Large Firms vs Small Firms

Reversion to Mediocrity

Or The Law of Averages.

Or Reversion to the mean.

Stunningly to casual observers, statistically, mathematically & realistically, the larger a tax firm is, the shoddier their performance. The smaller a firm is, the more likely they will outperform the larger firm.

But that doesn’t automatically make a small firm better than a larger firm. It depends on the average competence of their staff. In fact, I’d expect, generally speaking, large firms will generally outperform smaller firms. But that’s 100% due to their in-house processes, or operating manuals, and their insistence on operating according too those manuals & operating procedures. But that’s 100% due to my disappointment with the Lack of genuine competence among private practitioners. CPA profession.

Most people believe it’s just the opposite; that you can expect better results from larger firms than smaller firms. But that’s not the case.

Here’s the deal, the more people you have, the more difficult it is to hire top notch people. Eventually, 100% of the time, as your staff grows, your average performance will begin slipping as the talent you hire becomes less & less talented … It’s impossible to staff a large firm without that occurring.

But at Ellis we realized that earlier on, and we had some disappointing experiences that drove the point home. Now we keep our key staff we rely on, we keep it at a dozen or less. All of them are very bright people. That’s our culture. If they’re not bright, they’ll leave.

So we can keep our performance high when larger firms can’t.

A typical firm begins to grow because the owners are bright and outperform most competition. As the firm begins to grow, at first they just let it grow. But, after a few embarrassments, they begin limiting what staff can do. Eventually, they build operating procedure manuals which limit staff even more. Staff gets constrained but the owners sleep can sleep at night. They used to be known for their performance; now they’re known for being big.

The have reverted to mediocrity, just as statistics tell they will.

The lesson is, don’t be so eager to have a large, sophisticated tax & accounting firm. Look for a small to medium firm. Their performance is better.

Relationship Marketing is Evil

Or, tax professionals aren’t as good as they think they are. [Link]

We don’t know why businesses & their CEO’s hire the tax professionals the hire. But we know there’s a wide differential between the best person in the tax profession and the worst, or even an average professional. That won’t surprise anyone, but the amount of difference will startle you.After stumbling across an article in Business Insider about the surprising difference between a leading talent and an average talent, I did quite a bit of research and came up with this report [Here.] which I published a year ago. The Definitive Study on Human Performance.

RELATIONSHIP Marketing is a tool of the devil. It has wracked misery everywhere it gets a foothold. People who market by RELATIONSHIPs can’t be trusted because they don’t have your interests at heart, they are driven only by their own pecuniary interests. In a rational world, there would be no RELATIONSHIP marketing.

Every tax firm would be marketing on the basis of the RESULTS they get for their clients. But we obviously don’t live in a rational world. By leaps & bounds, the prevalence is, the average business selects tax professionals on the basis a

RELATIONSHIP. And they evaluate their tax professionals every year on the basis of that RELATIONSHIP. ELLIS achieves better results than the typical professional tax firm. We perform better than every firm that preceded us. We know that because we compare our returns with the previous guy’s returns.

Then one day we read in the Huffington Post and in a GAO report that most private businesses pay more tax at a higher rates than the Global 500. Subsequently we read a similar report from the SBA. But apparently no business read them. Because they are still paying more tax than the law requires at tax rates higher than the tax rates paid by theGlobal 500.

When I approach them about becoming their tax professional, these are the typical results. “I already got a a tax person. ‘Have a CPA already. “Robert, thanks but I have a company and friend that’s done them for years. “I’ve had the same great tax guy for years.”

We obviously don’t live in a rational world. In a rational world your taxes should be as low as they could possibly be because everyone would select a pax professional on the basis of RESULTS. But, that isn’t what they do. When I approach them with statistics showing that 99% of businesses pay more tax than the law requires, I get a blank stare. I get replies like , “I’ve used my guy for 27 years.” Or, “My tax guy is a good friend.” Never even a mention about results.

I don’t know what they think. Maybe they think I’m lying. Maybe they think they’re the one exception in a hundred. Maybe they don’t want to embarrass their tax preparer. But I suspect, they simply don’t care. They simply don’t want to know, the head in the sand approach. They just want to get out of the conversation as quickly as they can.

99% of private businesses pay more tax than the law requires. The rest don’t pay any tax.

Battle for the Tax Code

The Decades Long Battle for the Soul of America.

Appeals Court Judge Learned Hand vs President Roosevelt

Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” Judge Learned Hand.

The history of the tax code boils down into a massive fight for the soul of America between two men, President Franklin Roosevelt and Billings Learned Hand, an American judge and judicial philosopher. who was an avid supporter of free speech and noted for applying economic reason to American tort law. Their battle ground was the tax code. Roosevelt fought for an autocratic approach to tax, and Judge Learned Hand fought for a democratic approach to the code more in line with the 16th amendment itself. 

