Cross-collateralization Strategy Raises Concerns
Commercial lenders cross-collateralize loans to reduce risks. But accounting concerns and debt restructuring issues may emerge when using multiple properties to secure a loan associated with one property.
Placing loans on nonaccrual status
Generally, when interest payments on a loan are significantly overdue and collection of principal is deemed unlikely, the loan must be placed on “nonaccrual status.” If a bank experiences an increase in nonaccrual loans, it likely will be forced to bump up its reserves for loan losses, which may hurt its profits.
In some cases, cross-collateralization can cause multiple loans to be placed on nonaccrual status, even if some of the loans are still performing. The OCC, in its June 2012 Bank Accounting Advisory Series (BAAS), offers several examples that illustrate the potential impact of cross-collateralization on nonaccrual status.
One example involves a real estate developer that has two loans with a bank for two separate projects. Loan A is current and the bank expects full repayment of principal and interest. But loan B is placed on nonaccrual status.
According to the BAAS, placing one loan on nonaccrual status doesn’t automatically require the bank to give the other loan the same status. The guidance emphasizes that the obligors on the two loans are separate corporations wholly owned by the developer and there’s no cross-collateralization or personal guarantees.
If the bank subsequently negotiates a cross-collateralization agreement with the developer, must loan A also be placed on nonaccrual status? According to the BAAS, by entering into a cross-collateralization agreement, the bank is merely taking steps to improve its position relative to the borrower. It need not place loan A on nonaccrual status if cross-collateralization doesn’t change the repayment pattern of the loans or endanger loan A’s full repayment.
In another example, loans A and B are related to separate real estate projects, are personally guaranteed by the developer, and were initially cross-collateralized. Project A has the cash flows to repay loan A in full but no excess to meet a shortfall on loan B, which is past due.
According to the OCC, if the developer has the ability and intent to make the payments on both loans, the bank could maintain both loans on accrual status. If the developer lacks the ability and intent to make the payments, both loans should be placed on nonaccrual status.
Because the loans are cross-collateralized, collectibility should be evaluated on a combined basis. The developer, as guarantor, is the ultimate repayment source for both loans, so placing only loan B on nonaccrual status wouldn’t reflect that the collectibility of the entire debt is in doubt. To find the June 2012 BAAS, go to http://www.occ.gov/publications/publications-by-type/other-publications-reports/baas.pdf.
Under current accounting standards, if restructured loans are considered troubled debt restructurings (TDRs), they may result in additional valuation allowances or losses on a bank’s financial statements. Generally, a restructuring is a TDR if a bank grants a concession to a borrower experiencing financial difficulties.
Some banks use cross-collateralization in an attempt to avoid TDR status on reworked loans. They might, for instance, defer loan payments or reduce the interest rate in exchange for additional collateral.
Seeking expert advice
If you have questions about the strategy of cross-collateralization, contact your CPA. He or she will be able to advise you on your financial moves.
Scott Drake, CPA, is a Member of the firm of Smith Elliott Kearns & Company, LLC. Scott joined SEK&Co in 1975. He is the lead member of the Financial Institution Services Group Team which has extensive experience providing services such as external audits, SOX 404 exams, outsourced internal auditing, loan reviews, IT exams, ACH & BSA exams, SEC compliance and reporting, and taxplanning and compliance.
All closely held businesses should have buy-sell agreements. If designed properly, these agreements help ensure a smooth ownership transition if an owner dies or leaves the business. They can also provide an owner’s surviving family members with the liquidity they need to pay estate taxes and other expenses.
Perhaps the most critical aspect of a buy-sell agreement is its valuation provision. This establishes the price (and thus the methodology for determining the same) for which the company or remaining owners are permitted, or required, to buy back a departing owner’s interest. Any ambiguity in the agreement’s pricing terms — or misunderstandings about what they mean — can lead to unpleasant surprises when the buy-sell agreement is triggered.
