Other tax resources are available on our website.
Happy New Year!
Other tax resources are available on our website.
Happy New Year!
Setting up accounting software and getting it working properly for your business or non-profit organization can earn you a badge of honor. Or, it can be stumbling block for bookkeepers, accountants, and CFO’s.
Who should perform the set up and conversion? Should you run dual systems during the conversion? Should you ditch your old chart of accounts and start over? Are you dreading entering in your customer and vendor data bases? Did you budget enough time and money for the conversion? Or maybe you don’t even know where to start.
I am offering these tips which are based on experience with all kinds and sizes of businesses and non-profit organizations.
Use a checklist
I can’t tell you how important it is to have a roadmap for an accounting system conversion. Where can you get one? You can start with the checklist provided by the accounting software manufacturer. You can ask your CPA for one. You can go on-line and find one. Or, you can develop one yourself, a method that I think is best. However, any checklist is better than no checklist.
Map out a timeline and budget
Do not plan a software conversion during your busy seasons. Schedule it for the slow times. Can you import your old data into your new software? If not, and if you are going to lose your historical data (which these days you should be able to avoid), then you’ll probably need to do the conversion at year end, which may unfortunately also coincide with your busy times. And, it will probably cost more in time and money than you have in your budget.
Build the bones of the system: your chart of accounts
The most important detail to attend to is what to do about your chart of accounts. It needs to be the right size and have the right level of detail. But how do you know what this is? A chart of accounts is meant to group your assets, liabilities, equity, income and expenses by broad, commonly accepted categories so that anyone looking at your trial balance can instantly understand the categories used and make meaningful comparisons to other entities. For example, it is not common practice to have separate general ledger accounts for each employee’s cell phones. Instead, common practice is to use a general ledger account called “Communications Expense” or “Telephone expense.” Here is a good overview from Wikipedia.
While there can be an architecture to the chart of accounts, it needs to follow a logical pattern. If you are going to use departments you need to decide whether you are grouping cost centers or revenue centers. Revenue centers are true divisions of a company or NPO – both income and expenses are tracked by location, program, or function. Cost centers involve only tracking costs of a department or function, and not the revenue. Fund accounting can be even trickier: if you are using sub-codes to track restricted funds, you can’t use these same codes to track spending by grants. While a restricted grant may be a sub-set of temporarily restricted net assets, the inverse is not true. It’s best to think through your architecture before implementation by drawing it out on a piece of paper.
Non-profit organizations have the most complex charts of accounts relative to their size because they are required to report to outside grantors, contributors and governments in ways not required by for profit entities. Remember: the more complex your chart of accounts, the longer it will take your bookkeeper to post even “simple” transactions, because each item of income and expense will need multiple sub-codes attached to it.
That is why it is sometimes it is simply not cost effective to try to build an elaborate and integrated chart of accounts that satisfies these requirements. It can be easier and less time consuming to reserve grant reporting and fund tracking to an off the books solution such as Excel, especially for smaller organizations with limited resources.
Set up your data bases for customers and vendors
Hopefully, you’ll be able to import your customer and vendor data bases from your old software. But, if not, you’ll need to input all of your vendors and customers names, addresses, and other information into the software, prior to using it. These data bases form the platform for the accounts payable and accounts receivable subsidiary ledgers. In some software programs, incorrectly identifying a customer as a vendor, and vice versa, can cause you to lose valuable historical information about that customer or vendor, so it is critical to get these data bases set up in advance, and not input them “on the fly” even though this will be tempting. You’ll notice that I’ve said nothing about setting up employees. This is because I rarely recommend that a company or NPO run its own payroll. A service bureau should be employed to do that for you – it is more efficient, less expensive, and exposes you to far less risk of errors and penalties. However, you will need to develop a posting journal/process, and you’ll also need controls over the payroll input and output from the service bureau.
Ready, set, go
Once you’ve got your historical balances, beginning balances and budget information into the chart of accounts, you are ready to start using the system. Many CPAs recommend using parallel systems for at least the 1st month, but I think that is optional. As long as you have put in adequate controls and reconciliation processes, you should be able to have confidence in the new system right away. These controls typically include: month end bank reconciliations for all bank accounts, month end reconciliations to all subsidiary ledgers (accounts receivable, accounts payable and payroll, typically), daily or weekly management oversight of data entry, user passwords, and control over system access. Setting up controls is not necessarily intuitive, so it’s usually a good idea to get your accounting firm involved in helping you with this portion of the transition. Then, you’ll need to train your managers on the new controls and how to implement them. And lastly, make sure your backup procedures have been tested and are working well – another very important control that is often overlooked.
