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Mandatory capitalization of R&E expenses—will the new rules impact your business?

04.13.22

Read this if you invest in research and development. 

Businesses that invest in research and development, particularly those in the technology industry, should be aware of a major change to the tax treatment of research and experimental (R&E) expenses. Under the 2017 Tax Cuts and Jobs Act (TCJA), R&E expenditures incurred or paid for tax years beginning after December 31, 2021, will no longer be immediately deductible for tax purposes. Instead, businesses are now required to capitalize and amortize R&E expenditures over a period of five years for research conducted within the U.S. or 15 years for research conducted in a foreign jurisdiction. The new mandatory capitalization rules also apply to software development costs, regardless of whether the software is developed for sale or license to customers or for internal use.

Tax implications of mandatory capitalization rules

Under the new mandatory capitalization rules, amortization of R&E expenditures begins from the midpoint of the taxable year in which the expenses are paid or incurred, resulting in a negative year one tax and cash flow impact when compared to the previous rules that allowed an immediate deduction.

For example, assume a calendar-year taxpayer incurs $50 million of US R&E expenditures in 2022. Prior to the TCJA amendment, the taxpayer would have immediately deducted all $50 million on its 2022 tax return. Under the new rules, however, the taxpayer will be entitled to deduct amortization expense of $5,000,000 in 2022, calculated by dividing $50 million by five years, and then applying the midpoint convention. The example’s $45 million decrease in year one deductions emphasizes the magnitude of the new rules for companies that invest heavily in technology and/or software development.

The new rules present additional considerations for businesses that invest in R&E, which are discussed below.

Cost/benefit of offshoring R&E activities

As noted above, R&E expenditures incurred for activities performed overseas are subject to an amortization period of 15 years, as opposed to a five-year amortization period for R&E activities carried out in the US. Given the prevalence of outsourcing R&E and software development activities to foreign jurisdictions, taxpayers that currently incur these costs outside the US are likely to experience an even more significant impact from the new rules than their counterparts that conduct R&E activities domestically. Businesses should carefully consider the tax impacts of the longer 15-year recovery period when weighing the cost savings from shifting R&E activities overseas. Further complexities may arise if the entity that is incurring the foreign R&E expenditures is a foreign corporation owned by a US taxpayer, as the new mandatory capitalization rules may also increase the US taxpayer’s Global Intangible Low-taxed Income (GILTI) inclusion.

Identifying and documenting R&E expenditures

Unless repealed or delayed by Congress (see below), the new mandatory amortization rules apply for tax years beginning after December 31, 2021. Taxpayers with R&E activities should begin assessing what actions are necessary to identify qualifying expenditures and to ensure compliance with the new rules. Some taxpayers may be able to leverage from existing financial reporting systems or tracking procedures to identify R&E; for instance, companies may already be identifying certain types of research costs for financial reporting under ASC 730 or calculating qualifying research expenditures for purposes of the research tax credit. Companies that are not currently identifying R&E costs for other purposes may have to undertake a more robust analysis, including performing interviews with operations and financial accounting personnel and developing reasonable allocation methodologies to the extent that a particular expense (e.g., rent) relates to both R&E and non-R&E activities.

Importantly, all taxpayers with R&E expenditures, regardless of industry or size, should gather and retain contemporaneous documentation necessary for the identification and calculation of costs amortized on their tax return. This documentation can play a critical role in sustaining a more favorable tax treatment upon examination by the IRS as well as demonstrating compliance with the tax law during a future M&A due diligence process.

Impact on financial reporting under ASC 740

Taxpayers also need to consider the impact of the mandatory capitalization rules on their tax provisions. In general, the addback of R&E expenditures in situations where the amounts are deducted currently for financial reporting purposes will create a new deferred tax asset. Although the book/tax disparity in the treatment of R&E expenditures is viewed as a temporary difference (the R&E amounts will eventually be deducted for tax purposes), the ancillary effects of the new rules could have other tax impacts, such as on the calculation of GILTI inclusions and Foreign-Derived Intangible Income (FDII) deductions, which ordinarily give rise to permanent differences that increase or decrease a company’s effective tax rate. The U.S. valuation allowance assessment for deferred tax assets could also be impacted due to an increase in taxable income. Further, changes to both GILTI and FDII amounts should be considered in valuation allowance assessments, as such amounts are factors in forecasts of future profitability.

