LedgerCore Financial

The Weekend Ledger

…the telling of real situations experienced by real clients over the past three decades (for real)…

Issue 4
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“GROWING BROKE: WHEN MORE SALES CREATE LESS CASH”
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Most business owners assume that increasing sales is good news… and it absolutely is!

But growth requires cash. And, under the wrong circumstances, a rapidly growing company can actually run out of cash while its sales and profits are increasing.

That sounds contradictory until you look at what happens between making a sale and actually collecting the money.
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PROFIT DOESN’T NECESSARILY MEAN CASH IN THE BANK
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Suppose a company normally generates $200,000 of sales each month. Business takes off, and monthly sales increase to $300,000.

That is a 50% increase in revenue.

Great news!

But suppose most customers pay 45 days after they are invoiced. The company has to perform the work—or purchase and deliver the product—before it gets paid. Employees still expect their paychecks every two weeks. Vendors expect payment. Rent, insurance, utilities, and taxes continue to come due.

The company may now be financing substantially more business for its customers than it was before.

The sale increased revenue… it did not necessarily increase cash. Yet.
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ACCOUNTS RECEIVABLE CAN CONSUME CASH
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Consider a business with $2,400,000 in annual sales:

If customers take approximately 30 days to pay, the company might normally carry around $200,000 in accounts receivable.

Now suppose annual sales grow to $3,600,000. At the same collection rate, accounts receivable could increase to approximately $300,000.

That additional $100,000 of accounts receivable represents sales the company has made—but cash it has not yet collected. Meanwhile, many of the expenses required to generate those sales have already been paid.

Hey, the company grew and certainly its income statement looks better, but $100,000 of additional cash is now sitting in customers’ accounts instead of the company’s bank account.
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INVENTORY CAN DO THE SAME THING
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For businesses that sell products, growth often requires purchasing more inventory before the additional sales occur.

A company expecting significantly higher sales may need to place larger orders, maintain higher minimum inventory levels, or purchase materials weeks or months before the finished product is sold.

Most non-nerds (aka non-accountants) don’t know that up to the minute it’s sold, inventory is an asset… not an expense. That means that moving $100,000 from the bank account into inventory does not immediately reduce net income by $100,000… there’s no ding against the bottom line yet, but that cash is still gone.

It has simply changed form—from cash in the bank to products sitting in a warehouse, storeroom, kitchen, showroom, or job site.

That distinction matters when a business is growing quickly.
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THEN THERE’S EQUIPMENT
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Growth frequently requires additional equipment: a new vehicle, machine, computer system, kitchen appliance, piece of production equipment, or other asset may require a significant cash outlay.

For accounting and tax purposes, that expenditure may be depreciated over time—or, depending on the circumstances, accelerated through bonus depreciation or Section 179.

But neither treatment changes what happened to the bank account. If the company writes a $75,000 check for a down payment on some equipment, $75,000 of cash leaves the company that day.

The expense reported on the income statement may look very different, but - again - the cash is gone.
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DEBT PAYMENTS CREATE ANOTHER DIFFERENCE
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Suppose the business has a $10,000 monthly loan payment to finance that equipment that required that $75k down payment. In the beginning, the cash outlay closely matches the deductible expense because at the start of repayment, most of the payment is interest. But as time goes by, more and more of the payment is applied to principal repayment …which is not a deductible expense.

If $8,000 of that payment is principal and $2,000 is interest, the company has spent $10,000 of cash, but only $2,000 appears as an expense on the income statement. Over twelve months, that difference can become substantial and still nothing is wrong with the financial statements: they are simply measuring something different from the balance in the bank account.
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NOW PUT IT ALL TOGETHER
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Imagine a growing company reports $250,000 of net income for the year.

At first glance, the owner might reasonably expect the company to have generated something close to $250,000 of additional cash.

But during that same year:

Accounts receivable increased: -$100,000
Inventory increased: -$60,000
Equipment purchased: -$75,000
Loan principal repaid: -$50,000

That is $285,000 of cash absorbed by just four items. The result? …the company reported $250,000 of net income and still experienced a reduction in cash!
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GROWTH HAS TO BE FINANCED
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This is one of the most important concepts for the owner of a growing business to understand: someone has to finance the period between spending the money required to generate a sale and collecting the cash from that sale.

