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THE SALTMARSH REPORTF o c u s i n g o n t h e B u s i n e s s o f L a w
INSIDE THIS
ISSUE
Page 2:
Practice ManagementAttorneys and the IRS: Are You Caught
in the Cross Hairs?
Page 3:
Investment InsightsThe Art of Letting Go
Andrew Kent, CBA, CVA, CMEALitigation & [email protected]
Beth Varhalla, CPATax & [email protected]
Ronald E. Jackson, CPA, CGMATax & [email protected]
Christina Doss, AAMS ®
Investment [email protected]
Pensacola ● Fort Walton Beach ● Tampa ● Orlando
800-477-7458
V a l u a t i o n c o r n e r Best practices for buy-sell agreementsWhat’s the best valuation method for a buy-sell agreement? This question is the subject of much debate among business owners, valuation analysts and financial advisors.
Everyone agrees that fairness is the goal. But how can fairness be achieved with so many variables affecting the value of the company from day to day and year to year? Moreover, what’s really “fair”?
Critical Choices - A buy-sell agreement dictates what will happen when a partner or shareholder retires, dies, becomes disabled or leaves the company for some other reason. The agreement describes the arrangements of an owner buyout, including purchase pricing, funding and payment terms.
Having a buy-sell agreement in place takes the emotion out of the discussion when a partner leaves. The agreement minimizes the possibility that shares can be sold or left to individuals or businesses that might create an undesirable or untenable partnership for the remaining shareholders.
But what the buy-sell agreement hinges on is value. This is why the valuation provision is one of the most critical aspects of a buy-sell agreement. How much is the departing shareholder’s piece of the company worth?
Types of Provisions - Buy-sell agreements typically include one of three types of
pricing mechanisms: fixed price, formula and valuation. Most financial advisors agree that a fixed price is unworkable because the price is out of date as soon as it’s fixed.
Formulas are more flexible and are designed to reflect a current price based on current inputs at the time of the triggering event. The challenge with this methodology is agreeing on the various inputs and the nuances thereof. For example, if net income is the basis for calculation, then how, by what and over what duration is net income adjusted? Unless the buy-sell agreement precisely clarifies the in-puts, the document doesn’t serve its purpose well.
A valuation appears to be the “fairest” way. But like a formula approach, it begs the question of inputs as well as the standard of value to be used, discounts, valuation date and appraiser.
Proactive Valuation - Z. Christopher Mercer, author of Buy-Sell Agreements for Baby Boomer Business Owners, suggests a valuation-based approach he calls “Single Appraiser, Select Now and Value Now.” While it has valuation at its core, the approach addresses a number of the questions that typical approaches leave unanswered.
Mercer suggests that the buy-sell agreement
name one independent appraiser (or firm) to do the valuation. This is not an unusual provision. However, Mercer suggests that the chosen analyst conduct the valuation now, and not wait until a triggering event. This initial valuation “tests” the valuation provision in the buy-sell agreement and gives owners a baseline value, which is reappraised every year or every other year to keep the value current.
Mercer identifies several advantages to this approach. The owners know the current value of the company at all times and know precisely how that number is calculated. Any issues regarding interpretation of the valuation provision in the buy-sell agreement are ironed out prior to any triggering events. When the buy-sell agreement is actually triggered, there are no surprises. All parties are confident in its mechanics and resulting outcome.
Each company is different, and every set of partners has unique issues. No matter how peaceful and friendly the current relationship between partners, discussing the buy-sell agreement valuation provision tends to cause anxiety. For this reason, it’s wise to make decisions about the buy-sell agreement while everything is copacetic, everyone’s in good health and the business is thriving. Revisiting the valuation provision now can save a lot of heartache — and money — in times of stress.
3rd Quarter 2015
of investor behavior by research group Dalbar. In 20 years, up to 2012, for instance, Dalbar found the average US mutual fund investor underperformed the S&P 500 by nearly 4 percentage points a year.
