NEW YORK-Managing solely for the bottom line can come back to bite companies at tax time, with the perverse result of hurting the financial statements so important to existing and potential stakeholders.
The adage that there is never time to do it right but always time to do it over often proves apt in describing young companies in a hurry to hit the ground running, especially in dynamic and competitive industries.
Telecommunications carriers, as well as equipment and software vendors, often fall headlong into this trap of their own making, said John Graham, senior manager of state and local tax practice for KPMG L.L.P., Atlanta. Furthermore, undoing the damage after the fact costs more than preventing it at the outset.
Without a sound skeleton, a body would be just an amorphous blob. Likewise for a company. Structural planning is therefore critical, especially if the game plan is to optimize options for future sale, spinoff or tracking stocks of individual lines of business.
New carriers engaged in multiple kinds of telecommunications services and established carriers entering new services are best advised to segregate these as subsidiaries or limited liability corporations under the parent’s umbrella, Graham said.
Equipment vendors might fare best if they establish entities to hold intangibles, like patents and intellectual property, that are separate from those manufacturing the products themselves. For one thing, this more precise structure simplifies the process of charging royalties or licensing fees to unrelated companies. It also can help improve the debt rating of equipment manufacturers that lend money to buyers to finance the purchase of their products.
“You could do some internal leveraging to give the manufacturing subsidiary the right debt-to-equity ratio or the right amount of working capital,” Graham said.
“It isn’t as big a consideration for software companies, but they may want to do this to keep their options open for going public. Different classes of debt are assigned different levels of (bondholder) protection. And you seldom see a public company that doesn’t have a parent holding company and operating subsidiaries with different classes of debt.”
Start-up companies have a pronounced tendency to keep things simple, but revamping their internal structure once they diversify or wish to go public becomes an expensive exercise in reverse engineering, Graham said.
Often new companies also overlook the identification and comparison of business location and retention packages various state and local governments offer. Once they decide on one or several general areas that are desirable locations for their business, they would be well advised to comparison shop for available job creation credits, property tax abatements and other incentives.
“These used to be pretty much limited to large manufacturers, but now municipalities are going after call centers and other clean industry and trying to cultivate a critical mass of high technology companies,” Graham said.
“Many companies don’t pursue these incentives because they think they aren’t big enough to get them.”
Start-up carriers also have a tendency to engage in another shortcut practice that costs them more unnecessarily in property taxes. When they look for financing of their network construction, they include in the total costs those nonrecurring items like permit, engineering and design fees.
That makes sense when raising money. It does not, however, when establishing a value for the network itself as the basis for property tax assessment. Companies that do not bother to take out of the count those one-time expenditures wind up paying continuously additional property taxes on those items, Graham said.
Sales taxes on capital equipment pose another potential pitfall. One kind of error that costs extra is payment of sales tax in a lump sum up front instead of on the installment plan over the useful life of the equipment. An opposite but equal mistake is to amortize those sales taxes for a period longer than the equipment’s useful life.
Companies in a rush to get to cash -flow positive often trip over their neglect when it comes to computation of sales taxes they must collect from their customers.
“Companies are a lot more reluctant to get the full detail of what needs to be done on the sales tax side because this isn’t creating any immediate benefit to them,” Graham said. “A lot of the common billing software tailored for telecoms pretty much punts when it comes to state and local taxes.”
Because state and local tax officials know new companies will not be earning income immediately, “start-up companies will be audited long before and a lot more frequently for sales than for income taxes,” he said.
Furthermore, the tax man is not the only one likely to bite. A potential acquirer will always conduct a due diligence review to uncover hidden liabilities. “Exposure to unpaid sales taxes, especially if you have no idea how to quantify them, could kill an acquisition deal,” Graham said.
The long reach and strong arm of the Internal Revenue Service also should be considered.
“Some of the accounting policies companies adopt early on cannot be changed, particularly if they have been in place for more than a year, without permission, usually from the IRS. This can be complicated and expensive,” Graham said.
“Ultimately, the tax liability goes to the bottom line.”