3 approaches to setting a price
In general, there are three ways to set the price: 1) an independent appraisal, 2) a formula, such as book value or a multiple of earnings, and 3) negotiation by the parties. All buy-sell agreements use one or a combination of these approaches, and each approach has its pros and cons.
Independent appraisals generally produce the best results. They account for the special characteristics that distinguish a particular business from others in its industry. They also ensure that the price reflects an interest’s value at the time it’s transferred. An appraisal is the best way to ensure that all parties are treated fairly. The downside of this approach is that it’s the most expensive.
Valuation formulas are inexpensive and easy to use, but they fail to reflect changes in a company’s value over time. Book value, for example, might be a good indicator of value when a company is founded, but often it becomes less accurate over time because it fails to account for earnings, goodwill or the current fair market value of the company’s assets. (See the below “Book value undervalues interest by millions.”)
Formulas based on multiples of earnings or cash flow also may be unreliable. For one thing, multiples are derived from industry averages, which may not accurately reflect the characteristics of the business being valued. Also, the values produced by these formulas tend to fluctuate, often underestimating value in good times and overestimating it in bad times. In essence, valuation multiple formulas can result in an undesirable outcome for one or more parties to the agreement.
Negotiated pricing can be effective, so long as the parties are able to agree. If they can’t, litigation may be the only option. One potential solution is to call for a negotiated price, but provide for an independent appraisal in the event the parties can’t agree.
To avoid litigation over a buy-sell agreement, it’s critical to choose terminology carefully and define key terms if necessary to eliminate ambiguity. For example, business owners often provide that the buyout price for an interest is its “value,” without specifying whether the term refers to fair market value, fair value, investment value, book value or some other standard.
It’s also important to specify the level of value, such as controlling interest or minority interest. Often, parties to buy-sell agreements assume that in the event of a buyout they’ll receive their pro-rata share of the business’s value as a whole. But if the agreement sets the price based on “fair market value,” the price may be discounted to reflect lack of control or marketability. If the parties intend for the buyout price to be fair market value without regard to discounts or premiums, the agreement should say so explicitly.
One issue that’s often overlooked is the valuation date. The value of a business can change dramatically over a short time, so the selection of a valuation date can have a big impact on the buyout price. Generally, it’s best to use a specific date, such as the last day of the company’s most recent fiscal year. If the date of the triggering event is used, owners may be able to time their departures in a manner that maximizes the price they’ll receive.
Get professional help
It’s always a good idea to consult a valuation professional when planning a buy-sell agreement. An expert can help you draft the valuation provision to help ensure that all parties are treated fairly, and also to make certain there are no surprises. Further, it’s imperative that the parties to the agreement periodically review it, since circumstances and issues may change over time.
Book value undervalues interest by millions
One case — the Estate of Cohen v. Booth Computers — illustrates the dangers of relying on book value to set a buyout price in a buy-sell agreement. The 2011 case involved a family partnership agreement. In the event of a partner’s death, it called for a buyout price of net book value plus $50,000.
After one partner died, the sole surviving partner implemented the buyout clause, which set the price at $178,000. The partner’s estate sued, alleging, among other things, that the buyout provision was “unconscionable” because the fair market value of the interest at the time was more than $11 million.
The court held that the buyout provision was enforceable, noting the term “book value” was unambiguous.
View Other Valuation and Succession Planning Blog Posts
View Information on SEK&Co Valuation Services
Download Things to Consider As You Plan Your Business Succession
Jacob Kaufman, CPA, CVA is a Member of the firm of Smith Elliott Kearns & Company, LLC. Jake joined SEK&Co in 1989. He is the lead member of the Business Valuation Team and serves as a consultant to the Accounting Services and Tax Departments in the firm's Chambersburg office. Jake's valuation experience was learned through years of study and practical experience. In addition to valuation theory and implementation, Jake possesses the relative tax, finance, and accounting experience necessary to perform a thorough quality valuation.
