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Tax Consideration for Creative Agencies

Published by Summit Marketing Team on 27 May 2020

The Virtual CPA Success Show for Creative Agencies: Episode 13

We are in the middle of tax season, and we are sure many of you have a lot of questions about how to lower your tax bills, what laws you need to be aware of, and how your specific business model should prepare your taxes.

In this episode, we are joined by Jody Grunden and Dave Danic to talk about how to prepare taxes for your creative firm! Listen to learn the main things you will need to keep in mind during the upcoming tax season.

Jamie Nau: Hello everybody, and welcome to today's podcast. Today, there's a little bit of backstory behind our subject. So incase no one knows, we have a couple of podcasts that we run through Summit, and one of our podcasts is more geared towards CFOs, and we really hesitated having a tax subject because we feared a lot of people would use that podcast to go to sleep instead of actually be entertained. So we eventually brought Dave Danic on, and that was one of our most downloaded podcast so far, out of all of our podcasts. So because of that, Jody wanted to have Dave on his show because he wanted to get his downloads a little higher. So today we're going to talk taxes with Dave and Jody, and we're going to start with some very general tax stuff,  stuff that applies to any company. Then we'll go a little bit more into it for creative agencies. So welcome to the show, Dave and Jody.

Jody Grunden:: Thanks Jamie.

Dave Danic: Thanks Jamie. After that introduction my fee just went up. It's really good to be here.

Jamie Nau: Yeah, Dave's asking for a raise after this. So Dave, do you want to start off with some of those general tax rules that people should follow?

Dave Danic: Yeah. I mean, you know, general tax law doesn't break out what type of business you are in most cases. So the tax law is really simply based on saying, you brought in money, you spent money, what do you have left over? And that's what you're going to pay taxes on,  from a business perspective. So there are some general rules that we get a lot of questions on and a legitimate way to go about things. One of those is timing of income. So if you're a cash basis taxpayer, which we see, a lot of agencies are, saying you pay tax on the cash you receive and then that is reduced by with deductions of cash you spend. So the tried and true method was, let's defer our income and accelerate our deductions. We get a lot of questions like, hey, should I hold onto these checks that I got in the mail? Well, technically, no, that that's called constructive receipt. So if I get a check in the mail on Thanksgiving and I stick it in the bottom of my desk and wait until January 3rd to deposit it, I would say if you're under examination and it was proved that you actually had the check, that would be saying, you actually had the cash. So that old method of saying, let's have a stack of checks in my desk and then run to the bank in January, we don't advise that as much. But one of the things that you can do is that if you have a good handle on your collection cycle with your clients, and you know, they pay within 15 or 20 days instead of billing on December 1st, why not shift your billing to be December 20th when you know they're going to pay in January. So that's a more legitimate way, or an actual legitimate way to say, I know I'm going to actually receive the cash after January 1st.

Jody Grunden: Quick question on that Dave, is that a lot of our clients are at one point get confused a lot of times and say you know, hey, I want to be in a cash base, you know, for my taxes, so I don't want to be on accrual base at all. Maybe Jamie, this is more a question for you. Can you be on accrual based on financial statement purposes, and cash based on tax?

Jamie Nau: That’s a great question. I think the accrual basis for your financial statements is really important. We've talked about this in another podcast, and it’s really the correct way to look at your business. You know, especially in a service based industry, you can be deceived by your numbers. You know, you could collect five hundred thousand dollars in month one for work you haven't done yet, you feel you're doing awesome, and then month two not collect anything. Again, it doesn't really matter when you collect the cash, it matters for cash purposes, but for analyzing your business and for what your production metrics are, it really matters about when you're doing the work. So it's really important we emphasize this over and over again to do accrual for your financial statements, and then on the tax bases to have cash, that's usually not too hard of a conversion, and we can go into that a little bit, but to take those accrual books and turn them into cash it's not that much work.