Sometimes the company finances it with accumulated cash. Sometimes vendors help finance it by providing payment terms. Sometimes customers help finance it through deposits or advance payments. Sometimes a bank finances it through a line of credit. And sometimes the owner finances it by putting additional money into the company. That can be a lot of juggling…

And the faster the company grows, the larger that financing requirement can become.
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MORE SALES CAN ACTUALLY MAKE THE PROBLEM WORSE
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When working capital is already tight, the instinctive response is often: “We need more sales.”

Maybe.

But if every additional sale requires the company to spend cash today and wait 30, 45, or 60 days to collect from the customer, rapidly increasing sales can make the immediate cash shortage worse.

That does not mean the company should stop growing! It just means the company needs to understand how much cash its growth requires—and where that cash is going to come from.
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THIS IS WHY CASH FLOW PROJECTION MATTERS
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A traditional income statement tells you whether the business generated a profit over a period of time. It does NOT tell you whether the company will have enough cash in the bank three weeks from Tuesday to make payroll.

That requires looking forward.

At LedgerCore, our cash-flow projections generally extend through the normal payment terms on outstanding customer invoices. If customers typically pay within 30 days, for example, we can project expected collections against payroll, vendor payments, debt service, taxes, owner distributions, and other known cash requirements during that period.

And there’s a reason we stop at the edge of A/R: the farther a cash-flow projection extends beyond known receivables and obligations, the more it depends on assumptions about sales that have not happened, invoices that have not been issued, and expenses that may change.

Our objective is not to predict the future (if we could do that, “we’d” be on a beach on Majorca instead of writing this column). No, our objective is to use the information we actually have to identify a potential cash shortage while there is still time to do something about it. I mean, hey, while it may still seem too-short a notice, identifying a $100,000 cash requirement three weeks in advance provides considerably more options than discovering it three days before payroll.
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WE’RE HERE TO HELP
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At LedgerCore Financial, we believe growth should be planned not only from a sales and profitability perspective, but also from a cash-flow perspective.

If your company is growing while cash seems to be getting tighter, the answer may not be obvious from the Profit & Loss Statement alone.

We can help identify where cash is being absorbed, evaluate working-capital requirements, analyze accounts receivable and inventory trends, and prepare short-term cash-flow projections based on expected customer collections and known upcoming obligations.

Because sometimes the question isn’t, “is the business profitable?”… it’s “do we have enough cash to go this fast?!?”

Let us help you figure that out ;-)

The Weekend Ledger
Issue 3
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"YOUR FINANCIAL STATEMENTS ARE TRYING TO TELL YOU SOMETHING"
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Most business owners receive financial statements because they're supposed to. They get a Profit & Loss Statement. Maybe a Balance Sheet. They look at revenue, glance at the bottom line, see whether there's money in the bank, and move on.

But receiving financial statements and actually USING financial statements are two very different things. Your financial statements are trying to tell you something. The trick is knowing what questions to ask.
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THE PROFIT & LOSS STATEMENT: "DID WE ACTUALLY MAKE MONEY?"
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The Profit & Loss Statement—also called an Income Statement—is usually the financial statement business owners understand best. It tells you how much revenue the business generated, what it cost to generate that revenue, what the business spent to operate, and ultimately whether it made or lost money during a particular period.

But the number at the bottom isn't nearly as useful by itself as it is in context. "Did we make $100,000?" is one question. "Why did we make $100,000?" is a much better one. The answer matters because it helps tell you whether that result is repeatable. A great month driven by one unusually large sale tells a very different story from sustained growth in revenue or an improvement in margins.

Did revenue increase? Did gross margins improve? Did payroll grow faster than sales? Are certain expenses creeping upward? Did one unusually good—or unusually bad—month distort the results? A good P&L shouldn't just tell you whether you made money. It should help tell you WHY.
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THE BALANCE SHEET: "WHAT SHAPE ARE WE ACTUALLY IN?"
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If the P&L tells you what happened over a period of time, the Balance Sheet gives you a snapshot of where the business stands at a particular moment. What does the business own? What does it owe? How much do customers owe the business? How much does the business owe vendors, lenders, credit cards, taxing authorities, and others?