The Data Collection Form is a federal form which summarizes the results of audits performed under OMB Circular A-133. The Data Collection Form itself is required to be updated at least every three years in order to keep the information accurate and relevant to federal agencies. In addition to the new Data Collection Form, the Federal Audit Clearing House developed a new internet data entry system. This new system was launched January 7, 2014.
Under normal circumstances the Data Collection Form is due 30 days after the receipt of the auditor’s report or 9 months after year-end, whichever is earlier. However, due to the delay in the forms availability, the Office of Management and Budget has granted an extension to all Data Collection Form submissions to February 28, 2014. This is an automatic extension and no application or inquiry is necessary.
A few of the significant changes to the new system and form include:
- A new login page which requires all users (auditor and auditee) to set up personal accounts.
- New minimum password requirements and periodic password updates.
- Password resets no longer utilize security questions and answers.
- An Excel template is available for each report to upload awards and
findings for submission.
- Only the certification official will have access to certify the report, eliminating the need for signature codes as in prior years.
- Updated language to keep the form consistent with new Clarity Standards terminology.
- Beginning with the 2014 submissions uploaded PDFs must be unlocked, unencrypted and 85% text searchable.
- Also beginning in 2014 all audit findings are required to be identified by standardized reference numbers.
Smith Elliott Kearns & Company, LLC will provide specific instructions to our clients regarding the new system as part of our audits. Please feel free to contact us if you would like more information.
Leighton Stiffler is an Audit Supervisor. Leighton joined the Carlisle, Pennsylvania office of Smith Elliott Kearns & Company, LLC in 2008 and provides audit services to a variety of clients including healthcare institutions, local governments and other non-profit organizations. These healthcare institutions include Federally Qualified Health Centers (FQHCs) and Long Term Care and Retirement Centers (LCRCs). The type of local governments Leighton serves includes school districts, boroughs, municipal authorities and other quasi-governmental agencies.
The word “audit” often produces negative thoughts. However, an audit can be a positive thing. Employee benefit plan audits, which are generally required for plans with 100 or more eligible participants, help to protect the assets and the financial integrity of the Plan. An audit can help ensure that funds will be available to pay retirement, health, and other promised benefits to employees. A quality audit will help ensure that the plan is being operated in accordance with the Plan Document and help reduce the risk of fines and penalties assessed by the Department of Labor (DOL) in instances of noncompliance.
If you maintain a “small plan” which is generally defined as an employee benefit plan with less than 100 participants, an annual audit is not required. However, you might desire the benefits an audit can produce, but are reluctant to incur the full cost of an audit. If so, consider employing a firm such as ours that specializes not only in audits of employee benefit plans, but also performs third party administrations on nearly 300 plans annually, to provide consulting services or an agreed-upon procedures engagement, to specifically target a few keys areas that tend to be the most common areas of noncompliance, for big and small plans alike. In an agreed-upon procedures engagement, you tell us what “testing”, “vouching”, or “recalculating” you want us to do. This targeted approach to looking at your plan can ensure you are paying for what is most important to your overall plan structure and give you peace of mind that your plan is in compliance with the key features of the plan document and government laws and regulations, noncompliance with which can result in fines and penalties assessed on the plan sponsor.
The following is a sample of the more common deficiencies noted during a plan audit and the operational provisions of the plan that result in the deficiency. Plan provisions like these could be “tested” during an agreed-upon procedures engagement to help detect noncompliance, should it exist.
- The application of an incorrect definition of plan compensation. Some plans exclude fringe benefits, bonuses, vacation, overtime, commission and/or other types of wages. Furthermore, some plans’ definition of plan compensation is different for employee versus employer contributions, or it is different for various groups of employees. Scenarios like these often lead to incorrect calculations because systems are not in place to use the proper plan compensation.