The new mandatory capitalization rules for R&E expenditures and resulting increase in taxable income will likely impact the computation of quarterly estimated tax payments and extension payments owed for the 2022 tax year. Even taxpayers with net operating loss carryforwards should be aware of the tax implications of the new rules, as they may find themselves utilizing more net operating losses (NOLs) than expected in 2022 and future years, or ending up in a taxable position if the deferral of the R&E expenditures is material (or if NOLs are limited under Section 382 or the TCJA). In such instances, companies may find it prudent to examine other tax planning opportunities, such as performing an R&D tax credit study or assessing their eligibility for the FDII deduction, which may help lower their overall tax liability.

Will the new rules be delayed?

The version of the Build Back Better Act that was passed by the US House of Representatives in November 2021 would have delayed the effective date of the TCJA’s mandatory capitalization rules for R&E expenditures until tax years beginning after December 31, 2025. While this specific provision of the House bill enjoyed broad bipartisan support, the BBBA bill did not make it out of the Senate, and recent comments by some members of the Senate have indicated that the BBB bill is unlikely to become law in its latest form. Accordingly, the original effective date contained in the TCJA (i.e., taxable years beginning after December 31, 2021) for the mandatory capitalization of R&E expenditures remains in place.
 
The changes to the tax treatment of R&E expenditures can be complex. While taxpayers and tax practitioners alike remain hopeful that Congress will agree on a bill that allows for uninterrupted immediate deductibility of these expenditures, at least for now, companies must start considering the implications of the new rules as currently enacted. 

Topics: r&d

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Read this if you work at a renewable energy company, developer, or other related business. 

When entering into agreements involving tangible long-lived assets, an asset retirement obligation can arise in the form of a legal obligation to retire the asset(s) at a certain date. In the alternative/renewable energy industry, these frequently present themselves in leases for property on which equipment (i.e., solar panels) is placed. In the leases there may be a requirement, for example, that at the conclusion of the lease, the lessee remove the equipment and return to the property to its original condition.

When an asset retirement obligation is present in a contract, a company should record the liability when it has been incurred (usually in the same period the asset is installed or placed in service) and can be reasonably estimated. The fair value of the liability, typically calculated using a present value technique, is recorded along with a corresponding increase to the basis of the asset to be retired. Subsequent to the initial recognition, the liability is accreted annually up to its future value, and the asset, including the increase for the asset retirement obligation, is depreciated over its useful life.

As a company gets closer to the date the obligation is realized, the estimate of the obligation will most likely become more accurate. When revisions to the estimate are determined, the liability should be adjusted in that period.

It is important to note that this accounting does not have any income tax implications, including any potential increase to the investment tax credit (ITC).

These obligations are estimates and should be developed by your management through collaboration with companies or individuals that have performed similar projects and have insight as to the expected cost. While this is an estimate and not a perfect science, it is important information to share with investors and work into cash flow models for the project, as the cost of removing such equipment can be significant. 

Recording the liability on the balance sheet is a good reminder of the approximate cash outflow that will take place in the final year of the lease. If you have any questions or would like to discuss with us, contact a member of the renewable energy team. We’re here to help.

Article
Asset retirement obligations in alternative/renewable energy

Read this if you use QuickBooks Online.

You should be running reports in QuickBooks Online on a weekly—if not daily—basis. Here’s what you need to know.

You can do a lot of your accounting work in QuickBooks Online by generating reports. You can maintain your customer and vendor profiles. Create and send transactions like invoices and sales receipts, and record payments. Enter and pay bills. Create time records and coordinate projects. Track your mileage and, if you have employees, process payroll.

These activities help you document your daily financial workflow. But if you’re not using QuickBooks Online’s reports, you can’t know how individual elements of your business like sales and purchases are doing. And you don’t know how all of those individual pieces fit together to create a comprehensive picture of how your business is performing. 

QuickBooks Online’s reports are plentiful. They’re customizable. They’re easy to create. And they’re critical to your understanding of your company’s financial state. They answer the small questions, like, How many widgets do I need to order?, and the larger, all-encompassing questions like, Will my business make a profit this year?

