Your Portfolio Allocation and Emotional Reactions: The Coronavirus and Portfolio Discipline

Here we go again – we’ve been down a similar road before, so none of this is news to those who have been with us through prior overreactions by market participants.

Volatility is part and parcel of participating in the market. When fear grips the market, selloffs by those who react to that fear provide portfolio opportunities for those who understand and adhere to a strategy. It is AIKAPA’s strategy to maintain your risk allocation and either ride out the volatile times or rebalance into them. Meaning that if you don’t need cash in the short-term, we buy when everyone else is selling.

As news of the Coronavirus (or other events outside of our control) stokes fear and uncertainty on a variety of fronts, it is only natural to wonder if we should make adjustments to your portfolio. If you are reacting to fear, then the answer is a resounding NO. On the other hand, if you are applying our strategy in combination with an understanding of the impact on business, then the answer is likely YES. When an adjustment is indicated we look for value and BUY while selling positions that are relatively over-valued. If the market continues to respond fearfully (without a change in value) then we will likely continue to buy equities and may sell bonds to fund those purchases. The only caveats to this strategy are that we must know that you don’t have short-term cash flow needs, that we stay within your risk tolerance, and that we are buying based on current value (keep in mind that value is based on facts not fear).

If you feel compelled to do something, then consider the following:

  1. Contact your mortgage broker and see if it makes sense to refinance (likely rates will drop soon after a significant market decline).
  2. Seriously examine the impact this has on your life today and let’s talk about changing your allocation once markets recover.
  3. Review the money you’ve set aside for emergencies and prepare for potential disruptions if these are likely.
  4. Business owners should consider the impact (if any) on their business, vendors and employees. Particularly important will be to maintain communication with all stake holders and retain a good cash flow to sustain the business if there is a possibility of disruptions.
  5. Regarding your portfolio, if you have cash/savings that you want to invest, this is a good time to transfer it to your account and have us buy into the market decline.

Market changes are a normal part of investing. Risk and return are linked. To earn the higher returns offered by investing in stocks, it is necessary to accept investment risk, which manifests itself through stock price volatility. Large downturns are a common feature of the stock market. Despite these downturns the stock market does tend to trend upwards over the long-term, driven by economics, inflation, and corporate profit growth. To earn the attractive long-term returns offered by stock market investing, one must stay invested for the long-term and resist the urge to jump in and out of the market. It has been proven many times that we can’t time stock market behavior consistently and must instead maintain portfolio discipline (if you want a historical overview of markets, see the “Market Uncertainty and You” video on our website www.aikapa.com/education.htm).

It is your long-term goals and risk tolerance that provide us with our guide to rebalancing and adjusting your portfolio, not short-term political, economic or market emotional reactions. In your globally diversified portfolio, we will take every opportunity to rebalance and capture value during portfolio gyrations. This IS the benefit of diversification and working with AIKAPA.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Business Owners: Hiring family

One of the most common reasons individuals become business owners is to have more control over their time and financial decisions—to create and be able to drive their own vision in an environment that they choose, and hopefully enjoy.

Those decisions include, among others, what types of solutions the business will offer, how clients will be serviced, which vendors the business will use, and who the business will hire and fire.

Moreover, the IRS’s website states, “One of the advantages of operating your own business is hiring family members.” The IRS is very clear that businesses can and should hire family members. They know that at times family members are the glue that keeps small businesses functioning and often provides owners with the time needed to lead and grow their companies. Small businesses are an essential part of the US economy. The most common family members hired by small companies are spouses since the success of a small business owner is often entwined with the support they receive from their life partner. This is so common that even 401K plans for single-owned businesses include spouses. Though more common, hiring family members can go beyond the spouse and includes anyone that is related, a sibling, a parent AND even a child. [see more details on the IRS perspective on hiring family https://www.irs.gov/businesses/small-businesses-self-employed/family-help].