- Failure to comply with participant deferral elections. Plan sponsors have the ultimate responsibility to ensure that the participants’ deferral elections are processed according to their directions. Changes to employee deferral rates and amounts must be reviewed often to ensure that payroll is processing the withholdings accurately. Incorrect calculations can result in the plan sponsor being liable for missed deferrals and any corresponding employer contributions on those amounts. It is also important to be aware of the IRS deferral limits for the year and ensure that no participant exceeds the annual limit. For plans with a year-end other than December 31, it is important to note that deferral limits are based on a calendar year, not the plan fiscal year.
- Improper calculation of employer contributions. Plan documents specify whether employer contributions are to be determined based on each pay period’s wages or determined based on annual wages. Plan sponsors oftentimes make contributions each pay period based on pay period wages, but the plan document dictates an annual calculation is required. It is permissible for plan sponsors to make contributions throughout the year so long as the calculations are “trued-up” at year end. We often find that this “true up” is not done. Also, some plan documents contain a specific formula for calculating employer profit sharing contributions, if offered by the plan, and oftentimes the correct formula is not used.
- Late remittance of employee contributions. DOL regulations require employers who sponsor large pension plans to remit employee contributions (and loan repayments) as soon as administratively feasible, but in no event more than fifteen business days after the month in which the participant contributions and loan repayments were withheld or received by the employer. Employers who sponsor small plans have 7 days from the date contributions and loan payments are withheld or received by the employer. The DOL enforces significant penalties on plan sponsors for late remittances and requires the plan sponsor to remit lost earnings when contributions are not remitted timely.
- Misunderstanding hardship distribution rules. Some plans permit hardship distributions for certain causes. Plan sponsors must ensure that the plan allows for hardship distributions before authorizing one to be made. It is imperative that plan sponsors maintain documentation supporting the cause of the hardship. Upon distribution of a hardship, regulations require that employee deferrals cease for the next 6 months.
We find that many audit deficiencies are a result of turnover amongst payroll and human resource staff, lack of a good system of internal controls, and a lack of understanding by plan personnel and management of the plan document and DOL rules and regulations. Employers must be cautious and not rely on third party administrators to perform their fiduciary responsibilities. If you maintain a small employee benefit plan and are looking for the benefits of an audit without the full cost of an audit, please contact us to discuss fees and options. We would be happy to help you customize an engagement that fits your needs.
Kara M. Darlington, CPA is an Associate Member of the Firm. Kara joined the firm in 1996. She has extensive management experience in auditing the firm’s nonprofit, governmental, employee benefit plan, and other clients. Kara is based in the firm’s Hanover office; her continuing education has included tax and audit considerations of nonprofit organizations and audit and compliance considerations of employee benefit plans including 401k plan audits.
Krystal A. Mitchell, CPA is an audit Manager. Krystal joined the firm's Hanover office iKrystal Mitchell, CPAn 2008; she has over 8 years of experience in private and public accounting. Krystal specializes in accounting and auditing services for employee benefit plans. Her continuing education has included audit and compliance considerations of employee benefit plans (including 401k plan audits) for the past 5 years.
For those of you who've gotten used to seeing Rates & Dates in our printed newsletter, you can now view, print or save a PDF version of this file by clicking on the "Open 2014 Rates & Dates" hyperlink below.
Hi Bracket had learned over many years to defer income late in the year to the next year. This fit right in with his philosophy of “never pay a tax until you have to” even though the next year might have higher income. Late in the year he got a letter from the Social Security Administration informing him of an increase in his Social Security benefit amount which was more than offset by an increase in Medicare premiums (income related) so his benefit actually went down. Doesn’t seem American does it?
Each year Social Security looks at your income for the prior year including non-taxable income and as your income exceeds certain levels, the Medicare part B and D premiums for the next year go up – to as much as three times the regular amount. This applies to a spouse also when a joint return is filed. Now that can be a significant amount of premium payment increase for the same coverage. So, maybe Hi’s deferral of income into the next year didn’t work out so well if it caused a spike in that year.