Getting the lay of the land

Let’s look at how reports are organized in QuickBooks Online. Click Reports in the toolbar. You’ll see they are divided into three areas that you can access by clicking the labeled tabs. Standard refers to the comprehensive list of reports that QuickBooks Online offers, displayed in related groups. Custom reports are reports that you’ve customized and saved so you can use the same format later. And Management reports are very flexible, specialized reports that can be used by company owners and managers.


A partial view of the list of QuickBooks Online’s Standard reports 

Standard reports

The Standard Reports area is where you’ll do most—if not all—of your reporting work. The list of available reports is divided into 10 categories. You’re most likely to spend most of your time in just a few of them, including:

  • Favorites. You’ll be able to designate reports that you run often as Favorites and access them here, at the top of the list.
  • Who owes you. These are your receivables reports. You’ll come here when you need to know, for example, who is behind on making payments to you, how much individual customers owe you, and what billable charges and time haven’t been billed.
  • Sales and customers. What’s selling and what’s not? What have individual customers been buying? Which customers have accumulated billable time?
  • What you owe. These are your payables reports. They tell you, for example, which bills you haven’t paid, the total amount of your unpaid bills (grouped by days past due), and your balances with individual vendors.
  • Expenses and vendors. What have I purchased (grouped by vendor, product, or class)? What expenses have individual vendors incurred? Do I have any open purchase orders?

The Business Overview contains advanced financial reports that we can run and analyze for you. The same goes for the For my accountant reports. Sales tax, Employees, and Payroll will be important to you if they’re applicable for your company.

Working with individual reports


Each individual report in QuickBooks Online has three related task options.

To open any report, you just click its title. If you want more information before you do that, just hover your cursor over the label. Click the question mark to see a brief description of the report. If you want to make the report a Favorite, click the star so it turns green. And clicking the three vertical dots opens the Customize link. 

When you click the Customize link, a vertical panel slides out from the right, and the actual report is behind it, grayed out. Customization options vary from report to report. Some are quite complex, and others offer fewer options. The Sales by Customer Detail report, for example, provides a number of ways for you to modify the content of your report so it represents exactly the “slice” of data you want. So you can indicate your preferences in areas like:

  • Report period
  • Accounting method (cash or accrual)
  • Rows/columns (you can select which columns should appear and in what order, and group them by Account, Customer, Day, etc.)
  • Filter (choose the data group you want represented from several options, including Transaction Type, Product/Service, Payment Method, and Sales Rep)

Once you’ve run the report, you can click Save customization in the upper right corner and complete the fields in the window that opens. Your modification options will then be available when you click Custom reports, so you can run it again anytime with fresh data.


You can customize QuickBooks Online’s reports in a variety of ways.

We’ll go into more depth about report customization in a future article. For now, we encourage you to explore QuickBooks Online’s reports and their modification options so that you’re familiar with them and can put them to use anytime. Contact our Outsourced Accounting team if you have any questions about the site’s reports, or if you need help making your use of QuickBooks Online more effective and productive.

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Getting started with reports in QuickBooks Online

Read this if you use QuickBooks Online.

Are you taking on a worker who’s not an employee? QuickBooks Online includes tools for tracking and paying independent contractors.

The COVID-19 pandemic created millions of self-employed individuals and small businesses. Whether they chose to, or circumstances forced them to, these new entrepreneurs had to learn new ways to get paid and to prepare their income taxes.

If you’re thinking about taking on a contract worker, you, too, will have to educate yourself on the paperwork and processes required to comply with the IRS’ rules for his or her compensation. It’s much easier than hiring a full-time employee, but it still takes some knowledge of how QuickBooks Online handles these individuals.

You’ll also need to make certain that the person you’re hiring is indeed an independent contractor and not an employee. The IRS takes this distinction very seriously. If you’re at all unsure of your new hire’s employment status, we can help you sort it out.

Creating records for contractors

Once new contractors have accepted your offer, you’ll need to have then fill out an IRS Form W-9. You can download a copy here. Employees complete the more detailed Form W-4 so that the employer can withhold income taxes correctly, but you won’t have to withhold taxes for your contract workers. They will be responsible for calculating and paying quarterly estimated taxes and filing an IRS Form 1040 every year. 

You, though, will be responsible for sending them an IRS Form 1099-NEC (Non-Employee Compensation) every January if you paid them more than $600 during the previous year. You do not need to send a 1099-NEC to a corporation or to an LLC that is treated as a C Corp or an S Corp. 

