| |
 |
|
David Hardesty
|
Today
I am interviewing David Hardesty, Vice President of the
accounting firm
Wilson
Markle Stuckey Hardesty & Bott, and author of several
books on e-commerce taxation, governance and
Sarbanes-Oxley. David has been honored by Accounting Today
as one of the “Top 100 Most Influential People in
Accounting” for 2004.
Anthony: A number of
entrepreneurs start working on their ideas before setting up
a formal business structure. How are the expenses they incur
during this very early stage treated for tax purposes?
David: Before you are actively
involved in a business, i.e. when you’re starting a
business, or thinking about buying a business, you are
subject to section 195, which basically says that expenses
related to the acquisition or the creation of a new business
are deferred. You then amortize these expenses when you
start active business.
When I teach out of my book “Electronic Commerce:
Taxation and Planning", we actually spend a fair amount
of time on start-up costs because that's very important for
technology companies. We discuss when they apply and when
they don’t. The bottom line on start-up costs is the
following: If these costs would have normally been
deductible by an existing (ongoing) business under section
162 (which is your basic normal business expense section),
but were incurred during the start-up phase when you’re
either thinking about acquiring a business or creating a new
business, then that cost - which would have otherwise been
deductible as a normal business expense - becomes deferred
under section 195. Unfortunately, the new tax law extended
the amortization period, which used to be 60 months, to 15
years.
Anthony: Does this apply to
software development costs?
David: This gets to be tricky.
If the development has a fair amount of uncertainty, its
cost could qualify as section 174 expenses, which are
research and experimentation expenses. In this case, one can
elect to deduct these expenses in the current year without
any restrictions, or capitalize them. In the event they are
capitalized, these expenses are treated as placed in service
when business starts, which is when their amortization can
begin.
If on the other hand the development is routine in nature
(such as the configuration and implementation of purchased
software), then the associated expenses do not qualify under
section 174. Instead, they fall under the general rules for
a start-up company. This means that they are transformed
under section 195 and amortized over 15 years.
Alternatively, one may elect to capitalize these routine
software costs and place them in service on the date the
business starts. And under the new rules, which are fairly
generous, one can write off half of the cost of the software
in the first year. In addition, one can amortize that cost
over a 3 year period. So for practical purposes, 65% of the
cost is written off in the first year, but only after it is
placed in service.
Anthony: Technology
start-ups typically use an S Corporation or a C Corporation
as a form of business. When does it make sense to consider a
Limited Liability Company (LLC)?
David: I like LLCs because
they are easier to deal with. They are less formal than
corporations and have fewer limitations with regard to who
can own the entity, yet they offer the same liability
protection. With an LLC, you can issue units as stock. You
can also issue options to acquire units, which would be the
equivalent of non-qualified stock options (NQSO). However,
you cannot have the counterpart of an incentive stock option
(ISO).
Also, with an LLC, you have more flexibility as far as
making distributions to owners. Getting assets in and out of
the LLC is a lot easier. While it’s easy to get assets into
a C or an S Corporation, it can be very difficult to get
them out without triggering a taxable event. It really
depends on the situation, and is something that you need to
analyze quite closely.
Often times, in a small bootstrapped situation, an LLC
may be preferable. In fact, I often recommend to clients a
one person LLC, when appropriate. It’s simple to deal with.
You report all your income and expenses on a Schedule C, but
you still have limited liability.
If you intend to issue different classes of stock, such
as common stock and preferred stock, then you are out of the
S Corporation scenario and pretty much only in C corporation
territory. Note that you can do that with an LLC, but it’s a
lot more difficult. In fact, if you want a pass-through
entity like an S Corporation, the only way to have more than
one class of stock is through an LLC because there are no
limitations on the number of classes of stock you can have.