Jamie Nau: So Dave based on that then, the same scenario we gave, let's say I was an accrual based taxpayer, and holding checks back in November, what does that do for me?

Dave Danic: If you're an accrual basis taxpayer? Oh, it doesn't really matter. So, I mean, it's like if you bill it, then regardless of if you received the cash, it's a taxable item for you. So the CFOs on our team, and our tax department have to coordinate a lot, because a lot of the financial statement analysis, which is excellent and necessary for a healthy company, is not based upon, you know, we talk a lot about cash, but there are a lot of adjustments that need to be made for your analysis. So on the tax side of things, we are really concerned about when the cash is received.

Jamie Nau: So Dave, my follow up question here is, you talked about, okay, you can either push cash collections into the next period, or possibly accelerate cash payments into the current period. It's pretty important to understand what your tax situation is before you do that, right? Can you explain that a little bit, how you would understand that going into December?

 Dave Danic: Sorry. On the video, Jody just put on his sunglasses, so I blacked out there for a second. But anyway, in terms of actually accelerating deductions, that is also a great method to lower your tax bill for the given year. So things to look at one, supply, like computers, things of that nature. Maybe you have to change up your computer release schedule so you're paying more out at the beginning of this lease. If you're used to signing your leases for Apple, or Dell, in January, shifted into December. Insurance, look at your insurance to see if you can prepay those premiums up into December for the entire year, because for service based businesses it's kind of hard. You know, I'm not going to advise to go buy a pickup truck, you know, to get accelerated depreciation. That doesn't make sense, but there are still some other expenses for a service based company, such as those computers, insurance premiums, things of that nature. Maybe some rent that you could accelerate up a couple of months.

Jody Grunden: What's the expense roles? Before most accountants would say, five hundred dollars, anything under five hundred lets expense. What are the new rules based the tax law?

Dave Danic: The IRS, five or six years ago, made it a lot more generous in the burden for depreciating those types of items. Computers, they set the limits be twenty five hundred, or you can use a limit of twenty five hundred and not have to worry about it. We advise for doing that. Just because it's much less of a burden on trying to calculate depreciation on all these items. This is tax accountant nerdy talk.

Jody Grunden: Yeah, but if I go to Best Buy, and buy three computers and three monitors, and stuff like that, and it all totals seventy five hundred bucks. How does that get treated?

Dave Danic: I would advise to split them out separately and then use the rules for depreciating for each separate item. I do that because I've seen a lot of times when you pick up a new client, they have this list of equipment that just says, computer, computer, computer, computer. I think we should probably have a better handle on what's floating around the office, or across multiple employees if we have a distributed company. So we actually know what's going on here. So I like to have at least another fixed assets schedule where you're actually monitoring what's going on. Even if it's list as Apple Computer, Jim. Apple Computer, Jane, and then maybe the serial numbers.

Jody Grunden: And maybe the monitor's on top of that if they got additional costs for monitors.

Dave Danic: Yeah.

Jamie Nau: I think this is great. I think, you know, we talked about this a little bit, but, you know, Jody’s sunglasses distracted you from my real question. But the general tax rules of obviously pushing back revenue and accelerating expenses do help your deduction. But with that, it's important to know where you're at. There's certain years where it's important to do that, and there's certain years you might not want to do that. How do you get that handle on, okay December 1st, knowing where your taxes are at, or might be, so you can make those decisions better?

Dave Danic: It's all based on forecasting, which is not exactly my department, but we get information from the client, or from our CFO team, to say in June, how are we looking from a taxable income perspective? The June timeframe we generally have a decent idea where we're going to end up, and we can make the adjustments to say, here's where our taxable income is going to be versus what our book income is going to be. Then once we start getting into September, October, we've got nine to 10 months of data. So we should have a really good handle on where your taxable income is going to be, and then provide guidance in months 11 and 12 to say, maybe we want to push out this job, or hey, we can maybe accelerate, or if we pick up this income it’s not going to impact us. If we do receive the income, let's put some aside in our tax reserve account so we have it available when we have to pay those taxes come April 15th.