When hiring family members (either as employees or as 1099 consultants) a business owner must adhere to the same rules as for nonfamily members. From a strictly operational point of view, one clear advantage of hiring family is that a family member can provide support or services that the owner, for whatever reason, is uncomfortable having performed by a nonfamily member. This may be particularly true when the business wishes to keep its financial reports “for family eyes only” or if the business relies on sensitive proprietary information or compliance rules that could be jeopardized by employee turnover. Similarly, a family member can provide cohesion and ensure the retention of corporate knowledge when employees leave the firm – this is invaluable to many small businesses. On the other hand, owners might hire a parent or a child solely to provide them with a taxable income while they engage in work that benefits the business owner’s vision.

The business owner does have the responsibility of deciding on a fair level of compensation for all employees. To avoid potential conflicts within the firm, compensation ought to be similar to that of any regular employee performing the same function. Another more flexible option, is to hire family members as 1099 consultants. Consultants have more flexibility on the tasks they can perform and the compensation they are awarded.

Hiring family can be a straightforward way to reward family members who contribute to the success of the business. Providing spouses, siblings, children and even parents with taxable earnings while serving in roles that provide benefit to the business owner and the running of the business.

For business owners in high tax brackets, hiring family (who are in lower tax brackets) can garner meaningful tax relief. If hiring children, it also provides for “good parenting” opportunities and leadership development. The key to hiring your child is to strictly abide by standards of bona fide age-appropriate work, ensure a reasonable wage, and follow federal and state regulations relating to labor standards. Getting a handle on all of this, can feel overwhelming but it is actually fairly straight forward.

When hiring a minor (family or not) the Fair Labor Standard Act (FLSA) must be followed which has restrictive language on the type of employment for those under the age of 14. FLSA actually states the specific jobs that are permitted which include delivering papers, casual babysitting, or modeling/acting. Starting at age 14 the regulations only limit the amount of time (not the type of job) but also that the work doesn’t expose the minor to dangerous environments such as radioactive areas and working in demolitions (among others).

Hiring family as employees (rather than consultants) is a constant balancing act that requires careful consideration but can deliver financial benefits. It may be prudent, at least initially, to place hired family under the direct supervision of a trusted nonfamily employee that will have full authority over mentoring. This works well for minors but not so well with adults. The potential for unhealthy rivalries and vying for attention amongst siblings and hired staff can sour what is often an exceptional opportunity. Open communication and clear accountability is the key to success when hiring family as employees. Everyone involved must have a clear picture of where they stand, eliminating time wasted on misunderstandings and second guessing one another’s motives and intentions.

The process is a bit easier and the rules a bit more advantageous if family members have their own business (1099 reporting business) and are hired as consultants to support the business owner. In addition, as a 1099 consultant, they have the flexibility to also work outside the family business. Often their total earnings will be taxable at much lower tax brackets than they would be if it was earned by the higher earning business owner. They will also qualify for tax-deferral and social security on their net business earnings.

We encourage you to consider hiring family members particularly if you are a business owner with high earnings and high tax liability. We strongly recommend hiring family members when we discover that family already provide unpaid assistance to the business owner and are in need of financial support or need to increase their social security income.
Let us know if you are considering including a family member (parents, spouse or children are the most common) in your business. We’ll provide a summary of the benefits to you, your family and your specific business.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

The TCJA Tax Act Several Months In

I’ll quickly summarize the impact of the TCJA (Tax Cuts and Jobs Act) that we’ve observed on personal taxes and then I’ll switch to the impact on small business owners by covering QBI (the Qualified Business Income) and changes to deductions.

The tax bracket has dropped significantly for personal federal taxes since the top rate is now 37% AND the higher tax brackets begin at much larger taxable income. Though this sounded like a great opportunity to reduce the family tax liability it was combined with drastic changes to the estimated tax deductions and elimination of exemptions. The net result for residents of high-income tax rate states (such as California) and who used Schedule A itemized deductions is that their taxes actually increased. Most others found no change or a small reduction in their tax liability in 2018 from the new rules EXCEPT for small business owners. We expect the same in 2019.