With careful crafting, you can actually form within an LLC
different classes of ownership. For example, you can use
multiple S corporations as members of the LLC, with each S
corporation housing one class of stock. The LLC itself
creates the rights in the entity. The only benefit, in this
case, would be the pass-through status. Venture Capital
investors will typically require that the business be
organized as a C Corporation, and would not go for the kind
of LLC structure I just described.
Anthony: Can you explain the
concept of nexus in e-commerce for sales tax?
David: The basic nexus rule
for sales tax is as follows: if you are an e-commerce
company of some kind, you have nexus, and you have to
collect sales or use tax in any state in which you have
physical presence, or in which you have agents. Physical
presence could be employees, equipment, a plant, or agents
in that state; and agents could be independent contractors
who are working as your agents.
Let’s take the example of online computer retailers.
Almost all states take the position that if you are selling
computers online, and you, the seller, arrange to have some
company or computer shop in a state perform warranty
services for you, this company or computer shop is your
agent even if it is independent. However, this policy is
based on facts and circumstances. Most online computer
retailers are arranging for the warranty work to be provided
on behalf of an entity that is separate from the seller, and
which, as a result, would not be considered an agent. In all
of the state income and sales tax laws, two separate
companies are treated as separate entities, even if they are
related, unless they are not treated by the companies
themselves separately.
There’s been a classic e-commerce dilemma with
bookstores, and California has been on the cutting edge with
this. These bookstores would have retail outlets as well as
an online store, and they isolate their e-commerce operation
in a separate corporation or entity. It’s called entity
isolation. Under the sales tax law, the separate entity
would not have nexus for sales tax in California just
because a related company has stores in that state. If it
were the same company, there would be no question. The real
question is: are the retail stores the agents of the online
company? Is their behavior causing them to be agents? In one
case, California issued a ruling saying that the online
bookstore had nexus in the state because the stores were its
agents. All they were doing was handing out discount coupons
in the retail stores for the online store. For California,
this was enough to consider them agents. Personally, I don’t
think this was nearly enough to establish nexus, and a lot
people I talk to don’t believe that either, but that’s the
way California ruled it. I have not heard what happened with
this case. I assume it’s being litigated.
With the so-called clicks and mortar model, where you
have an online company and a bricks and mortar company, some
people think that somehow the online company can avoid
collecting sales tax because the two companies are separate.
If they are truly separate, it works. But for practical
purposes, they usually are not. In most situations, they are
trying to treat them, from a retailing point of view, as one
company. And that’s the experience the customers want. They
want to be able to order online and pick up at the store, or
order online and return merchandise at the store. They want
the online outlet to be just another shopping channel. My
personal feeling is that the entity isolation model for
clicks and mortar will no longer work with respect to nexus
prevention going forward. Eventually it’s going to
disappear. The only online companies that will not collect
sales tax are the pure online companies, such as Amazon.
Anthony: Are the nexus rules
the same for state income tax?
David: State income tax rules
are much squishier. They haven’t been litigated very much. I
tell my students to basically assume that the same rules
pretty much apply. There are just simply different issues.
For sales tax, it’s clear that you or your agent have to
have physical presence in a state before you have nexus in
that state. Most of the recent cases that I’ve seen for
income tax indicate that those same rules apply. However,
physical presence is not as tangible. For instance, there
was a case in South Carolina involving a toy retailer whose
trademarks were owned by a separate entity incorporated in
Delaware. The Delaware corporation licensed the trademarks
to all the stores around the country. This was a clear case
of entity isolation. However, South Carolina claimed that
the trademarks owned by the Delaware corporation were
located in the South Carolina store, and earning income
there. Therefore, it ruled that the Delaware Corporation had
nexus in South Carolina, and must pay income tax on the
royalties received. There are other similar cases involving
trademarks, which have gone either in favor of the state or
the taxpayer.