The Better Way would be to look at tax planning on a longer term basis because the immediate future might not be the only thing affected. Increases in income, including timing spikes, can cause several bad things to happen. Not only the premiums but higher income tax brackets, advent of the additional Medicare tax on investment income and wages, loss of exemptions, limit on itemized deductions, higher rates on capital gains and, oh yes, Alternative Minimum Tax. We frequently work with clients in planning for the long run; there is a lot to consider.
Over the past several years the Internal Revenue Service (IRS) has taken a firm stand regarding costs associated with the holding period of Other Real Estate Owned (OREO). The IRS historically considered this real estate property as property acquired for resale. Section 263A of the Internal Revenue Code applies to property acquired for resale and requires that costs related to these properties be capitalized into the basis of the property, rather than recognizing the expenses on the tax return in the year the expenses are incurred. However, for financial statement reporting purposes, many banks typically deducted these costs as incurred. The difference in how these costs were recognized created a temporary difference and a related deferred tax asset.
In many cases, IRS exam teams have required banks to capitalize all direct and indirect costs of carrying the real estate property. As a result, many banks have either voluntarily or involuntarily converted their method of accounting for these costs to the capitalization method (i.e. treating as held for resale under section 263A).
In February 2013, the Office of Chief Counsel of the IRS issued a General Legal Advice Memorandum (GLAM 2013-001) relating to the treatment of OREO under Section 263A. The memorandum states that when OREO is acquired by the loan-originating bank either by deed-in-lieu of foreclosure or through foreclosure proceedings, the bank’s acquisition and sale of the property which previously secured a held loan does not convert the bank into a reseller because the sale of the OREO is viewed as an extension of the loan origination activity. Therefore, the bank is considered to be acting in its capacity as a lender and not as a traditional reseller of property, meaning the property was not acquired for resale within the meaning of Section 263A. As a result, the purchase and sale of OREO is considered to occur within the normal course of business or trade allowing the related costs to be deductible in the year the expenses are incurred rather than requiring capitalization of these costs.
What are the options for a bank which has previously capitalized the costs of OREO properties in their tax returns under Section 263A and now wants to change to another permissible method of accounting?
Pursuant to Rev. Proc. 2014-16, effective January 24, 2014, banks are now enabled to apply for an automatic consent for a change in accounting method. In order to qualify for this change in method of accounting, the applicant must originate, or acquire and hold the investment, loans that are secured by real property and acquire the real property that secures the loan at a foreclosure sale, by deed-in-lieu of foreclosure, or in another similar transaction. In order to apply for the change in accounting method, banks are required to file a signed copy of the completed Form 3115 with the IRS' Ogden, UT office no earlier than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with its federal income tax return for the year of change.
Luke C. Martin, CPA is a Member of the Firm of Smith Elliott Kearns & Company, LLC. Luke joined SEK&Co's Chambersburg, Pennsylvania office in 1989. Luke serves on the firm's Technology Committee and has significant experience in the tax compliance and accounting areas of the practice. He also has extensive experience with financial institution taxation, preparing financial statements and relation reports on internal controls, compliance and management advice. Luke has spoken at conferences and seminars on banking taxation issues.
After the employer mandate of the Affordable Care Act (ACA) was delayed until 2015, many of you probably breathed a sigh of short-term relief. There are, however, still provisions of the ACA that are applicable to employers RIGHT NOW. A good portion of them were previously applicable, but there are new concerns.
Restrictions on HRAs and Medical Insurance Premium Reimbursements
The IRS has announced that standalone health reimbursement arrangements (HRA) and medical insurance premium reimbursement arrangements violate the ACA after 2013. An HRA is a plan where employers reimburse employees for medical expenses up to a fixed dollar amount. A medical insurance reimbursement plan is just as it sounds, employers reimburse employees for medical premiums paid by the employer under a non-employer sponsored medical insurance plan. Under the ACA these reimbursement plans are non-compliant and could be subject to a penalty of up to $100 per day/per employee covered under the plan. The reasoning behind them being non-compliant is that by definition they limit the benefits paid under the plan. Thus, even if the underlying insurance purchased through an insurance premium reimbursement arrangement meets the ACA regulations, the reimbursement plan itself does not and therefore such an arrangement is not in compliance with the ACA. There are very limited exceptions to these rules. These provisions do not apply to any governmental plan and to any plan if on the first day of such plan year, the plan has less than two participants who are current employees. Therefore, employer payment plans and HRAs should not be subject to the penalty if fewer than two current employees are covered under the arrangement. There are three ways to avoid these penalties. One is to provide an employer-sponsored qualified ACA plan, another is simply replacing a premium reimbursement arrangement with a taxable increase in wages and allowing employees to pay their own medical premiums. The last option is available to small employers with 50 or fewer employees.