Small business owners have a unique new tool in the TCJA – the QBI deduction. This tool provides a real opportunity to reduce taxable income and therefore tax liability. The QBI deduction is available from 2018-2025 and is only for pass-through entities (businesses that are not C Corporations). This deduction is available without income restrictions for businesses that are deemed a ‘Qualified Business”.

The chart above specifies that to qualify for this deduction you must be a Qualified Business. To be a Qualified Business it can’t be a service business or be a trade or business that involves the performance by the employer of services as an employee. The following are NOT a Qualified Business: doctors, lawyers, accountants, performers, athletes, health care professionals, financial and broker service providers, partnership interests. Only two service providing businesses are considered a Qualified Business: engineering and architectural firms. Though unclear in the code as to how gray areas would be decided the key catchall is that you can’t be a ‘Qualified Business’ if the business’ principal asset is the reputation or skill of one of the owners. Most of our clients own excluded (non-qualified) businesses.

As an excluded business owner (such as attorneys, consultants, etc.) you MAY STILL qualify for this QBI deduction IF your personal taxable income falls below the limits of $315K and $157.5K (married filing jointly and single filer respectively).

The QBI rule allows a Qualified Business (or excluded businesses that qualify under the taxable income limits) to reduce their taxable income by 20% of their QBI (QBI is business profit, not W2 income). An IMPORTANT CAVEAT is that the 20% deduction is the lesser of QBI or taxable income.

For example, if your business profit is $200K and your taxable income is $100K the actual deduction is $20K not the $40K that you might have expected. Regardless this new tool does provide for a way to reduce taxes.

When I initially reviewed the code, I was very excited for the Qualified Businesses owned by our clients since they were to benefit regardless of income. It was not until the last few months that a complicated wrinkle has limited this excitement. We’ve found that even Qualified Businesses have hurdles if the taxable income exceeds these same limits ($315K/$157.5K for married filing jointly and single filer respectively). If the business owner’s taxable income exceeds these income limits, then two additional rules are used rather than just receiving a deduction of 20% of QBI. For Qualified Businesses in excess of these limits there is a two-pronged test to measure the lesser of 20% of QBI (profit) OR the greater of either 50% of all W2 wages or W2 wages plus 2.5% of your qualified equipment/land costs. Yes, after jumping all of these hoops we found that some QB businesses didn’t qualify for 20% of QBI because the W2 weren’t high enough. Even so, the business owner did obtain a deduction though not as high as was initially estimated.

Added to the QBI deduction the TCJA rules also include these changes:

1. Entertaining clients is no longer a business expense that is deductible federally (it used to be 50% deductible). Office parties are still 100% deductible.

2. Businesses supported by debt financing can only deduct 30% of the owner’s adjustable taxable income BUT don’t despair since it will only apply to small businesses that have gross receipts of $25M for each of the last three years.

3. NOL deduction (Net Operating Loss) which is often carried back two tax years or future 20 years will now be only allowed for years going forward AND limited to 80% of income in that year.

I’m providing this education article to give perspective on how you benefit from the TCJA tax rules. Our ultimate goal is to have you knowledgeable enough to understand the critical role of taxes in your planning. If you have additional questions feel free to ask us or your tax preparer.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Tax Planning: Year-End Items to Consider

Tax planning consists of ensuring that tax liability is appropriate (given the tax code, family finances, and family goals) and that required actions are completed by the deadlines. At year-end, we identify relevant actions and relevant timeline.