In all these cases, there has to be some kind of actual
presence, whether physical or through the company’s
intangibles, that are explicitly in the state to establish
nexus. I have not seen a case, for instance, where a company
had nothing in the state (no intangibles, no property, no
employee) and was still liable for income tax. So one must
have presence to establish nexus, but it’s not always clear
how much presence is needed to make that determination. The
boundaries aren't nearly as hard and fast as they are for
sales tax.
On the other hand, there are some protections in the case
of state income tax. For example, suppose all you’re doing
in a state is soliciting sales for tangible personal
property. You can have sales representatives living in the
state permanently. You can even have a sales office in that
state. If the property is shipped from out of the state into
the state and the sales are approved and processed out of
the state, that would not create nexus for state income tax
- although it would for sales tax purposes.
Anthony: What is your
position on the proposed new accounting treatment of stock
options?
David: As you know, the
proposed new accounting treatment of stock options calls for
the expensing of stock options by public companies based on
the fair value method. The same requirement is applicable to
private companies, but the impact on the profit and loss
statement is typically small to non-existent because it
allows the use of the intrinsic method instead of the fair
value method.
Personally, I am in favor of the new rules for 3 reasons:
- Take two identical technology companies with one
difference – one pays in cash and the other in stock
options. Under the current accounting rules, their
profitability is not easily comparable. It may be done
through disclosures and footnotes to the financial
statements, but it’s not a practical approach because
investors won’t always take the time to read these
disclosures and footnotes. Also, not only can you not
compare 2 companies, but you can’t even compare the same
company or get a trend over the years as it matures and
switches from stock option compensation to cash
compensation. To get a fair comparison, you would need to
make adjustments to the start-up phase assuming that
compensation was in initial stock options instead of cash.
This can be complicated, and makes it difficult to assess
the operating performance of that company over time.
The purpose of a profit and loss statement is to tell
how profitable a business is. That’s the bottom line. So
if you have employees you’re not paying with cash, and
you’re not accounting for their stock options, you're
looking artificially better. Some people would argue that
one must take into account the benefit derived from not
using cash. That’s true: you have a cash flow statement
for that and you can measure the impact on cash using
metrics involving cash flow and free cash flow.
- The Financial Standards Accounting Board (FASB), which
is an independent group of smart and competent accounting
professionals, has proposed these new rules as the
preferred way to account for stock options. I'm inclined
to allow the FASB to say this is the best way to go
because they are the experts. I happen to agree with them,
but that’s beside the point. I think we should let the
experts decide. The last I heard, 70 out of the top 250
companies that trade on the New York Stock Exchange have
already adopted these new rules. After Enron and WorldCom,
we’ve made significant efforts to increase the credibility
of the US financial markets, including making the FASB an
independent entity. With Sarbanes-Oxley, the FASB has
become an independent organization with its own funding.
Before that, it was basically funded by the Big 4
accounting firms. So we should let the FASB make its
decisions without interference from outside entities.
Overriding the FASB on this issue will negatively impact
the credibility of US financial reporting and ultimately
that of the US financial markets.
- In the extreme, if you destroy the credibility of US
accounting rules, the capital markets will no longer be
able to stay in the US. They’ll be in London. And in order
to issue stock, you’ll have to issue it on the London
exchange and conform to their rules. You’ll end up having
to conform to these rules anyway, because stock option
rules are the international standard. All the FASB is
really doing is conforming to the rest of the world, which
has already adopted these standards effective January 1,
2005.
Anthony: Should
entrepreneurs be concerned with Sarbanes-Oxley for their
start-ups?
David: It's not a concern for
small start-up companies. However, if you contemplate going
public, you have to be Sarbanes-Oxley compliant for each one
of the years for which financial statements are presented to
the SEC in the S-1 registration statement. If you were not
Sarbanes-Oxley compliant during any of these years, you
would have to be re-audited, which is not always possible.
Additionally, certain relationships between various parties
in the company (Board of Directors, officers, etc…) have to
be in place and conform with Sarbanes-Oxley restrictions in
order to be Sarbanes-Oxley compliant. If these relationships
and restrictions were not in place during the years being
reported on the S-1, you could end up in a situation where
you simply cannot be compliant. Your best bet is to be
compliant throughout the period being reported to the SEC.