Jody Grunden: I think Dave made good point there, the forecast is huge. It’s a dynamic forecast, and is constantly changing all the time. So like he mentioned in June, we're not looking backwards and saying, hey, how much do we have so far in taxable income from January through June, and let's multiply that by two and assume it's going to the same thing. That very rarely works because everything's so dynamic, in everybody's businesses, but especially the creative agency world. So having that forecast is really important, because you know the actual data from January through June, and then you should know what the forecasted remainder of the year is going to be. So let's say your taxable income is a half million dollars from January to June, but then from July through December, you're only forecasting two hundred thousand dollars for whatever purpose, and so then we're basing all that tax, once we do the adjustments, on the seven hundred thousand, not doubling the January through June or any other part of that. And so then the key there, I guess, is that every month as the forecast changes because life happens, then we look and see, hey, where are we at? And so instead of seven hundred thousand, maybe you had a great August and September, where now you are at eight thousand dollars, we need to make that small adjustment that we're talking about. Then it becomes really important towards the end, like Dave was saying that, well, if it's big enough where we've now you got cash in the bank, we're not worry about that, and we want to cut our burden down, then maybe a couple of computers like he was saying, if we need to buy many in the first quarter, let's accelerate that purchase it makes total sense. But like what Dave did say is it does not make sense to drain your cash to save taxes. That is a silly, silly thing to do and we don't recommend that whatsoever.

Dave Danic: Yeah but even from a more positive perspective, when we do know what our tax liability is going to be, hopefully we have one that means you have a profitable business, but what it does mean is that if the owner wants to take a profit distribution, if we had this bucket of cash at the end of the year, we can say, OK, we saved X amount for taxes. This remainder, if you want to take a profit distribution, hey enjoy the fruits of your labor. Take it out. But we know we need to keep this aside. I've seen too many stories of where they take out too many distributions. Whether they want to buy a house, they want to buy a car. Then it comes back, and here's the tax bill. It just creates stress. Our job is to make tax not surprising, and not stressful, at least in our department. That's one of the biggest value ads that our department  can add to our clients and agencies.

Jamie Nau: I think the one thing that everybody might not connect here is when you're talking about forecasting, especially for taxes, it is important to have a balance sheet forecast as well. That net income forecast isn't going to get you there when it comes to taxes, especially if you're on accrual basis. If you’re in accrual basis you need to understand where your balance is going to be at the end of the year to really understand what your tax liability is going to be. And with that, if you have a dynamic forecast like Jody said, you can kind of play with the numbers, you know, kind of like these situations we are talking about. What happens if we don't collect this AR, and it's sitting AR what's that going to do to our tax benefit and that type of stuff? Then the second part of that is, you know, if you're already forecasting a loss for the year and you know that on December 1st, you might not want to accelerate the expenses this year because it's not really going to help as much as if you were to have that in the following year, when you're hopefully going to have that gain. And so I think that's the importance of having that forecast. It really gives you the ability to understand what those numbers are going to do, and be able to plug those numbers in there and say, what happens if we do this? What will it do to our tax liability? To know that in December or November or October, the earlier you do it, the better the conversations you're going to have and the more you're going to understand those next steps to take.

Dave Danic: Our goal usually is to have our tax situation wrapped up by October 15th, because even if I tell a client what their tax liability is going to be in late December, that's only four months that is some major swings happen, or you have some other events that you want to take care of it does not provide too much time to even have to build up reserves if I had been doing it through the year or so.

Jamie Nau: So I shouldn’t be tax planning on April 14th? Is that you're telling me?

 All: Laughing [in audible]   

Dave Danic: Well if you have a liability, pay it as late as you can, but as long as you have it, I don't care when you pay.

Jody Grunden: More importantly you shouldn’t be surprise on April 14th. You already got the money set aside. That’s the big thing.