What about “S” Corporation Shareholders?
The Internal Revenue Code permits employees who are more than 2% shareholders in an S corporation to deduct health insurance premiums as an adjustment to income on their individual tax returns if the premiums are included as wages on their W-2. The corporation deducts the premiums the same as any other business expense. These rules have not changed as a result of the ACA. Where the potential problem comes is when the S corporation is reimbursing or paying premiums on non-employer sponsored health insurance for more than one S corporation employee. With more than one employee, then the arrangement may be considered a “group plan” and therefore subject to ACA, and consequently the penalty for non-compliance. There is still some uncertainty about the applicability of these rules. As a suggestion, if you are currently reimbursing “S” corporation shareholders for health insurance premiums, consider waiting to make the reimbursement until later in 2014. Hopefully we will have more clarification by then. For additional information about the ACA, including other requirements already in place, please refer to previous articles published on our website (www.sek.com)
Benjamin S. Boyer was promoted from Staff Associate to Senior Associate. Ben joined the firm in 2011 after serving as an intern during tax season. He graduated from Shippensburg University with a bachelor’s degree in Business Administration with a major in Accounting. Ben serves audit clients in the Carlisle office.
Iuliana M. Cobzaru was promoted from Staff Associate to Senior Associate. Iuliana joined the Chambersburg office in 2010 after serving as an intern in the Hagerstown office. She graduated cum laude from Wilson College with a bachelor’s degree in Accounting and passed the CPA exam in 2013. Iuliana provides tax services to individual and business clients in the Chambersburg office.
Cory A. Cuffley, CPA, MAC was promoted from Staff Associate to Senior Associate. Cory graduated from Bloomsburg University of Pennsylvania with a bachelor’s degree in Business Administration and from Villanova University with a master of accountancy degree. He works with individual and business clients providing tax, audit and review services in the Hanover office.
Kelly A. DeGroff, CPA was promoted from Staff Associate to Senior Associate. Kelly graduated cum laude from Shippensburg University with a bachelor’s degree in Business Administration, majoring in Accounting. She joined the Hagerstown office of SEK&Co in 2012, bringing with her four years of tax preparation experience. Kelly works with clients providing estate administration and fiduciary tax compliance services.
Jaimie S. Kaufman was promoted from Staff Associate to Senior Associate. Jaimie earned a bachelor’s degree in Business Administration from Shippensburg University with a dual major in Accounting and Management Information Systems. She joined SEK&Co’s Carlisle office in 2009 and works with the firm’s small business and individual clients providing accounting, consulting and tax services.
Kellie J. Reese, MBA was promoted from Staff Associate to Senior Associate. Kellie graduated cum laude from Towson University with a bachelor’s degree in Accounting and magna cum laude from Frostburg State University with a master’s degree in Business Administration. She joined the audit department after serving several successful internships in the Hagerstown office. Kellie provides audit services to employee benefit plans, nonprofit organizations and manufacturing clients.
PROMOTED TO SENIOR ADMINISTRATOR
Susan R. Muck was promoted from Administrator to Senior Administrator. Susan graduated from Shippensburg University with a bachelor’s degree in Business Administration. In 2002, she joined the Retirement Plan Services Group in Chambersburg, bringing with her three years of general accounting experience. Her primary responsibilities include providing third party administration and consulting services to her clients’ retirement plans.