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

But in addition to the wording of the 16th amendment, above, there was another consideration which Roosevelt did not like.  After Congress released the wording to be voted on by the nation, Congress became aware that the amendment would not pass. So they took out ads in newspapers all over the country saying,

“We will only tax profits.”

That did the trick; the 16th amendment passed; and the ad became part of the legislative intent requiring the courts consider that important limitation in any litigation.

Most of Learned Hand’s career he spent as a judge on the United States of Appeals for the Second Circuit. He was never nominated for the Supreme Court, despite being one of the most respected and accomplished jurists in American history, because Roosevelt hated him. 

This fight between these two men is responsible for the evolution of tax law into the backbone of the philosophy of America. Without a liberal tax code, America would not be the same. The battle was fought over the meaning of the 16th Amendment. The stance each man took was completely opposite the other man’s  Roosevelt favored ditching the democratic approach to taxation & the 16th amendment after 16th amendment was passed in 1913.  Over the entire battle, Roosevelt made the IRS became extremely, inducing Congress to create powerful judicial safeguards against the government. Hand was responsible for much of those protections.

Roosevelt was born in 1883 and died in 1946. Learned Hand was born in 1872 and died in 1961. Their careers and their influence overlapped each other. Although Learned Hand won the argument, the eventual result wasn’t obvious for years. Their result of their long battle was decisive in determining the extent of Presidential and government power.  Hand was one of the most influential jurists in American history, but he spent the entire apex of his career on the Court of Appeals. He was never nominated to the Supreme Court because Roosevelt hated him. Their battle was a fight to the death.

The Issues

Roosevelt’s position on income tax was he could do what he wanted with it. His administration was very aggressive on income tax. For his entire presidency, the top tax rate was between 80% and 90%. From 1934 to 1937, during a time when the top tax rate was 90%, Roosevelt carried out a tax trial charging Andrew Mellon with tax fraud, The prosecutor didn’t think the evidence supported Roosevelt’s position, but he prosecuted the case for four years and won the case. Mellon had to pay $600,000 is back taxes. You can read about it here.

Roosevelt was also generally opposed to tax deductions, including business tax deductions. He & Learned Hand fought over taxes and other issues until Roosevelt died. The battle ended with his death in 1945, and the results came in, in 1954 with the Supreme Court Case now referred to as Glenshaw Glass. That case provided the basic framework of the American tax system when it made the case that tax deductions had to be ordinary, necessary in pursuit of profits by a legitimate business.  Over time it evolved to …

“Tax deductions must be ordinary, necessary & reasonable in pursuit of profits by a legitimate business, and they must meet the additional tests of valid business purpose & economic substance”

Also in 1954, the issue was also dealt with by Congress in Section 162, Trade or Business Deductions, in much the same way the Supreme Court dealt with it.

Learned Hand is a legitimate American Hero. He saved the Republic. If the government could tax at high rates and no deductions, we would have a much different country today. Roosevelt’s tax policies were driving companies out of the U.S. for greener pastures overseas. But Learned Hand ended that. The same thing happened in the Obama administration, but tax reform is bringing U.S. dollars back from overseas.

Learned Hand is noted for applying economic reason to American tort law. Among his quotes are the following.

Top quotations about U.S. taxation. 

First. A given result at the end of a straight path is not made a different result because reached by following a devious path.  Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938).

Second. A transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred. While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not.  Commissioner v. National Alfalfa Dehydrating, 417 U. S. 134 (1974).

Third. Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)

Fourth. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes. Judge Learned Hand.

Fifth. Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

My favorite. “Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” This is the essence of tax planning. Judge Learned Hand.

Employment Tax Bombshell

The IRS is shifting it’s emphasis from income taxes to employment taxes, starting in three states: Wisconsin this month; Texas & Arkansas next month. At that pace they will be auditing employment taxes in every state with a year.

That is going to hit like an atomic bomb.

Despite the tone of the article, this is a fundamental shift in IRS audit focus and it is going to be far more dangerous than the typical tax audit. Particularly in California. This is going to rattle through California like a runaway freight train. In fact, this is going to raise more money for California than the UBER case.

You can be legal in California and still break Federal law.

Stay tuned. 

Read the third paragraph in the Accounting Today article. That spells it out. The IRS can no longer afford to audit tax returns with limited success. Very few cheat on their tax returns, because the risk is to high. The constant threat of audit worked. But in most states, the contractor / employment laws are widely ignored. And there is little consequence to pay. Consider the Uber decision. In some states, like California, they are relatively easy to get around.

For every contractor making $130,000 or more, the IRS will net nearly $30,000. Plus penalties & interest. A single employee shifted from contract to employment under federal law reaps more tax than any audit I have ever been involved in.

The Accounting Today article.