A company can report a healthy profit and still have a weak Balance Sheet. It can be carrying too much debt, accumulating unpaid bills, struggling to collect receivables, or consuming cash faster than the P&L would suggest. That's why looking only at the P&L can give you a very incomplete picture.

The P&L tells you how the business PERFORMED. The Balance Sheet tells you what that performance has DONE TO THE BUSINESS.
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"IF WE MADE MONEY, WHERE IS THE CASH?"
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This may be one of the most common questions in business accounting. The P&L says the company made $75,000, but there certainly isn't an extra $75,000 sitting in the checking account. So where did it go?

Maybe customers haven't paid yet. Maybe the company bought equipment. Maybe it paid down debt. Maybe the owner took distributions. Maybe inventory increased. Maybe the company paid bills this year for expenses recorded last year. And here's one that frequently surprises business owners: the principal portion of a loan payment reduces debt on the Balance Sheet—it isn't an expense on the P&L. A business can therefore use a significant amount of cash paying down debt without reducing its reported profit by the same amount. Profit and cash are related, but they are NOT the same thing.

And the reverse is equally important. Having plenty of money in the bank doesn't necessarily mean the business is profitable. The cash could have come from a loan, an owner's contribution, the collection of old receivables, or simply from delaying bills that still need to be paid. That's why managing a business by looking at the bank balance can be dangerous.

Your bank account tells you HOW MUCH CASH YOU HAVE. It doesn't necessarily tell you HOW YOU GOT THERE.
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ACCOUNTS RECEIVABLE: "ARE OUR CUSTOMERS ACTUALLY PAYING US?"
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Revenue isn't particularly useful if you can't collect it. An Accounts Receivable Aging report tells you not only how much customers owe you, but how long they've owed it. A growing receivable balance can make the P&L look terrific while creating a serious cash-flow problem underneath.

That's why the aging matters. A $50,000 receivable balance made up mostly of invoices from the last 30 days tells one story. A $50,000 balance filled with invoices that are 60, 90, or 120 days old tells a very different one.

Sales are important. COLLECTIONS are what pay the bills.
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ACCOUNTS PAYABLE: "WHAT HAVE WE SPENT THAT WE HAVEN'T PAID FOR YET?"
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Accounts Payable tells the other side of the story. A business can temporarily make its cash position look stronger simply by not paying its bills. That's why a healthy checking-account balance viewed without the Accounts Payable Aging can be misleading. Cash you still owe to somebody else isn't really available cash.

How much is due this week? What's already overdue? Are vendor balances increasing? Are we routinely pushing bills into the next month because cash isn't available? Those aren't merely bookkeeping questions. They're management questions.

And sometimes an increasing A/P balance is one of the earliest warnings that a profitable-looking business is developing a cash-flow problem.
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ONE MONTH DOESN'T TELL YOU VERY MUCH
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Numbers become information when you give them something to compare themselves to. Financial statements become substantially more useful when you stop looking at them in isolation. How does this month compare with last month? How does this quarter compare with the same quarter last year? Are margins improving? Is payroll consuming a larger percentage of revenue? Are receivables growing faster than sales? Is debt going down—or quietly creeping upward?

A single month's financial statements are a photograph. Comparative financial statements start to become a MOVIE. And that's when patterns become visible. Trends, changes in margins, unusual expenses, deteriorating collections, increasing debt, and other developments can be difficult to see in one set of numbers but obvious when those numbers are placed beside prior periods.
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BOOKKEEPING AND FINANCIAL REPORTING AREN'T THE SAME THING
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Good bookkeeping matters. Transactions need to be entered correctly, accounts reconciled, expenses classified properly, and the books kept current. But that's the starting point—not the finish line.

Bookkeeping records what happened. Good financial reporting helps you UNDERSTAND what happened. Great financial reporting helps you decide WHAT TO DO NEXT.