Current Year actions …

  1. Estimate total earnings and total tax withholdings along with any tax-deferral that has or will be made for the current year. Use these and your deductions to estimate Federal and State tax liability.
  2. Ensure that expected tax liability has been paid either through payroll or through estimated tax payments. It is always best to pay taxes through payroll.
  3. For the self-employed, estimating taxes and ensuring that enough but not too much tax is paid throughout the year is part of tax planning. This is particularly important for businesses that have no payroll and pay their income tax and self-employment tax (i.e. Medicare and Social Security) simultaneously. Without tax planning, it is common for these businesses to underpay their Federal tax liability.
  4. Again, estimating profit from business entities (S Corp, C Corp, LLC, or sole proprietorship) allows business owners to adjust cash flow and meet tax deadlines. Business owners often create or contribute to various tax-deferral plans. The largest pre-tax contributions are for plans that have to be created prior to year-end.
  5. Any deductible contributions to H.S.A., Traditional IRAs or other accounts need to be made by their specific deadlines. These contributions might lower taxable income today (Traditional IRA, pension and 401K) or be tax free in the future (Roth) or both tax free now and in the future (H.S.A.).
  6. Year-end provides an opportunity to harvest investment accounts and therefore reduce or increase capital gain. Capital gain can be countered against capital losses to provide a net gain or loss which will either increase or decrease tax liability for any given year. We can reduce tax liability by adjusting what we buy/sell (i.e. the lot) at year-end depending on the overall tax burden. Keep in mind that tax rates differ based on taxable income. The federal tax rate for gain can be from zero to 23.8%.
  7. Estimating overall tax liability prior to year-end allows families to adjust deductions and employers to make needed capital purchases before year-end.

Actions based on next year’s rules …

Since we don’t yet know the tax rules that will apply in 2018, it will be especially difficult to fulfill the second part the year-end tax planning (where we either act or defer actions this year based on comparing the tax code in both the current and coming years).
Based on the two tax proposals (House and Senate versions) we consider acting prior to year-end if there is a high probability that a tax advantage will be lost in the new year and it plays a significant role in the person’s finances.

Though neither proposal appears to “simplify” taxes, both bills make significant changes to current tax rules and may, in fact, make it ideal to take some actions before the end of 2017 (taking advantage of current rules), while delaying those that benefit from the rules in the new year.

It will now be the job of the legislative committee to reconcile the differences without inserting any new provisions which will then need to go to the House and Senate for final approval. It is still too early to take action according to one or the other proposal but exploring the impact in light of individual tax circumstances makes sense.

  1. It may be worth considering accelerating itemized deductions into 2017 that are targeted for elimination. For example State income tax is scheduled to disappear in both proposals. Nevertheless, consideration must be given to unique situations, particularly regarding AMT (Alternative Minimum Tax).
  2. Consider recognizing tax losses prior to year-end (which is a normal annual year-end tax action) but the ability to select tax lots may disappear in 2018. The new rules may require that sales “first-in-first-out” (FIFO) which results in higher tax liability as it recognize higher gains on the sale of a security. We are hoping FIFO will not survive the reconciliation process but if it does we’ll have to act quickly before Dec 31.
  3. If you are planning to transfer very large assets between family members you would be well advised to wait until 2018 when there is an increased tax exemption. This doesn’t change the annual gifting which is currently at $14K in 2017 (and will be $15K in 2018).

Though we all want to contribute our share of taxes to sustain our communities and our way of life, it is always prudent to annually evaluate and implement the best way to handle tax liability considering current and future implications.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

A business owner quandary: cash or accrual?

Financial statements are one of the most powerful and least utilized business tools. Small business owners need to master financial statements if they hope to work not just in their business, but on their business. And yet, I see all too often just how little time business owners spend exploring them. In my experience the bookkeeping burden doesn’t excite us into spending time on financials beyond tax preparation. In this discussion, basic features of cash and accrual financial accounting are presented with the goal of demystifying them and providing an opportunity for exploration.

One of the first decisions when starting a business is to determine the most appropriate accounting method for the business and for tax filings (the two most common are cash and accrual).