Anthony: For technology
companies, R&D tax credits can be a good way to realize some
tax savings at some point in time. How should they handle
projects that are eligible for those credits?
David: First, you must
evaluate each project to determine whether it is eligible
for the R&D credit. One question is whether it is Research &
Experimentation; the other is whether it qualifies for the
credit. Projects with uncertainty involving technology
should be evaluated for eligibility. By uncertainty I mean
projects for which you don’t know from the start which
method you’ll be using and what they will look like when
you’re done. Internal use software has a different set of
rules.
You need to qualitatively evaluate how innovative each
one of those projects is. The only people able to make that
assessment are the engineers working on those projects, and
it’s usually hard to get them to answer these types of
questions. For a start-up company, the company itself has to
have a real commitment if it wants to get these credits -
it’s the commitment to track all the information you need:
quantitative and qualitative.
I recommend on the front end, once you have established
eligibility, that you create project files. In the project
file, you have the resume of the person working on the
project. You want to know if that person is the kind who
does research. You also need to know whom this person
reports to, and who works for this person. For every
researcher, you can take his/her salary plus materials and
supplies. You can also take the salary of his/her immediate
supervisor. Of course the supervisor may be working on
different projects, so if one fifth of the supervisor’s time
is managing the researcher, then that’s the portion of
his/her salary that will be used in computing the credit.
You also need to know who is directly assisting the
researcher on the administrative side and take that person’s
salary that is directly related to providing administrative
support to the researcher. We call it the one-up-one-down
rule: the researcher in the middle, then the supervisor and
the assistant. For that, you need to know who is doing what.
You will also need to capture all the time that is being
spent on that project. You do that by creating project codes
and recording the time on timesheets. In addition, you must
document the risk up front, because you don’t get the tax
credit unless there is some significant uncertainty as to
whether or not you can complete the project. So you describe
what you are trying to do including an outline, benchmarks
and milestones. You also evaluate the various research
options, and provide the initial budget for the project. As
the project progresses, you periodically update the file to
include what worked and what didn’t work. You continuously
monitor the progress of the project and report on it until
completion. You can pretty much include the entire project
up to completion, whether it’s a software product, a tire or
a circuit board. All along you must be evaluating whether or
not you are performing what’s called a process of
experimentation. This means that you have risk, you are
evaluating risk and eliminating risk - which is the key to
taking the credit. All of that is very qualitative. It’s not
just numbers.
Creating project codes and using timesheets is an
absolute minimum, and most of the time people don’t even do
that. In that case, you can’t even support taking the
credit. All in all, this has to come from management or
someone who has the ability to get answers, knowing very
well that if you don’t get the information, you don’t get
the credit.
Bio
David Hardesty is a vice president of Wilson Markle
Stuckey Hardesty & Bott, Certified Public Accountants, APC.
He has been a member of the firm since 1984.
David is a consultant on taxation of technology companies
and taxation of electronic commerce. He's also a consultant
on corporate governance and accounting, and in particular
audit committee governance. David was selected by
Accounting Today as one of the Top 100 Most Influential
People in Accounting for 2004.
An adjunct professor at Golden Gate University's Graduate
School of Taxation, David teaches the courses Taxation of
Electronic Commerce and Remote Sellers, and Choice of
Entity. He is a frequent speaker on tax issues and a
member of the American Institute of Certified Public
Accountants and the California Society of Certified Public
Accountants.
David began his accounting career as an auditor with
Touche Ross & Company (now Deloitte Touche) in 1978. In 1981
he moved to Grant Thornton, CPAs, an international CPA firm.
He joined Wilson Markle Stuckey Hardesty & Bott in 1984.
David received his MBA in taxation from Golden Gate
University, one of the country's premier tax schools.