That distinction matters because perfectly reconciled books can still produce financial statements nobody is actually using to run the business.
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THE NUMBERS SHOULD LEAD TO QUESTIONS
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The purpose of financial reporting isn't to hand a business owner a stack of reports once a month. It's to start a conversation.

"Why did our gross margin fall three points?" "Why are sales up 15% but cash is down?" "Why has payroll increased faster than revenue?" "Why are receivables taking longer to collect?"

"Why is this expense suddenly twice what it was six months ago?" "Can we afford to hire another employee?" "Can we afford to buy that equipment?" "Can we afford to distribute this cash—or does the business need it?"

Those are the questions that turn accounting information into management information.
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*** BOOKKEEPING RECORDS WHAT HAPPENED. GOOD FINANCIAL REPORTING HELPS YOU UNDERSTAND WHAT HAPPENED. GREAT FINANCIAL REPORTING HELPS YOU DECIDE WHAT TO DO NEXT. ***
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*** YOUR FINANCIAL STATEMENTS SHOULDN'T JUST TELL YOU WHAT HAPPENED. THEY SHOULD HELP YOU UNDERSTAND WHY IT HAPPENED—AND WHAT YOU SHOULD DO ABOUT IT. ***
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WE'RE HERE TO HELP
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At LedgerCore Financial, we believe accounting should do more than produce accurate books and tax returns. Financial information should be understandable, timely, and useful to the people actually making decisions.

If you're receiving financial statements every month but aren't quite sure what they're telling you—or if you're only looking at your bank balance to figure out how the business is doing—we're available for consultation.

Producing the numbers is accounting. Understanding what they're telling you—and using that information to make better decisions—is financial management.

The Weekend Ledger
Issue 2
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"THE SHORT-TERM RENTAL TAX LOOPHOLE: WHAT IT REALLY IS"
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Spend enough time on social media looking at tax strategies and eventually you'll encounter some version of this:

“Buy a short-term rental, generate a large tax loss through depreciation, and use that loss to offset the income from your job or business.”

It's often called the “short-term rental loophole.” And unlike many things described as tax loopholes on the internet, there really is something to this one. But it's not quite as simple as buying a house, listing it on Airbnb or Vrbo, and deducting a large paper loss against your other income.

The strategy works because of an interesting intersection between the tax rules governing rental activities, passive losses, material participation, and depreciation.
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THE PROBLEM WITH TRADITIONAL RENTAL LOSSES

Rental real estate can generate significant tax deductions. In addition to ordinary operating expenses such as repairs, insurance, property taxes, management fees, and utilities, owners generally depreciate the building and certain improvements over time. As a result, a property that produces positive cash flow can sometimes report a loss for tax purposes.

There's a catch:
Under the passive activity rules, rental activities are generally treated as PASSIVE ACTIVITIES. That means a loss from a traditional rental property generally cannot simply be used to offset wages or income from an unrelated business, which are all NON-PASSIVE ACTIVITIES.

There are exceptions, but for many higher-income taxpayers, those rental losses are suspended and carried forward until they can be used in a future year. This is where short-term rentals become interesting.
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WHEN A RENTAL ISN'T A “RENTAL ACTIVITY”

For purposes of the passive activity rules, not every activity involving the rental of property is treated as a rental activity. One important exception can apply when the average period of customer use is SEVEN DAYS OR LESS.

Think vacation homes, cabins, condos, and other properties rented for a few nights at a time. If the activity meets this exception, it may no longer be automatically classified as a rental activity under the passive activity rules.

That doesn't automatically make the losses deductible. But it opens an important door.
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MATERIAL PARTICIPATION IS THE KEY

Once the activity is no longer automatically treated as a rental activity, the next question becomes whether the owner materially participates in operating it.

The IRS provides several tests for material participation. Depending on the circumstances, an owner may qualify based on the number of hours worked in the activity, how those hours compare with the participation of other individuals, or other participation tests.

This is where the short-term rental strategy differs dramatically from traditional rental real estate. If the activity qualifies under the short-term-use rules AND the taxpayer materially participates, the activity may be treated as NONPASSIVE.

