Description
Insight Article
To Accrue or Not to Accrue Distributions: That Is the Question
By Laura Heleniak, Manager, and Dan Szidon, Partner
March 2016
Entities that are organized as a pass-through entity (PTE), such as S
corporations and limited liability companies, are generally not subject
to federal or state income taxes. The shareholders (owners) of these
entities report their share of taxable income or loss on their personal
tax returns. For most nontaxable entities, distributions are made to
the owners to assist them in paying their tax liabilities.
A PTE should consider policies to determine the amount of owner
distributions and whether or not to accrue them. We believe it is
advisable to have a policy that guides the amount and timing of when
distributions are accrued.
When should year-end distributions be accrued?
A PTE should consider accruing distributions at year-end to better
match the return of equity to the earnings.
This is the same concept as matching revenues and expenses for the period. Therefore, it is advisable to accrue distributions to match the amounts that will be distributed to cover the owner’s tax liability to the year they relate to. For example, in the current year, an owner will need to pay his or her tax liability by April 2016. This will typically result in a large distribution in the following fiscal year, since most PTEs are required to have December 31 year-ends.
Accruing distributions by the corporation as of December 31, 2015, will better match when the tax liability was incurred and better reflect the year in which the distributions were needed to pay for the taxes. It may also be beneficial for PTEs to accrue for distributions when there are buy-sell agreements whose values are based on book value. This would present a more “economically” accurate picture of book value in the event a transaction is triggered under the agreements. Another reason to consider accruing distributions is related to bank covenant calculations. Some bank covenants (typically cash flow coverage or fixed charge coverage ratios) are based on cash flow availability.
Timing of distributions can dramatically impact these covenants, especially if the covenants are calculated on a 12-month rolling period. If the distributions are better matched with income, this will give your lenders a clearer picture of the ability to use cash to pay for other items such as the ability to pay debt payments or the ability to pay for capital expenditures. Deferred taxes? While it is true that PTEs generally do not have to record financial deferred taxes, this does not mean they are not incurring “economic” deferred taxes. For instance, many owners of PTEs will face higher future taxes because of accelerated tax depreciation rules.
Bonus and Section 179 deprecation incentives have helped many companies conserve cash by lowering their cash tax burdens by accelerating deductions. © Wipfli LLP As a result, PTEs with capital-intensive business can have significant future tax burdens that are, in effect, unrecorded. One way to account for this is to accrue long-term distributions to be paid when those differences reverse. If nothing else, PTEs should periodically calculate their future “deferred tax” burden so they can properly plan their future cash needs. What does GAAP say? GAAP says that distributions should be recorded when the appropriate governing body declares them.
This is why it is important to have a policy in place to govern the recording of distributions. For instance, a policy could be as simple as to accrue all unpaid return of earnings expected to be paid out in the following fiscal year. Such a policy makes the practice of waiting until after year-end to determine the precise amounts acceptable.
It is not advisable to selectively choose when to accrue and not accrue. There may be some instances when it may not be sensible for PTEs to accrue for their future distributions. If the users of your financial statements place a premium on net book value, then it may not be wise to accrue for distributions. Overall, PTEs that apply accrual accounting principles to record distributions find their financial statements to be more informative and better reflect the economic activity of their companies. About the Authors Laura Heleniak is a manager in our Milwaukee office, focusing on assurance and accounting services for manufacturing and distribution companies as well as employee benefit plan audits. Contact Laura at 414.431.9344, or email her at lheleniak@wipfli.com. Dan Szidon is the partner in charge of Wipfli’s audit and accounting practice. Contact Dan at 414.431.9328, or email him at dszidon@wipfli.com. About Wipfli LLP With associates and offices across the United States, Wipfli ranks among the top accounting and consulting firms in the nation.
The firm’s associates have the expertise, skills, and experience to advise in areas from assurance and accounting to tax and consulting services. In addition, through the firm’s membership in Allinial Global, Wipfli can draw upon the resources of firms in over 100 countries from around the world. For more information, visit www.wipfli.com. 1 .
This is the same concept as matching revenues and expenses for the period. Therefore, it is advisable to accrue distributions to match the amounts that will be distributed to cover the owner’s tax liability to the year they relate to. For example, in the current year, an owner will need to pay his or her tax liability by April 2016. This will typically result in a large distribution in the following fiscal year, since most PTEs are required to have December 31 year-ends.
Accruing distributions by the corporation as of December 31, 2015, will better match when the tax liability was incurred and better reflect the year in which the distributions were needed to pay for the taxes. It may also be beneficial for PTEs to accrue for distributions when there are buy-sell agreements whose values are based on book value. This would present a more “economically” accurate picture of book value in the event a transaction is triggered under the agreements. Another reason to consider accruing distributions is related to bank covenant calculations. Some bank covenants (typically cash flow coverage or fixed charge coverage ratios) are based on cash flow availability.
Timing of distributions can dramatically impact these covenants, especially if the covenants are calculated on a 12-month rolling period. If the distributions are better matched with income, this will give your lenders a clearer picture of the ability to use cash to pay for other items such as the ability to pay debt payments or the ability to pay for capital expenditures. Deferred taxes? While it is true that PTEs generally do not have to record financial deferred taxes, this does not mean they are not incurring “economic” deferred taxes. For instance, many owners of PTEs will face higher future taxes because of accelerated tax depreciation rules.
Bonus and Section 179 deprecation incentives have helped many companies conserve cash by lowering their cash tax burdens by accelerating deductions. © Wipfli LLP As a result, PTEs with capital-intensive business can have significant future tax burdens that are, in effect, unrecorded. One way to account for this is to accrue long-term distributions to be paid when those differences reverse. If nothing else, PTEs should periodically calculate their future “deferred tax” burden so they can properly plan their future cash needs. What does GAAP say? GAAP says that distributions should be recorded when the appropriate governing body declares them.
This is why it is important to have a policy in place to govern the recording of distributions. For instance, a policy could be as simple as to accrue all unpaid return of earnings expected to be paid out in the following fiscal year. Such a policy makes the practice of waiting until after year-end to determine the precise amounts acceptable.
It is not advisable to selectively choose when to accrue and not accrue. There may be some instances when it may not be sensible for PTEs to accrue for their future distributions. If the users of your financial statements place a premium on net book value, then it may not be wise to accrue for distributions. Overall, PTEs that apply accrual accounting principles to record distributions find their financial statements to be more informative and better reflect the economic activity of their companies. About the Authors Laura Heleniak is a manager in our Milwaukee office, focusing on assurance and accounting services for manufacturing and distribution companies as well as employee benefit plan audits. Contact Laura at 414.431.9344, or email her at lheleniak@wipfli.com. Dan Szidon is the partner in charge of Wipfli’s audit and accounting practice. Contact Dan at 414.431.9328, or email him at dszidon@wipfli.com. About Wipfli LLP With associates and offices across the United States, Wipfli ranks among the top accounting and consulting firms in the nation.
The firm’s associates have the expertise, skills, and experience to advise in areas from assurance and accounting to tax and consulting services. In addition, through the firm’s membership in Allinial Global, Wipfli can draw upon the resources of firms in over 100 countries from around the world. For more information, visit www.wipfli.com. 1 .
