalties when a similar increase in an estimated tax payment might not.