David is the author of the following
books:
- Electronic Commerce: Taxation and Planning
- Sales Tax and Electronic Commerce
- Corporate Governance and Accounting Under the
Sarbanes-Oxley Act of 2002.
- Practical Guide to Corporate Governance and
Accounting; Implementing the Requirements of the
Sarbanes-Oxley Act, 2004 Edition
- Practical Guide to Corporate Governance and
Accounting; Implementing the Requirements of the
Sarbanes-Oxley Act, 2005 Edition
- The Director's Guide to Sarbanes-Oxley Compliance
|
|
This
article is a selection of resources and tools available on
the Net at no charge. It's organized in 3 sections:
- Business resources
- Website resources
- General interest
Whether or not you're bootstrapping, I trust that you'll
find something here that you can use or learn from. As
always, I welcome your feedback and any suggestions of other
links you’ve found useful.
1. Business Resources
PricewaterhouseCoopers’ Vision to Reality: A series of
tools & techniques including:
- Financial model templates (generic and service
business)
- Business plan and executive summary templates
- Accounting policies and procedures
- Discussion on valuations
- Other resources
Please note that you will need to register online before
you can access some of the above resources.
PricewaterhouseCoopers’ MoneyTree Survey: Very useful
venture funding statistics by region, industry, stage of
development, financing sequence, VC firm, and Investee.
StartupJunkies.org: Good source of information specific
to start-ups. Topics include market research, business
modeling, business planning, finance, valuations,
incorporation, and other information.
Salary.com: Salary and compensation data by job category
and region. Aside from its many obvious applications, I rely
on this source when developing the staffing part of a
financial plan.
US Patent
& Trademark Office: US Patent and Trademark applications
filing, status checking and search.
California Secretary of State - Business Programs:
Information about starting a business in California,
California business search, and business entities
(Corporations, LLCs, LPs, etc…).
Bureau of
Labor Statistics: Labor economics and statistics.
US
Census Bureau: Census and economic data.
Small Business Administration: Information about
starting, financing and managing a small business.
Internal Revenue Service: Tax information, rules,
publications and forms.
Google Directory of Venture Capital: List of venture
capital firms in the Google Directory.
WorkIt:
A very useful service that keeps start-up professionals
abreast of events and networking opportunities in the San
Francisco Bay Area.
Blogs:
Venture Blog,
Brad
Feld,
Seth
Godin,
Tim Oren,
Martin Tobias, and many others that can be found listed
or linked to in the previously mentioned blogs.
2. Website Tools
Whois: Domain name availability.
Link Popularity: Reports the link popularity of a
website on Google, Altavista and Hotbot.
Mike's Marketing Tools: Search engine rankings, link
popularity checker, top 500 searched internet keywords, and
other tools.
Alexa:
Search the web and get information on reach, rank and page
views for any website based on visitors who have the Alexa
toolbar in their browser. I rely on the Alexa metrics on a
regular basis to monitor the relative popularity of Venture
Momentum’s website. It’s sort of like getting a grade on my
homework in a huge class comprised of millions of
webmasters.
Wayback Machine: Did you know about this cool tool? You
can see archives of your website or someone else’s.
3. General Interest
Online
Dictionary,
Thesaurus, and
Translation.
WhitePages.com: White pages, business search, area code
lookup and zip code finder.
Weather.com: Weather news and forecast.
Mapquest: Maps and directions.
Shopping.com, and
BizRate.com
for shopping comparison.
Online Metric Conversions: conversions of area,
distance, speed, weight, temperature and many others.
Z-Score (at creditguru.com): Developed by Professor
Edward Altman from New York University’s Stern School of
Business to predict bankruptcy of publicly traded companies.
The score was derived based on data from manufacturing
firms. Valuebasedmanagement.net also provides the
Z-Score formula with 2 different sets of weights to
score both public and private companies. Note that these
models are not applicable to start-ups. |