Jamie Nau: Okay, so let's kind of turn directions here a little bit and let's talk a bit more about creative agencies. So we've talked about general taxes. But, you know, we have a lot of creative agencies that listen to this podcast, and that's really who Summit is oriented for. So what should I be thinking of, as a creative agency, or an owner of a creative agency, that I might not be thinking of in terms of taxes?

Dave Danic: You know, this is one that I've seen that with the new tax law, I've seen this a handful of times and it's based upon this new qualified business income deduction. So the tax law is a couple of years old, but the big news was the big corporations, Apple, Facebook, GM, we're getting all these tax breaks. But really it was structured also to give all businesses a tax break through this QBI deduction. The law was written that they wanted to try to get as many people to get this tax break from a business owner perspective. But they had some carve outs where they say you're not going to get it. So accountants like us, we don't get it, attorneys don't get it, consultants don't get it. That was kind of the scary one for creative agencies, because a lot of people say, yeah, we do consulting. Well, accountants do consulting. Plumbers could say they do consulting, you know, and they're trying to advise someone. We've seen that most of our creative agencies are actually qualifying for this, because really it's not as much consulting as it is that, you know, I'm actually designing a website, or I'm creating a marketing plan, or developing the marketing plan. So but also, look at the deliverable that you're providing to your client, if it's tangible in terms of a website, then I would say you're not less of a consultant, but more of a maybe an engineer who do qualify for it. So I would say if you go to your accountant and you're not qualifying for the QBI deduction, which is a 20 percent deduction for you, you really want to go back and say, let's beat this up a little bit more and see if we qualify. Let's look through the exemptions. That's the first one for agencies, I would say, doublecheck.

 Jody Grunden: Real quick on that one, there's a big hubbub about should I be a C-corp versus LLC, which is going to be the more beneficial for that QBI deduction. What's your take on that?

Dave Danic: Well, the QBI deduction is only applicable to flow through entities like an S-corp, or a partnership, not a C-corp. C-corps certainly get a nice 21 percent rate, but if you're a C-corp and you're an agency, a lot of those profits are coming out as dividends, which creates a different layer of tax on you. So I would say if you're an agency that's retaining cash, and you've got big plans for acquisitions over the next five to six years, you're building up that cash and not distributes the owners, a C-corp is possible, and it might make sense. But for most of our clients, still staying as an S-corp is probably the most tax advantageous way to go.

Jody Grunden: I agree.

Jamie Nau: For that QBI that you're talking about Dave, do you have to change the way you market your company in order to make sure you're not considered a consultant? What other tips can you give to make sure that you know again if you aren't really in that consulting field?

Dave Danic: Yeah, I would scrub your website just to see how much consulting is put on your advertising that you're going out to clients on. Look at your statements of work to see what the deliverable is, how much is actually specifically consulting versus other, hey, I designed the website, I designed a logo, things of that nature, and keep that to a minimum.

Jamie Nau: Great, all right, so what else, for the creative agencies out there, what other tax implications should they be thinking about?

Dave Danic: The other one that we tax with our clients is the R&D credit, which has been around for a long time, probably back into the 60s, and the reason Congress put it into play was they wanted domestic companies to start investing in technology so they could create jobs, and keep our economy at the forefront of technology. So obviously, though, the world has shifted in the past 40 to 50 years, and creative agencies are more of a software, intangible space. But the credit does apply to companies that are creating software, and actually designing websites, and code does qualify for that. So agencies need to look at projects that they're working on that they’re really not getting paid for. There are some carve outs where if even if you are getting paid we can look at the contracts to see if it qualifies. But if you're investing into new technology and you're actually testing different ways of doing it, this could be a pretty nice write off, especially for early stage agencies that might be really trying to build up a new product or something like that. So you could save 10 percent on your labor costs from a credit. So if I'm paying, if the qualified research expenses come out to be about one hundred thousand dollars, my credit could be ten thousand dollars. That's a lot of money. So certainly something that you should dive into to see if you qualify for that.