And that means a tax loss generated by the property may potentially offset other nonpassive income. That's the “loophole.”
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WHERE THE LARGE LOSSES COME FROM

Simply operating a short-term rental doesn't necessarily create a large tax loss... but accelerated depreciation CAN.

A portion of a property's purchase price is generally allocated to the building and depreciated over many years. But certain components of the property may qualify for substantially shorter depreciation periods.

Through a cost segregation study, a property owner may be able to identify components that qualify for accelerated depreciation rather than depreciating the entire building over the normal residential real estate recovery period. Depending on the property, applicable depreciation rules, and the year the assets are placed in service, this can move a significant amount of depreciation into the earlier years of ownership.

Here's the counterintuitive part: The property can produce POSITIVE CASH FLOW while simultaneously producing a SUBSTANTIAL TAX LOSS.

If that loss is nonpassive because the owner satisfies the applicable short-term rental and material-participation rules, it may potentially offset income elsewhere on the taxpayer's return.
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IT'S NOT AN AUTOMATIC WRITE-OFF

This is where some internet explanations of the strategy become dangerous. Buying a vacation rental doesn't automatically give you a deduction against your salary.

Among other things, you need to consider:

• The property's actual average customer-use period
• Whether you materially participated in the activity
• How much time you and others spent operating the property
• Whether a property manager was involved
• Personal use of the property
• Proper allocation between land and depreciable property
• The depreciation methods available for the year the property was placed in service
• Whether a cost segregation study is appropriate
• Documentation supporting your participation

And those rules need to be evaluated EACH YEAR. A strategy that works one year doesn't necessarily produce the same result the next.
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DOCUMENTATION MATTERS

If you're relying on material participation, documentation becomes particularly important.

You should be able to substantiate the work you actually performed in operating the property. That might include communicating with guests, coordinating repairs, purchasing supplies, managing listings, handling reservations, bookkeeping, inspecting the property, and performing other legitimate management activities.

Simply estimating your hours when an IRS examination occurs several years later is not where you want to find yourself. Good records should be part of the strategy from the beginning.
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WHO IS THIS STRATEGY REALLY FOR?

The short-term rental strategy can make sense for several different types of taxpayers.

Some investors already want to own investment real estate and see short-term rentals as an opportunity to combine a potentially appreciating asset with current income and favorable tax treatment. Others approach short-term rentals as an actual business, with the goal of building a profitable hospitality operation that generates positive cash flow.

The strategy can also be particularly attractive to higher-income taxpayers who are already looking for real estate investments and may receive substantial current tax benefits from depreciation, provided they are willing and able to meet the material-participation requirements.

And sometimes the opportunity already exists: a taxpayer may own a second home, former residence, or other property that could make economic sense as a short-term rental.

What these situations have in common is simple: THE UNDERLYING INVESTMENT SHOULD MAKE SENSE ON ITS OWN.

Tax benefits can significantly improve the economics of a good investment, but they shouldn't be the only reason for making one. Buying a poorly performing property, taking on substantial debt, or operating a business you don't really want simply to generate a tax deduction can quickly become a very expensive way to save taxes.

And if you remember only one thing from this article, make it this:

*** A good short-term rental tax strategy can make a good real-estate investment better. It generally shouldn't be used to make a bad real-estate investment look good. ***
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SO, IS IT REALLY A LOOPHOLE?

Not really—at least not in the sense that the word “loophole” usually implies. There isn't a secret provision in the tax code allowing Airbnb owners to magically deduct the cost of vacation homes against their salaries.

Instead, there is an unusual interaction among several perfectly legitimate tax rules. When the facts line up correctly, those rules can create an extremely valuable tax result.

That's why we prefer to think of the short-term rental “loophole” as a TAX PLANNING OPPORTUNITY. And like most good tax planning opportunities, it works best when the planning happens BEFORE DECEMBER 31—not when the tax return is being prepared several months later.
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WE'RE HERE TO HELP

If you own a short-term rental—or you're considering purchasing one primarily because of the potential tax benefits—LedgerCore Financial is available for consultation.