This documented difference between simple index returns and what investors receive is often due to individual behavior—in being insufficiently diversified, in chasing returns, in making bad timing decisions, and in trying to “beat” the market.
Recently, one of Australia’s most frequently quoted brokers broke ranks from the industry and gave the game away on
this “busy” investing. In his final note to clients before retiring to consultancy work, Morgan Stanley strategist Gerard Minack said he had found over the years that investors were often their worst enemies.
“The biggest problem appears to be that—despite all the disclaimers—retail flows assume that past performance is a good guide to future outcomes,” Minack said.
“Consequently, money tends to flow to investments that have done well, rather than investments that will do well. The net result is that the actual returns to investors fall well short not just of benchmark returns, but the returns generated by
professional investors. And that keeps people like me employed.”
It’s a frank admission and one that reinforces the ancient Chinese wisdom: “By letting it go, it all gets done. The world is won by those who let it go. But when you try and try, the world is beyond the winning.”
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale. Diversification does not eliminate the risk of market loss. Past performance is no guarantee of future results. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
I n v e s t m e n t I n s i g h t sT H E A R T O F L E T T I N G G O ( C O N T )
For additional articles like those included in this edition of The Saltmarsh Report, visit saltmarshcpa.com/cpa-news
Saltmarsh, Cleaveland & Gund, P.A., has been a leader in the professional services industry for more than 70 years. Serving clients across the southeast from our offices in Pensacola, Ft. Walton Beach, Tampa, and Orlando, our success has been built on the principals of honesty, integrity, accuracy and the highest levels of service to our clients and community.
We understand that building a successful law practice in today’s competitive marketplace takes more than just technical expertise - it takes a team. Saltmarsh has built a team of professionals serving the legal services industry, so that you can draw on the diverse experience and expertise of our staff.
Whether in our traditional tax and accounting services or in specialized areas of practice such as forensic accounting and litigation support, business valuation, investment advisory or management consulting, our team of CPAs, analysts, and consultants are here to address your needs and help you achieve your goals.
3rd Quarter 2015 Page 4
By: Jim ParkerVice President Dimensional Fund Advisors Australia Limited
P r a c t i c e M a n a g e m e n tA t t o r n e y s a n d t h e I R S : A r e y o u i n t h e A u d i t c r o s s h a i r s ?
In many areas of life, intense activity and constant monitoring of results represent the path to success. In investment, that approach gets turned on its head.
The Chinese philosophy of Taoism has a word for it: “wuwei.” It literally means “non-doing.” In other words, the busier we are with our long-term investments and the more we tinker, the less likely we are to get good results.
That doesn’t mean, by the way, that we should do nothing whatsoever. But it does mean that the culture of “busyness” and chasing returns promoted by much of the financial services industry and media can work against our interests.
Investment is one area where constant activity and a sense of control are not well correlated. Look at the person who is forever monitoring his portfolio, who fitfully watches business TV, or who sits up at night looking for stock tips on social media.
In Taoism, by contrast, the student is
taught to let go of factors over which he has no control and instead go with the flow. When you plant a tree, you choose a sunny spot with good soil and water. Apart from regular pruning, you leave the tree to grow.
But it’s not just Chinese philosophy that cautions us against busyness. Financial science and experience show that our investment efforts are best directed toward areas where we can make a difference and away from things we can’t control.
So we can’t control movements in the market. We can’t control news. We have no say over the headlines that threaten to distract us.
But each of us can control how much risk we take. We can diversify those risks across different assets, companies, sectors, and countries. We do have a say in the fees we pay. We can influence transaction costs. And we can exercise discipline when our emotional impulses threaten to blow us off-course.
These principles are so hard for people to absorb because the perception of investment promoted through financial media is geared around the short-term, the recent past, the ephemeral, the narrowly
focused and the quick fix.
We are told that if we put in more effort on the external factors, that if we pay closer attention to the day-to-day noise, we will get better results.
What’s more, we are programmed to focus on idiosyncratic risks—like glamor stocks—instead of systematic risks, such as the degree to which our portfolios are tilted toward the broad dimensions of risk and return.