Jamie Nau: So when is the time to make a decision? You know, I guess I know from what I've found in conversation with you, it seems like there's quite a bit of work that goes into making sure you get that deduction. So is it okay to wait for when a project is over and then kind of do the evaluation and try to go back? What's the best way to look at that?

Dave Danic: It's a lot harder after the fact. And because some of these research expenses, everything qualifies that was related to a project. So the moment that you sat around the boardroom table to say, what do we want to do tomorrow? And if it's something new in technology, put the clock on your time and say, we want administrative time, CEO time, CTO time, all the developer time, pick up all those dollars that you're using your resources for as a company to create something new to see if it qualifies. But yes, you can go back, you can even go back three years and claim the R&D credit. So it's harder to get the data together, and to have a tighter case in case you were examined, god forbid, but we certainly filed three years past on some of these projects.

Jamie Nau: And no one's wants to go in to an IRS audit with a bunch of napkins with scribble on it. You want to have good documentation behind it.

Dave Danic: Yeah, it's a lot harder to prove when you say, employee A worked 50 percent of their time on this, and employee B was 25 percent of their time. Those round numbers start getting a little bit more harder to justify for sure. So no napkins.

Jamie Nau: Really quick I am going to throw our email address out there. So we've gone through a lot of tax stuff here today. If you have any questions, you can always e-mail us at: vcfo@summitcpa.net. And anything related to the podcast feel free to email us about. We'll get back to you quickly. We want to make sure the podcast covers the topics that you're interested. If you want to be a guest we'd love to have you on. So again that email address is: vcfo@summitcpa.net. We definitely look forward to hearing from people, and hearing about possible topics, so please e-mail us. So we're kind of getting to the end of our time here. Any final topics Jody or Dave, that we may want to talk about here?

Jody Grunden: Yeah, the one I get all the time is about multi-state tax returns, whether it's sales or income tax. How does that nexus world work, especially when you're in a creative agency? I was just speaking with one recently, they were an East Coast agency and they're like, yeah, I file tax returns in one state. And I go, are all your employees in that one state right now? Can you kind of explain how that works too.

Dave Danic: Well, at this point of the podcast, we'll let everyone go get a cup of coffee. So we'll be going over this for the next 60 minutes. I don't know how I view it. There are 50 different states and they all want a piece of the pie. So you can't blame these jurisdictions for wanting more tax dollars. So they're crafting the rules for their own benefit. But the general practice is what I'm seeing is that, more states are saying, we don't care where you're located, we care about where your clients are located, and if you're a creative agency, I'm almost certain that everyone listening is going to have a client that is not based in the state, that they are organized in. So you need to look at your client list and see how that state that they're located in taxes income. So for instance, California, most populous state, a high taxing state, they changed their rules to say, if you have sales in California, in excess of five hundred sixty thousand dollars, you are required to register to do business out of state, and then you get the pass franchise tax. So they changed it to be the economic nexus, where they say, I don't care if you're in Baltimore, you're going to pay in California. So, man, Jody, it's a good question. It's a long answer because there's 51 different jurisdictions, because I'm now including D.C. into it. It can become very burdensome, and we have seen people be impacted by it, especially when they start hiring people in new states, because now the state knows that something's going on.

Jody Grunden: So you're saying that it's because we have like, 30 some employees outside of Indiana, maybe even more right now, there's a good possibility we should be filing tax returns in all those states?

Dave Danic: No, I'm saying that we should analyze if we have to file in most states, because now that we have an employee footprint, the risk is higher that the state could come after us.

 Jody Grunden: Because some states don't do the economic tests.

Dave Danic: That's right. Some states will say, we don't care where your clients are located, but we do care if you are producing your work in our state.

 Jody Grunden: Meaning attending a board meeting in that state?