Mayor Sam Adams recently announced a tax amnesty for scofflaws who have so far succeeded in not rendering unto the City/County what they owe in business income taxes. While I am not a big fan of amnesty programs, as they reward the wrong behavior and the wrong taxpayers, it is not surprising that businesses and property owners who have “nexus” within the City/County find themselves out of compliance with the tax code. Some do so deliberately, while others may simply be blissfully unaware of their tax obligations.
This is because the City/County tax code, unlike its counterparts among other municipalities, taxes only certain businesses and individuals. It relies on a very narrow tax base, and thus has an extremely high flat rate of 3.65%. It is essentially a payroll tax on successful business owners, and an income/capital gains tax on successful property owners.
But more importantly, the tax punishes privately held companies who do business within City/County borders while rewarding public companies doing the same. How can this be? Well, here’s a real life example from my CPA practice: Locally owned company with 3 shareholders, nets $4 million before owner salaries, and $1 million after owner salaries. In my example, none of the shareholders actually live within the City/County boundaries. What is their City of Portland/Multnomah County Business Tax? The total tab will be $136,500. If this same business were to be bought out by a publicly traded company, and management salaries were the same, the business would now have a tab of $36,500. In this example, that’s a $100,000 punishment for the locally owned company. Outrageous, no?
This strange phenomenon takes place because wages over $87,000 paid to more than 5% owners are “added back” to business net income to determine the tax. Basically, you have a payroll tax on owners who pay themselves more than $87,000 per year, a tax that is not paid by companies who do not have more than 5% owners.
Further, the filing requirements imposed by the City are highly invasive (and perhaps illegal?). Taxpayers who owe no tax whatsoever to the City/County are still required to provide copies of their individual tax returns, along with related Schedules C, D, and E, even though they have no income to report. The TriMet tax, administered by the State of Oregon has no such requirements. If you don’t owe the tax, you simply don’t file.
But, this is not so with the City/County. I have clients who fear their personal financial details are now sitting on some City employee’s desk, and that information that is required by federal law to be kept in strict confidence is being exposed to those who have no need (or right?) to see such information.
But worst of all, the City/County tax is neither a fair tax nor a simple tax. It relies on a narrow tax base (unfair) and it is one of the most complex and arcane municipal tax codes I have ever encountered. A fairer and simpler tax would be a payroll tax/self-employment tax similar to the TriMet tax. It could have a very low rate because of its broad tax base, and would be extremely simple to administer by simply tacking it on to the Oregon quarterly OQ filing.
A broader tax base would also help to discourage local businesses from the practice of fleeing the City/County boundaries to escape the tax. Regardless of what City leaders may say about this practice, every CPA I know has experience with clients who have relocated out of the City/County boundaries to avoid the tax.
In the meantime, if you own property or do business within the City/County borders and have not been filing your tax returns, now is the time to find out if the amnesty program can help you get into compliance.
Update June 20, 2012: This just in from my tax law reporting service:
“Oregon—Income Tax: Portland Confidentiality Provision Amended
Portland has amended its provision regarding confidentiality of business license tax taxpayers to provide that, in addition to existing prohibitions, it is unlawful for any Portland employee, agent, or elected official or any person who has acquired information to divulge, release, or make known in any manner identifying information about any taxpayer applying for tax amnesty, unless otherwise required by law. Ordinance No. 185312, City of Portland, effective May 9, 2012″
So, what is the penalty for unlawfully disclosing taxpayer information? From the City Code:
Contrast this to the penalty on IRS employees for unlawful disclosure of federal tax information (which is the same information the City employees have about its licensees):
“Penalties for Unauthorized Disclosure-Internal Revenue Code
Internal Revenue Code Sections 7213 and 7431 describe the penalties for unauthorized disclosure of federal information.
Under Section 7213 of the Internal Revenue Code, a governmental actor’s unauthorized disclosure is a felony that may be punishable by a $5,000 fine, five years imprisonment or both. Under Section 7213A of the Internal Revenue Code, the unauthorized inspection of federal tax information is punishable by a $1,000 fine, one year imprisonment or both. Section 7431 of the Internal Revenue Code permits a taxpayer to bring suit for civil damages in a U.S. District Court, including punitive damages in cases of willful disclosure or gross negligence, as well as the cost of the action.”
As you can see, City employees are subject to far less punishment than IRS employees who unlawfully disclose the exact same confidential information.