Ultimately, we are pushed toward fads that the financial marketing industry decides are sellable, which require us to constantly tinker with our portfolios.
You see, much of the media and financial services industry wants us to be busy about the wrong things. The emphasis is often on the excitement induced by constant activity and chasing past returns, rather than on the desired end result.
The consequence of all this busyness, lack of diversification, poor timing decisions, and narrow focus is that most individual investors earn poor long-term returns. In fact, they tend to not even earn the returns available to them from a simple index.
This is borne out each year in the analysis
Don’t look now, but you may have a target on your back. The legal profession is one of several industries the IRS has singled out for special scrutiny as part of its Examination Specialization Program (formerly known as the Market Segment Specialization Program).
In fact, the feds have released a revised Attorneys Audit Technique Guide that specifically identifies the accounting, banking and record-keeping practices used in the profession and highlights issues that revenue agents should focus on in examining a lawyer or law firm.
Who Gets Hit?According to the guidelines, solo practitioners face the highest potential for an audit. The IRS also considers attorneys who practice in the following areas to have higher potential for noncompliance:
• Criminal law• Real estate law • Immigration law
The audit guide identifies the records and documents typically kept by attorneys that IRS agents should request and review — everything from appointment books and client card indexes to disbursement ledgers and time reports. As they sift through these records, agents are advised to look for these common areas of noncompliance:
• Unreported income — Personal bank accounts will be analyzed to determine whether any client fees were deposited directly into a personal account instead of a business account. Particular attention will be paid to withdrawals from client trust accounts.
Agents will also scrutinize attempts by attorneys to defer income. As cash basis taxpayers, attorneys are required to recognize income in the year it is received. So, retainers and prepaid fees must be reported as income in the year received even if the services will not be performed until a later year.
Contingency fee cases also come under scrutiny. When a settlement or judgment is received and deposited into a client trust account, the contingency fee amount is typically includable in income for the year in which it is received (because it is determinable and available as soon as a client’s settlement or judgment is received).
• Non-cash income — The Audit Technique Guide also directs IRS agents to look for situations in which an attorney receives non-cash payment. Examples include when an attorney performs legal services to pay back a loan, trades legal services for other services or accepts stock in lieu of cash (as discussed in this issue’s lead article).
• Employment practices — Agents are also advised to check for employment tax issues, such as treating secretaries, paralegals and clerks as independent contractors when they in fact meet the IRS definition of an employee. See IRS Publication 1779, Independent Contractor or Employee, for more details on this important distinction.
• Advanced client costs — The IRS takes the position that advanced client costs should be treated as loans to clients if the attorney expects to later be reimbursed
for the costs. A classic example is the attorney in a contingency fee case who covers litigation expenses on behalf of the client with the agreement that the amounts will be recovered out of a future settlement or judgment.
Problems arise when attorneys deduct these costs instead and are later reimbursed. If the costs are never reimbursed, the attorney may deduct the amount as bad debt. To determine whether there is an expectation of reimbursement, IRS agents are advised to look at an attorney’s case selection, fee advancement processes and success rate.
Watch Your BackWith the IRS arming agents with specific tools for auditing attorneys and law firms, it is critical to check for potential areas of noncompliance. Make sure your accounting practices and tax filings comply with the Internal Revenue Code and corresponding regulations.
Protecting Attorney-Client Privilege During an AuditWhen the IRS comes knocking, it’s important to consider that fee arrangements and the identity of clients are generally not considered to be protected communications. However, while the specific fee arrangement is not protected, any portions of an engagement letter, retainer agreement or any other correspondence that reveals the client’s motivation for creating the relationship, the nature of legal services provided or the attorney’s litigation strategy is protected.
If an attorney invokes attorney-client privilege and refuses to provide documents, IRS agents are advised that it may be necessary to issue a summons for the documents. The attorney may then challenge the validity of the summons on the basis that the documents requested are protected by privilege.
I n v e s t m e n t I n s i g h t sT H E A R T O F L E T T I N G G O
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