Federal Law on employer vs. contractor.

To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.

Behavioral Control A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:

  • Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
  • Degree of instruction, more detailed instructions may indicate that the worker is an employee.  Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.
  • Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
  • Training a worker on how to do the job — or periodic or on-going training about procedures and methods — is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

Financial ControlDoes the business have a right to direct or control the financial and business aspects of the worker’s job? Consider:

  • Significant investment in the equipment the worker uses in working for someone else.
  • Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
  • Opportunity for profit or loss is often an indicator of an independent contractor.
  • Services available to the market. Independent contractors are generally free to seek out business opportunities.
  • Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.

Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:

  • Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
  • Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
  • The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
  • Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.

Consequences of Misclassifying an Employee

Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes. See Publication 1976, Section 530, Employment Tax Relief Requirements for more information.

CFO Services

A virtual CFO (Chief Financial Officer) is an investment in the growth of your company. As every business grows, something happens. The more they grow, the more background, bureaucratic chores consume your time. If you don’t get control of this trend, it will eventually swamp your business & your dreams along with it. Outsourcing frees your time to focus on achieving key core business goals and planning. We pull the busy work off your plate.

This is why you went into business in the first place instead of just getting a job. We pull the hated, boring, tedious but necessary functions off your hands and give them to people on our staff that love doing it. Believe it or not, there are people who love doing it. You don’t love doing it. You should fire yourself and hire us. That will make us both happy.

In addition, our qualified CFO talent is available for advice & CFO consultation. He or she is a crucial member of your strategy team. 

We have significant experience as CFO with Fortune 500 companies. 

Virtual Chief Financial Officer

CFO is an outsourced service provider offering high skill assistance in financial & administrative requirements of an organization, just like a chief financial officer & his staff do for large organizations.

Ellis experienced CFOs, executives, accountants & tax professionals perform administrative, accounting & payroll functions can help owners, management, and board members solve financial management & operational issues by providing unique guidance and advice. See business services.

You can depend on experienced, high-level professionals to provide the financial insights you need to meet the challenges you face. We provide all the back room services you need; as well as advice, explanations & recommendations.

    • Financial strategy
    • Short & long term forecasting
    • Financial systems strategy & design
    • Budgeting
    • Projections
    • Facilitating & supporting financial reporting
    • Raising capital
    • Interim CFO services
    • Cash flow analysis & restructuring
    • Renegotiating vendor contracts
    • Restructuring client contracts
    • Ensuring pricing is aligned with company & industry trends
    • Analyzing commission structures
    • Supply chain management
    • Attributing costs to revenues
    • Accounting & bookkeeping
    • Payroll
    • Financial Statement
    • Bill pay
    • Collections
    • Data driven management
    • Capture & interpret critical operating data
    • CFO service
    • Streamline & simplify
    • Cash management
    • Remote office
    • Management financial statements
    • Compiled financial statements

Why Do CEOs Get Fired?

I’m providing this because it’s interesting. None of the info is mine. I’ve credited the sources in the body. Statistics determined that 52% of CEO’s were fired, 48% resigned.

Enjoy.

52% of CEOs were fired. 48% resigned.

LinkedIn study of 4000

First jobs of CEOs were

  1. consultant,
  2. software engineer,
  3. analyst,
  4. sales manager,
  5. project manager,
  6. account manager,
  7. manager,
  8. founder,
  9. associate &
  10. software developer

Forbes study of 1087 Board members of most common function before becoming CEO.

That were they doing?

  1. Biz dev, sales,
  2. engineering,
  3. info tech,
  4. consulting,
  5. finance,
  6. entrepreneurship,
  7. operations,
  8. markets

What were they doing before becoming CEOs?

  1. 72% were directors before becoming CEO.
  2. 20% were promoted internally
  3. 80% promoted externally

Why were the fired?

  1. Poor business performance
  2. Board relationship
  3. Lack of key skill set
  4. Alienating the management team

Forbes – 1087 board members

  1. Mismanaging change
  2. Ignoring customers
  3. Tolerating low performers
  4. Denying reality
  5. Too much talk, not enough action

Why the board pulls the trigger

  1. They lose the board
  2. Being in the middle of scandal
  3. Not meeting expectations
  4. Not having majority control
  5. A new buyer
  6. Fire themselves (resign)
  7. Lose influence over their team
  8. Company outgrows their abilities

How to Prevent Getting Fired

  1. Know you can get fired
  2. Grow sales
  3. Pour into team
  4. Develop new leaders
  5. Bring on new customers
  6. Bring new partnerships
  7. Create alliances
  8. Prevent mismatch
  9. (From Patrick Bet-David on You Tube)

A Bad Tax Court Case for Certain Contractors

It is regular practice in this practice & others to incorporate individuals who are paid 1099 income. This allows the contractor recognize part of the income as “earned income subject to FICA and Medicare employment taxes” and part as “unearned income not subject to employment taxes.  This is a simple traditional tax savings technique that is recognized and utilized by probably 50% of tax professionals.