The cash method accounts for revenue when the money is received and for expenses when the money is paid out. It is useful for tracking monthly cash flow since it works just like a checkbook and the balance sheet appears like a checkbook register. Unfortunately, it can convey the wrong message regarding the long-term well-being of a company.

The accrual method of accounting provides a better picture of company profits during an accounting period by recording revenues when they are earned and expenses when incurred but it is not intuitive since the financials do not represent day-to-day accounts. Accrual accounting instead provides a view on long-term financial well-being.

So, what does the IRS require?

The IRS in 2001 relaxed prior requirements that forced many small businesses to use accrual accounting. To reduce the accounting burden on small businesses the current rules allow firms with under $5M in revenue to use cash basis accounting, unless they are an inventory based business.

For tax purposes, the accounting method is locked-in with the first business tax filing. After the initial year, a business uses the same accounting method unless it receives prior approval from the IRS.

It has been my experience that cash and accrual accounting are often misunderstood. It is important that small business owners address with their accountant, bookkeeper, and tax preparer how these two accounting methods will be implemented. The key is to be consistent in applying the rules.

What are some of the problems that may surprise you?

To cite an unusual example, a client sent you a check (on December 30, 2016) for interior decorating services you provided to her and you received the check on January 2, 2017.  Small businesses using cash accounting might be surprised that the IRS expects you to apply this check as income received in 2016. Strictly speaking, the rules require you to observe ‘constructive receipt’. Meaning, the money is available to you and under your control, whether or not you have taken actual possession of it. The fact that you haven’t deposited the check is strictly speaking a moot point as far as the IRS is concerned. Adhering to this ideal is a burden on small businesses. It’s our observation that accountants for small businesses operating on a cash basis consequently define constructive receipt as earnings and expenses in the register by December 31.

Constructive receipt argues against some commonly employed practices, such as delaying the deposit of income or the acceleration of expenses for the sole purpose of avoiding taxes. On the other hand, delaying invoicing does seem to be a more acceptable practice. It is generally more common for cash basis businesses to delay invoicing rather than delay cashing a check received so as not to run “afoul” of the constructive receipt rule.

To be clear, there is a large difference between the unintended receipt of a delayed payment (typically due to a tardy customer payment or a receivable that is in the mail) and deliberate manipulation. Here’s an example of a practice that is clearly not allowed. A small business owner is entitled to receive $20,000 on a contract completed in 2016. The owner contacts the client requesting that the payment not be made until January 2017. That’s not acceptable per published IRS rules.

On the other hand, IRS rules can sometimes be too onerous for a small business. For example, if you pay $2,000 in 2016 for an insurance policy effective for one year beginning July 1, you should deduct $1,000 in 2016 and $1,000 in 2017. It is my experience that this is seldom the practice for small business owners who without intending to avoid payment of tax, will register payment in the year paid without an evaluation of when the benefit will be derived.

Though few use the accrual method of accounting, its purpose is to match income and expenses in the same year. It is therefore critical to choose the year well – when there is any doubt on which year to choose, the decision is made on when ‘economic benefit’ was attained. This can be burdensome to small business owners since the assessment of ‘economic benefit’ is sometimes quite difficult to ascertain.

Under an accrual method, you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. As an example, you sold a computer on December 28, 2016 and billed the customer the first week of January 2017, but did not receive payment until February 2017. Using the accrual method, you must include the amount received for the computer with your 2016 income because ‘economic benefit’ was obtained when the computer was sold. Obviously, tracking and attribution requires a lot more work on the part of the small business owner using the accrual accounting method.

As part of learning to work on your business, not just in your business, it is important that you first develop confidence that your financial statements (Profit & Loss, Balance Sheet, and Cash Flow statements) accurately represent your financial activity. It can take time to develop a reliable and consistent system. Once you have confidence in your financial statements you should address deriving more from them than just how to handle business tax liability.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com