Dave Danic: New York City was big on saying the fact that you attended a client meeting in the city created Nexus, and then you had to pay taxes to New York City, which then meant you had to pay taxes to New York State. So see how it is a snowball effect? There's not a clean cut answer. It takes a lot of analysis. But I think you should just be asking the question of your tax accountant to say any concern her?

Jody Grunden: Then the other last question, that was income tax, with a sales tax what are you seeing? Because that seems to be something that's more and more, actually, a lot of these firms may qualify for sales tax now.

Dave Danic: Well, that's certainly something to analyze. So the old method of sales tax was that if I sold a tangible good, that was the only thing that was taxable, if I was selling a hat or a T-shirt or something like that. But now states are hungry for more revenue. So they're saying maybe we want to tax services, and SEO services, SEM, website design, hosting services, are all becoming targets for increased taxation from a sales tax front. So the big one we see is taxes that I think Hawaii also has some rules on taxing web design services in particular. So if you have clients there, certainly something to monitor. And if you have an employee in that state, then you really should be registering for sales tax on those services. And this is a big one. Not necessarily a tax perspective, but even from a business, because if you have an agency that's bidding on this work that doesn't charge sales tax on it, that’s like a 7 or 8 percent swing in quoting that you could be up against, and you're just trying to follow the rules.

Jody Grunden: Or even worse, you have a big client, and let's say you weren’t very profitable, something went wrong, now all of a sudden you get a notice from the state saying, hey, you owe us seven percent on the revenue, not the profits but the revenue, and maybe that clients policy is, hey, good luck, and you haven’t seen that client in two or three years..

Dave Danic: Yeah going back and collecting that from that client is very negligible. So that's kind of a contract question, too, with your attorneys. What kind of language should I have for sales tax liabilities in the event something comes back and it was found that it was subject to sales tax?

Jody Grunden: And I think there's some really good companies out there that specialize specifically in the sales tax. You have any recommendations at all?

Dave Danic: The big players are like an Avalara,  or a Tax jar, they're actually processing returns and they can build some APIs that link to different software’s so they could calculate pretty nicely. What I have found, though, it’s still really difficult to say if you’re actually subject to it. So there is a cost that I find that agencies will have to incur if you want to get a full nexus study, which is saying, I'm going to go through your customer list, I’m going to go through your employee list, and I'm going to give you a report of saying this is where you should be registering for sales tax. It's big in the media right now. I just read an article in, The Wall Street Journal, they're saying small businesses and the burden that they're having to overcome to properly do sales tax. And it's a big cost. So I don't want to leave on the sour note, but certainly something to monitor.

 Jamie Nau: I think the important thing is, is just to talk. I think the starting point would be to talk to your own CPA. Talk to them about both these subjects, both sales and income tax. They should at least understand how complex your business if, and whether you need to go to a specialist or not. I think that's really the starting point. Like you said, we could talk about this for five hours and not even give you enough information on it. So I think it's super important just to have that conversation with your CPA. They'll be able to identify how complex you are based on the contracts you have, based on where your employees are, and really kind of go through those evaluations to help you get through it.

Jody Grunden: I look at that as an extreme positive for those folks that weren't even aware of it, now at least it puts it on their table so that when they're bidding that big job in a state that does have that sales tax issue, at least they're aware of it now versus, you know, three months down the road when it's too late and they already signed the contract, and they're stuck with this extra 7 percent cost that they weren't expecting.

Dave Danic: It’s just good knowledge to have. The decision is typically up to you, the client, and what's your risk tolerance? Because we also had instances where they were there for two years and they left. So do I go back and do that?. Our job is to tell you the rules. Your risk tolerance may say, Okay, let's not file and move forward. Well that's up to you. We try to certainly give advice to our clients.

Jamie Nau: Well, I definitely want to thank both Dave and Jody for coming on. I think we had a lot of good topics today, a lot of information. I think we may even have a second podcast with you Dave to talk more when it comes to taxes. So definitely appreciate you guys coming on, and thanks for joining the show.


Tax Considerations for Creative Agencies

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