We can help evaluate how the short-term rental rules apply to your situation, discuss material participation and documentation requirements, prepare a cost segregation study, and estimate the potential tax impact before you make significant financial decisions.

Because there's a big difference between owning a short-term rental that happens to provide tax benefits and buying a property based on a tax strategy you saw in a 60-second video.

We're introducing "The Weekend Ledger", a series of articles designed for the small business owner seeking insight and guidance in tax, record-keeping, and business financial reporting!

Stay tuned for subjects ranging from keeping good books to tax-saving strategies...

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THE WEEKEND LEDGER
Issue No. 1


Why Owners of S Corporations (and LLCs taxed as S Corporations) Must Pay Themselves a Reasonable Salary

One of the most attractive benefits of electing S corporation tax treatment is the potential to reduce self-employment taxes. Many business owners are surprised to learn that both corporations and LLCs may elect to be taxed as S corporations, provided they meet the IRS eligibility requirements. However, many owners misunderstand how S corporation taxation works and inadvertently create tax problems.

If you actively work in your S corporation—whether it is a corporation or an LLC that has elected S corporation tax treatment—the IRS generally requires you to pay yourself a reasonable salary before taking shareholder distributions. Your salary is subject to payroll taxes, while distributions generally are not. This is where the tax savings can occur—but only when handled correctly.


What Is a "Reasonable Salary"?

Unfortunately, there is no bright-line IRS rule that defines a reasonable salary. Instead, the IRS considers a number of factors, including:

* Your duties and responsibilities
* The time you devote to the business
* Your education, training, and experience
* What similar businesses pay for comparable work
* The company's profitability and ability to pay

For example, if an S corporation earns $250,000 annually and the owner works full-time managing operations, paying a salary of only $15,000 while taking the remainder as distributions is unlikely to withstand IRS scrutiny.


The LedgerCore 40% Rule

Because there is no bright-line IRS test, LedgerCore Financial and its predecessor entities developed a practical framework for determining reasonable owner compensation.

Over more than 30 years of advising closely held businesses, we have refined what we call the LedgerCore 40% Rule. The methodology has evolved through decades of real-world experience and has been applied consistently throughout the firm's history. To date, it has successfully withstood IRS scrutiny while helping clients strike an appropriate balance between tax efficiency and compliance.

Under this approach, we generally recommend that an owner-operator's salary be at least 40% of the company's net income before deducting the owner's salary. However, we generally do not apply this guideline until the business generates more than $50,000 of annual net income.

We also recognize that this calculation can produce unrealistically high salaries for very profitable businesses. To address that, we cap our recommendation at 200% of the median annual wage for all occupations in the state where the S corporation is located. Using a statewide median rather than an occupation-specific wage provides a consistent, objective benchmark that can be applied across virtually every industry.

The LedgerCore 40% Rule is not an IRS rule or safe harbor. Rather, it is our firm's proprietary methodology for establishing a reasonable starting point for owner compensation. Every business is unique, and there are circumstances in which a higher or lower salary may be appropriate based on the owner's role, the nature of the business, and other relevant facts and circumstances.


Why It Matters

If the IRS determines that an owner's salary is unreasonably low, it may reclassify some or all shareholder distributions as wages, resulting in additional payroll taxes, penalties, and interest.

For that reason, owner compensation should be reviewed periodically as your business grows. A reasonable salary should reflect the value of the work you perform—not simply the amount that minimizes taxes.


We're Here to Help!

Determining a reasonable owner salary is one of the most important—and most misunderstood—aspects of operating an S corporation. While the IRS provides general guidance, every business has its own unique facts and circumstances.

If you're unsure whether your current compensation is appropriate, or if you're considering electing S corporation tax treatment, LedgerCore Financial is here to help. We offer consultations to evaluate owner compensation, explain the LedgerCore 40% Rule, and provide recommendations tailored to your business.

Whether you're establishing payroll for a new S corporation, an LLC electing S corporation tax treatment, or reviewing an existing compensation structure, we'd be happy to help you strike the right balance between tax efficiency and IRS compliance. Contact us today to schedule a consultation.