The measure of success is known as the “bottom line,” but is it really? The real measure of success is how much you—the business owner—are able to derive from your efforts. In other words, success is the amount you really put in your pocket. Taxes are one of the most important considerations in determining how much you really get to keep.

Business Entities
Before moving into the realm of possible tax benefits, it is important to understand the different types of taxable entities and determine which describes your business. Each entity has varying tax ramifications and benefits. A Sole Proprietorship, Partnership, Limited Liability Corporation, and an “S” Corporation are all taxed at the individual level. Whatever taxable income is reported on the tax return becomes a flow through to the individual(s) who own that entity, on a proportionate basis to their ownership interest. Individuals may also take a salary for their efforts in all but a sole proprietorship, allowing for a disproportionate distribution, but matching efforts by individual owners. A “C” Corporation is taxed as an individual entity. Owners are able to draw a “reasonable” salary and can take dividends from accumulated earnings (double taxed, but now at reduced rates on the dividend portion).

Changing from one type of entity to another can be as easy as making an election with the Internal Revenue Service (IRS) or as complicated as filing part-year returns, being taxed on the appreciation of your business, or changing the reporting accounting method and being locked into that form for at least five years. The latter is a confusing area that should only be attempted with competent advisors.

Accounting Methods
The “cash” method is the simplest and easiest to understand. Whatever is received (earned) is reported as income and the amount paid out for expenses is deducted to determine net income, exclusive of depreciation. This method is not available to taxpayors with a large inventory for resale (such as HMEs) but may work well for nursing agencies.

The “accrual” method records all transactions. Accounts receivable, accounts payable, prepaid expenses, deferral of income, capitalization of expenditures, and recognition of future debts (including interest and equipment leases) are some of the transactions recognized using this method.

The “tax basis” is a modified accrual method that does not comply with generally accepted accounting principles, but it is used by many tax payors and their professional tax advisors. As long as the method makes economic sense, and is applied on a consistent basis, the IRS rarely modifies the application during an audit. The recognition of accounts receivable and payable is standard, but after that, reporting may be in the eye of an imaginative beholder.

Areas of Possible Tax Savings
Accounts receivable should be evaluated at the end of each year. Those deemed to be uncollectible (or reasonably so) should be written off. Each dollar written off equates to a savings of 35% +/-. Some companies write off everything over 90 days, which may be a bit aggressive. The effect after a period of years is minimal because some of the receivables written off in the previous year are collected and have to be booked as income when collected. As long as sales are increasing, the aggressive approach to write-offs can be rewarding. A word of caution: When selling your business, you will have to explain why those written-off receivables are really good and you want to be paid for them—both as an asset and to be included in a multiple of earnings. Address special issues with Medicare or Medicaid separately.

Accounts payable should be evaluated to make sure that all invoices have been recorded—including those of a long-term nature such as equipment leases and contracts (whether fulfilled in the current year or to be paid over a period of time).Take inventory each year (not necessarily at year end depending on the inventory system) and evaluate for obsolescence. Set a standard such as any inventory more than a year old is considered obsolete and should be either written down or off. Be aggressive, but be able to support the write-off (concentrators and wheelchairs may be exceptions).

To improve cash flow and support the write-offs, sell slow-moving items at a discount. We do see aggressiveness carried to extremes in this area by writing off to cost of sales any purchase of inventory. This practice could result in more than a slap on the wrist by the IRS.

Capitalization of Equipment
Establish a standard for the capitalization of equipment, which includes a dollar limitation and a longer life that will trigger a purchase to be considered a depreciable asset. I prefer using over $1,000 and 3 years. A more aggressive posture would raise these standards, allowing for more purchases to be expensed. The liberal tax laws recently enacted will allow a first-year write-off of many of the purchases that would normally have to be depreciated. A special rule also allows a write-off for vehicles over 6,000 pounds (ever wonder why so many Hummers are now on the road?). Personal vehicles run through the business continue to be commonplace, sometimes to excess (six Mercedes). A reimbursement for personal use will go a long way in keeping the deduction from being disallowed in audit.

Pension Plans
Pension plans continue to be a great write-off. The discriminatory nature has been well explored and can be explained by any competent pension specialist. The smaller your business, typically the greater benefit to you. If you are over 50, consider a defined benefit plan. These are restrictive and require a payment in good and bad years, but the benefit to older employees can be substantial. Include your spouse to double the benefit if he or she works in the business, at least to some degree. You can exclude certain employees until they reach 3 years of continuous service.

Officers’ Life Insurance
Officers’ life insurance is a good way to ensure the continuation of the business and get a tax deduction. The corporation must own the policy and be the beneficiary, but the influx of cash can be used to buy out existing shareholders and/or their estates. Ask your tax expert about insurance trusts and their viability to lessen estate taxes and provide liquidity for corporate buyouts.

Officers’ Compensation
Officers’ compensation continues to top the list of the best way to withdraw funds from a “C” corporation. It also is the best way to provide disproportionate distributions of income from partnerships, LLCs, and “S” corporations. The caveat is that the compensation has to be reasonable for the industry and reasonable for the services provided (on both the high and low side). Reasonable is not paying the owner’s son $75,000 for a summer’s work while in college. Reasonable is not paying a bonus equal to the earnings of the business to cause “break even” for tax purposes. The best judge of reasonableness is what you would pay someone to assume your position (assuming you are replaceable).

There may be reasons not to pay a salary as high as possible. In the case of an “S” corporation, an owner with a salary of $60,000 is taxed Social Security and Medicare on his salary, but would avoid both on the earnings of the business. The savings can be substantial.

When the owner of the business also owns the property, there is an opportunity to derive some tax benefits through the setting of rent to the entity. Higher rent equals lower profits for the business, but a higher “passive” income to the owner, which can be used either as an offset of other passive losses, or to mitigate Social Security and Medicare taxes. This is especially true in the case of partnerships with active participation. Again, reasonableness is the key, but aggressiveness has its advantages.

Selling Your Business
Engage a tax expert familiar with mergers, acquisitions, and liquidations when the time comes to sell your business. Planning is the key. Know the results and ramifications before even starting the selling process. An experienced intermediary in the health care industry on your team is a plus, both in helping with the right tax results, and in finding the most qualified, synergistic buyers for your business.

Sole proprietorships, partnerships, LLCs, and “S” corporations are basically taxed the same on the sale of the business. The sale may be either an asset sale or the sale of corporate stock. The likelihood is that the profit will be taxed to you as a combination of long-term capital gain and ordinary income.

John W. Moffitt, CPA, CFE, CVA, is chairman of Value Alternatives Inc, a national merger and acquisition firm with offices in Dallas; Houston; Ventura, Calif; Hartford, Conn; and Stuart, Fla. He can be reached via email: johnvai@bellsouth.net   or through the Internet: www.valuealternatives.com.