IRS recently came out with new rules regarding how taxpayers must elect to group passive and active business and rental activities together. Grouping a passive activity with an active one can help taxpayers avoid the dreaded “material participation rules” – designed to blur your eyes and make you sleepy and irritable. Oddly, the passive activity rules upon which this new required grouping election is based were enacted back in 1987 with the infamous Tax Reform Act. Um…that was 25 years ago.
Importantly, for tax years 2011 and forward, the new guidance from IRS makes it necessary for all business owners with more than one “activity” to consider whether and how to apply these rules to their undertakings. Here is an overview of how the rules work:
Generally, there is no good reason to group rental activities together into one passive group. Doing so would mean that passive activity losses would remain suspended until each property in the group is finally sold.
Unfortunately, there is neither a bright line test, nor a safe harbor, to help taxpayers determine which activities can be grouped. So, it’s a good idea to carefully review the rules with your CPA firm to evaluate the best course of action.
(With apologies to economist and author Joel Slemrod, author of the paper, My Beautiful Tax Reform)
As an accountant, I get involved in the practical and tedious task of applying tax laws (and related loopholes) to our clients’ fact situations. Rarely do accountants get the time to contemplate (or fantasize about) tax reform, nor to consider systems used effectively by other countries. But, before tax season gets truly underway this year, I have been spending some time educating myself about these matters so that I can combine my practical knowledge with the wisdom of economists and policy analysts around the world.
Professor Slemrod has spent many years evaluating our tax system and expresses the view that a business Value Added Tax (VAT), combined with a highly progressive but simplified individual income tax would deliver the best combination of Fairness and Simplicity (my two objectives for tax reform), and would achieve what he calls “elegance”. He proposes an individual income tax that would exempt most individuals from filing returns, basically by eliminating all deductions and credits, thus broadening the tax base, and then relying on wage withholding to create the proper and equally applied tax to all labor income. The VAT tax would apply to ALL business income, and at a flat rate. Shareholders of corporations would be able to get a credit from the portion of their income already taxed at the corporate level, with the goal being to eliminate all double taxes, and to eliminate all preferential treatment now available through special deductions, credits and business entity selection.
Our current system attempts to tax income (roughly defined as increases in consumption power) by dividing it into 3 pots: labor income, business income, and income from the employment of capital. However, there is little consistency in how these different categories actually work. For example, if I am Mitt Romney and earn my income from “carried interest” I get to pay taxes at a flat capital gains rate of 15%. If I am Warren Buffet’s secretary, I get to pay taxes at much higher rates, depending on my income and deductions, and I also have to pay social security taxes. Publicly traded corporations are subject to a double tax whenever they pay dividends to their shareholders, whereas when they pay interest to their bondholders, they are not. If I lose money on a capital transaction, I can’t deduct the loss unless I have made money on other capital transactions. If I sell my home at a profit, I can exclude the gain up to $500,000 if I am (legally) married. If I earn all my income from dividends and capital gains, I might not have to pay ANY taxes. And, if I am a worker earning a good living, I may be subject to the Alternative Minimum Tax and lose the deductions that my neighbor, who earns less, gets to deduct, thus vastly increasing my marginal tax rate. These are just a few, selected examples of the way our tax system is both complex and unfair.
Fairness in taxation by definition would have to include progressivity as its underpinning. In fact, Professor Slemrod rejects consumption taxes outright, as they can never be made progressive enough. By taxing only consumption, such as through a national sales tax, those who would pay the highest effective rate of tax would be the poor and middle classes, who have to consume certain basic amounts in order to survive. That would be highly unfair, but would admittedly be a simpler tax to administer than our current income tax.
One reason tax reform is so hideous is that anything that affects the federal system will also affect all the states who are connected to the federal system for purposes of defining and determining taxable income. Any major reforms at the federal level will require these states to seriously evaluate and reform their own systems of taxation. Another reason is that by trying to achieve simplicity, one may introduce unfairness, and vice versa. For example, it might be fairer to measure and subtract inflation before taxing capital gains, but now you have introduced a highly complex calculation into the system. You can eliminate this problem by using a consumption tax instead of an income tax, but as noted previously, a consumption tax is a regressive tax, and thus, unfair.
