CASE STUDIES

 

State and Local Taxes (“SALT”) can be your friend

THE PROBLEM: A wealthy client had two family trusts which were located and serviced in Pittsburg. The income from the trusts was entirely interest, dividends and capital gains. The trusts did not file in either Pennsylvania or Michigan. In accordance with standard practice at the time, I excluded the Pennsylvania income from Michigan income. My client received a letter from the Michigan Department of Treasury disallowing the exclusion of the trust income and proposing a large deficiency (additional amount due) plus interest and penalties.

SOLUTION: I checked with the standard technical publications (CCH and RIA) and with a talented former colleague. I learned of a case, which allowed for the exclusion of Michigan income provided certain requirements were met. In this case, it meant that the trust had to be located in and administered in another taxing jurisdiction and had to file a return in that jurisdiction. I reviewed Pennsylvania tax law and discovered that my client could pay Pennsylvania taxes of about 2% and would meet all tests for excluding the trust income from Michigan taxes. I confirmed my proposed course of action with the trustees and received their OK to file Pennsylvania returns. The difference in tax rates on the trust income between Pennsylvania and Michigan was almost 8%. We kept the trust in Pennsylvania until the intangibles tax was repealed and Michigan personal rates were reduced. Since the client’s income was almost entirely from passive sources, most of which were from Pennsylvania, we were able to shelter most of his income from Michigan’s high tax rates.

SAVINGS: During the more than ten years we used this strategy, we saved approximately 8% on the trust income of approximately $150,000 per year for eleven years resulting in cumulative savings of at least $132,000.

The Importance of Cooperation with Tax Auditors

THE PROBLEM: My client, a large company with operations in 48 states, had undergone an audit. The audit resulted in a large deficiency (amount due) and, more ominously, the company had received a letter from a state court stating that it had found the client had willfully evaded the state revenue laws. This is serious because this finding means that the state may, at its option, pursue criminal charges. Additionally, if the company lost the case it would have to disclose the facts of the case to the SEC, not a pleasant possibility. The amount of the deficiency was approximately $2.1 million, of which $350,000 were penalties. This was an incentive to work very hard to meet the state’s documentation requirements.

SOLUTION: I had 15 days to prepare an answer so I worked quickly. I spoke with client personnel about what had happened and asked if threir records were sufficiently detailed that I could go back and provide a credible answer to the Department of Revenue. I spoke at length with the regional vice president to ensure I had backing for this project. There would be no sense in claiming I could answer the charges unless I had full support from the client to find the information and disclose it to the state.

After ensuring that I had the requisite support, I called the state’s Department of Revenue to begin the negotiations. I began by apologizing for the client’s failure to promptly respond to the Revenue Agent’s information requests. These requests were reasonable and the client’s failure to respond created an enormous amount of ill will on the state’s part. One positive outcome was that when I asked for an extension of time to respond to the questions, the State having reviewed my interim work, granted my request.

SAVINGS: The state abated all penalties and the payment, including interest, was less than $60,000 — less than 3% of the original deficiency. The resulting savings were over $510,000 per year for a four year period resulting in a cumulative savings of $2,040,000.

Knowing the Clients’ Business Can Save the Business

THE PROBLEM: My clients were three young owners who had bought an auto engine rebuild shop. They had excellent credentials, had received MBA’s with honors, and were anxious to become entrepreneurs. But, they bought the business with almost no due diligence or business experience and promptly became mired in losses. Could this company be saved? They at least were aware of the need for good financial statements for internal use and had enough sense to promptly call on their CPA for analysis of operations.

SOLUTION: I spoke to the owners and asked open questions about what they did and why they did it. I have some real world knowledge of engine rebuilds having assisted my father in three such rebuildings. I discovered that they had no credit policy and that they did not ask for a deposit up front. I also discovered that they did not “age” their receivables. That is they did not generate a listing of accounts receivable that were overdue by month (e.g. 30, 60 and 90 and over 90 days old). So I recommended a 30% to 50% deposit with the balance due upon completion of the work. I also recommended following up on old accounts. Some “dead beats” will respond to demands for payment.

I also looked at what we call inventory turns. A low number means that excess inventory is being held. This is costly since the owners borrowed money to purchase the inventory; they also paid costs such as insurance, as well as interest on the inventory. I suggested not ordering inventory, unless it was for small common items that could be used on almost any job.

I recommended promptly reconciling the bank account. I recommend creation of purchase orders for high dollar inventory.

Within three months the business had achieved profitability. Unpaid Accounts Receivable were reduced due to the imposition of advanced deposits and requirement to pay when the engines were picked up. Inventory was reduced by ordering only upon receipt of a deposit. This helped reduce working captial requirements. The business not only grew, but grew in profitability. The new owners had become successful (i.e. money making) entrepreneurs.

SAVINGS: A business saved. The company turned around in 60 days. They went from annual losses of approximately $50,000 to a net income of over $50,000 in less than a year.

Go the Right Way with Asset Utilization

THE PROBLEM: A former employer was barely breaking even, in spite of paying wages and salaries well below the industry average. It was non-unionized when most of the industry was unionized. For operating crews, it paid 25% of what its unionized competition paid and paid about 70% of what the few non-unionized companies paid. It was getting premium rates on its service based on its past reputation. All other expenses, except for fuel, were below its competitors. The fixed assets were purchased second hand and renovated, so capital costs were very low. And the company had almost no leverage at the time. Why was it barely breaking even?

RESULT: I prepared the taxes, in addition to reviewing credit reports, treasury operations, etc. Most of my time was taken up with state income/franchise returns. These returns required taxpayers to adjust their Federal taxable income and then apportion (i.e. attribute) a certain part to the taxing jurisdiction. There were several ways to do this and several of the states mandated an apportionment ratio of two parts: (1) airtime in the jurisdiction over total airtime and (2) time on the ground in the jurisdiction over time total time on the ground. The denominator measured the percentage of time an aircraft was flying. For my employer, the combined ratios in the denominator were slightly more than 11%. The apportionment ratio based on time in the air and on the ground was and is a good proxy for asset utilization. I confirmed this much by speaking with colleagues in two of our large competitors. They noted that these calculations were also sent to operating personnel and, of course, they were substantially higher than 11%. This was the key. Customers pay an airline to move freight, not to sit on the ground.

Without the authorization of senior management to make improvements in asset utilization, in less than a year the company lost 60% of its revenue base and slowly expired. Senior management chose to ignore this issue and it cost them the company.

LESSON LEARNED: The reason for the airline’s poor performance: poor asset utilization. Fixed assets can be costly and they can generate high depreciation/amortization expenses, as well as repair and debt service expenses. As a result, labor costs, although high, can be less than the costs associated with fixed assets. Southwest Airlines, among a few others, has discovered this. By using their air craft intensively (better asset utilization), they not only keep fixed asset costs down but provide a better service with more frequent flights.