That practice requires the taxpayer make arrangements with the employer to treat the corporation as the contractor instead of the individual owner and pay the corporation directly. But in some industries, such the financial services industry, contracting with the individual is required. There’s no way around it. This practice requires the individual contractor to pay FICA & Medicare tax on 100% of the earnings instead of just the part of the earnings that represent the value of his time.

A 2016 tax court case, Fleischer v. Commissioner required the owner to pay employment taxes on the entire earnings paid to the owner in the owner’s name. Fleischer was the result of a Tax Audit. 

This creates a problem for many contractors that we solved this years ago, before this audit or this court case even occurred. First the problem., then the solution we have developed.

However, in some cases the contractor does not have a proactive tax professional like Ellis that warn them about this up front, they don’t take precautions, they get caught on audit & ordered to pay a large shortfall in income tax plus penalties & interest. That creates a problem. We created the solution.

PROBLEM: The wage base for FICA tax is $132,900. The FICA tax rate is 6.2%. Maximum FICA tax is $8,603. This decision probably cost the taxpayer $4,300 for every year involved in the original audit. Plus penalties & interest.

SOLUTION:The likely solution to this problem is an employment contract.  I have a template of such a contract if you’d like to see it, drop me a message and I’ll shoot you a copy. If you’d prefer to draft your own, here are some considerations. Neither are guaranteed and have never been challenged by the IRS. There are no guarantees.

  1. Require Mr. Fleischer to remit revenues he receives from xxx to Corp.
  2. Make the payor aware in an email that you are employed by your corporation, Individual PC.
  3. Have an employment contract between the individual providing the services and the corporation (Individual, pc.) who the corporation can direct and control in a meaningful sense.
  4. The employment contract should disclose & make corporation’s controlling position clear.
  5. When possible, enter into contracts in the name of your S-Corp, and consider revising those that were entered prior to its formation;
  6. Use a corporation named Individual, pc. Then get a dba to do business in another name. Try using the name Individual, pc. name.
  7. Prepare a written employment agreement between you and your S-Corp;
  8. If you work in an industry, such as the financial services industry, where contracting in the name of an individual is required (whether by rule or as a function of practical considerations), ensure that any contract between you and your S-Corp includes the relevant provisions cited in Fleischer (1&2);
  9. Work with trusted professional advisers who can help you navigate the complex statutes and regulatory rules applicable to your business.

 

If you have a contractor friend, call this problem to his/her attention. He, she & you can find my contact info on my LinkedIn profile page.

Here is an article on the court case itself.

Keep plugging. If we can help you by cutting your income tax, our specialty, get in touch.

Two Tax Systems

The 16th amendment created two tax systems.

Back to the first article in this chain: In order to get people to vote for the 16th amendment, Congress, by means of newspaper ads,  promised the American public that they would tax only profits. Other additions came by way of litigation.

Congress promised to tax only profits.

This was codified in Section 162 in 1954. It was ratified by the Supreme Court, also in 1954. Economic substance & valid business purpose we added later by litigation.

Today, this is where we stand.

There shall be allowed as deductions all the ordinary, reasonable & necessary expenditures made in pursuit of profits in a legitimate business undertaking as long as it meets the economic substance & a valid business purpose tests.

Who decides to deduct an expenditure? You do. Not the IRS. There are no limitations on that. All you have to do is prove it’s ordinary, necessary & reasonable in pursuit of profits and meets the requirements of economic substance and valid business purpose.

If the IRS wants to disallow a deduction, they have to prove it in a court of law, or you have to agree. But they’re not bashful about challenging deductions, so dot your i’s and cross your t’s.

It was quickly established that wages were pure profits, so this applies only to businesses and business like enterprises, such as rental activities.

This is the foundation of modern tax practice.

The 16th amendment singlehandedly created the modern tax system in which every business files it’s taxes differently from every other business. Those with the best tax advisers will pay the legal minimum, taking advantage of every deduction and other legal maneuvers, but those with lesser tax advisers will pay more tax than the law requires. Do that long enough and you’re out of business. It boils down to a talent issue.

This concept  puts a lot of burden on the taxpayer. It’s up to the business owner to take all the deductions available. If you miss some, it’s nobody’s fault besides your own. It’s absolutely shameful that 98% of businesses pay more tax than the law requires. GAO.

98% if businesses pay more tax than the law requires; more tax at higher rates than the Global 500.

The IRS normally has three years to audit, measured from the return due date or filing date, whichever is later. But, the three years is doubled if you omitted 25% or more of your income. Even worse, the IRS has no time limit if you never file a return. What’s more, the IRS also has no time limit on fraud.