In order to restore legitimacy and moral authority to our government and its system of taxation, the current system MUST be reformed, and it must become fairer and simpler, yet still provide adequate funds. Any steps in those directions are to the good, hideous or not. President Obama’s recent budget proposals include some movements in the right direction: indexing and making permanent AMT exemptions, taxation of carried interest as ordinary income (too bad, Mitt), and simplification of the earned income credit. However, when you read the summary of the President’s budget (spanning 215 pages) you start to feel pretty queasy. More and more tax expenditures (credits and deductions) are being proposed in a desperate effort to insert more fairness into the system, but the end result is more, and much more, of the same highly complex and unfair system that we currently have. Can we give up our favorite deductions and tax credits in exchange for lower and more progressive tax rates? What might be beautiful is restoring the portion of total income taxes once borne by corporations in 1950 (30% of total revenues) from the shockingly low 7% today, something which could be achieved through a VAT tax.
There are a number of ideas being parlayed by presidential candidates, policy makers, and politicians regarding how to reform the U.S. tax code. Unfortunately, none of the ideas mentioned recently are new, nor do they address the fundamental reasons to reform the code, those being: Fairness and Simplicity, which I am capitalizing here as a way of elevating these concepts above other policy goals (involving unfairness and complexity).
History can be a great teacher. But, numbers CAN lie, and everyone has an agenda, including me.
But, let’s take a look at history and see if we can put it in today’s context. First, let’s look at tax rates. Currently, the top marginal rate is half of what it was in 1975 on incomes over $375,000 – 70% vs. 35%. All of the other rates are lower as well, but not by nearly as much. So, the bulk of the benefits of the tax bracket “flattening” has gone to those in the top tax bracket (not surprised, are you?)
Now, what about tax deductions and tax credits? These are also known as “Tax Expenditures” in the world of tax policy making. They are special tax breaks designed to benefit only certain taxpayers, such as the oil and gas industry, home owners, or low income workers with families. Tax Expenditures have risen 43% in the 3 years spanning 2006 to 2009 (think: George W.), and have risen 78% over the last 30 years. What this means is that Fairness has gone out the window, replaced by taxation bent on favoring certain taxpayers and disfavoring others. One taxpayer’s tax on the same income may bear no resemblance to another taxpayer with the same income due to the existence of these special deductions and credits.
Now let’s look at where the taxes come from today vs. where they came from 60 years ago. Employment taxes as a share of the total tax burden have risen 400% in the last 6 decades, going from 10% of total revenues in 1950 to a whopping 40% of total revenues today. Conversely, corporate tax revenues as a percent of total revenues have dropped 428%, going from 30% of total revenues to 7% in 2010. Meanwhile, total individual taxes (not payroll taxes) as a percent of total tax revenues have remained fairly steady for the last 60 years, at about 42%. The rest of the tax revenues come from estate, gift, and excise taxes, and these have fluctuated over the years, but overall, contribute a much lower percentage to total revenues than they did in 1950.
It is quite striking to note that despite all the tweaking and complexity of the current tax code, individuals still bear, overall, about the same burden that they did 60 years ago. The difference is in the mix. Working people of all income levels now bear a much larger burden of the total budget than they did 60 years ago. They contribute not only payroll taxes but income taxes as well. Their total federal effective tax rate can easily exceed 45% if they are self-employed and in the middle class. Wealthy individuals who do not work and derive most of their income from capital gains and dividends enjoy a much lower tax rate. Some of them enjoy a ZERO rate. And, in 2009, the top 10% of taxpayers, those with adjusted gross income exceeding $112,000 paid an overall average tax rate of just 18%. It should be noted however, that those with AGI below the median income of $32,000 (the bottom 50%) paid an average rate of only 1.85% (remember this doesn’t include payroll taxes). It is somewhat shocking to note that the incredibly low AGI number of $32,000 represents ½ of the taxpaying population, and it supports the recent census information indicating that nearly 50% of all Americans are living at or near the poverty level. The biggest beneficiary of the tax burden shift among taxpayers has been corporations, however. Maybe now that they are “people” we should tax them as individuals. That would raise a lot of revenue.
Oddly, tax revenue as a percentage of GDP has remained fairly constant at about 18% for the last 30 years. So, while tax revenues have been stable despite all the tweaking (an estimated 4,000 changes to the code just last year), the federal deficit has been skyrocketing, and WHO PAYS is really the question to ask yourself.
We are very far away from Simplicity and Fairness. The recent proposals to lower rates and take away some deductions (charitable contributions and home mortgage interest) would further skew the Fairness meter, being another boon for the super wealthy. However, taking away deductions does move us toward Simplicity.
In my next post, I’ll take on what I would do to bring about tax reform. In the meantime, although I might be using statistics for my “damned lies,” every fact in this blog post was taken from one of three sources: the Congressional Budget Office, the Joint Committee on Taxation, and the Internal Revenue Service.