You can complete the Vendor Information window for each independent contractor, checking the box in front of Track payments for 1099.

Using the information the contractors provide, you can create records for them in QuickBooks Online. If you don’t have a QuickBooks Payroll subscription, you can set them up as 1099 vendors. Click the Expenses tab in the toolbar and then on the Vendors tab. Click New vendor in the upper right to open the Vendor Information window. Complete the fields for the worker and be sure to check the box in front of Track payments for 1099, as shown in the partial image above.

The vendor records you create will appear in QuickBooks Online’s Vendors list (again, Expenses | Vendors). Click on one to open it. You can toggle between two tabs here. The first, Transaction List, will eventually display all your financial dealings with that contractor. Vendor Details opens the record you just created, which you can edit from this screen.

Paying contractors

When independent contractors send you invoices, you’ll return to this same screen. There are three ways you can pay them. Click the down arrow next to New Transaction in the upper right corner to see your options (or look down at the end of the row while you’re in list view). You can record the debt as a Bill if you want to pay it later (or if that’s the way you structure your recordkeeping). If you’re paying it right away, you can create an Expense or write a Check

You can choose an option from this vendor action menu to pay your independent contractors.

When you click one of these, QuickBooks Online opens a form with many of the contractors’ details already filled in. You’ll need to complete any additional fields at the top of the screen, and then either record the payment or debt under Category details or Item details, depending on how you do your bookkeeping. Either way, you’ll be able to enter the quantity and rate and/or amount and mark it billable (with a markup percentage, if you’d like) to a customer or project.

You’re probably going to want our help here, since there’s more than one way to pay independent contractors. If you subscribe to QuickBooks Payroll, you can use the service’s contractor features, which include the ability to invite your contractors to fill out their own records in QuickBooks Online. You may also want to add an account to your Chart of Accounts, and we’d want to offer guidance there. And you need to ensure that you’re classifying payments correctly, so they’ll appear in 1099 reports and 1099s themselves.

Creating records for independent contractors and paying these individuals seem like they should be simple operations. But anytime you’re dealing with payroll issues, you’re dealing with peoples’ livelihoods – and the IRS. We strongly encourage you to let us help you get this right. Contact the Outsourced Accounting team, and we’ll make sure you’re handling your worker payments with absolute accuracy.

Article
Hiring an independent contractor? How QuickBooks Online can help

The automotive industry is experiencing a convergence of disruptions unlike any seen since 1910. Autonomous, connectivity, electrification, mobility, and subscription business models are reshaping the automotive industry and creating a frenzy of activity.

There are dozens of self-driving car companies, an untold number of connectivity applications, and over 500 mobility related technology and technology-enabled solutions offered by existing companies and start-ups. Additionally, there are subscription models with varying degrees of success, with some original equipment manufacturers (OEMs) terminating programs recently and others recommitting to them, and regarding electric vehicles (EV), there are 17 public EV OEMs and four private EV OEMs. As Harley-Davidson’s recent announcement to take its EV division, LiveWire, indicates there is ample fuel to fund new entrants into this space and capital to accelerate innovation. Where this lands is anyone’s guess but the factors at play do suggest significant uncertainty.

To highlight the disruption occurring within the automotive landscape, two great examples of disrupters entering the market are Tesla and Carvana. These two companies currently have market capitalization that far exceed the traditional dealerships and OEMs. Carvana has a market cap of $31B, exceeding the combined market capitalization of Carmax, AutoNation, and Asbury. Tesla has a market cap of $1T, exceeding the combined market capitalization of Toyota, Volkswagen, GM, and Ford.

An integral part of the industry, dealerships are also seeing significant changes, especially as it pertains to EV, which is the focus of our discussion in the rest of this article.

The market for electric vehicles

The market for EVs resulted from changes in three main areas including regulation, consumer behavior, and technology.

Regulation

Governments and cities have introduced regulations and incentives to accelerate the shift to sustainable mobility. Regulators worldwide are defining more stringent emissions targets. The European Union seeks to align climate, energy, land use, transport, and taxation policies to reduce net greenhouse gas emissions by at least 55% by 2030. The Biden administration introduced a 50% EV target for 2030.

Consumer behavior

Consumer mindsets have also shifted toward sustainable mobility, with more than 45% of consumers considering buying an EV. A recent survey by Cars.com revealed two-thirds of Americans are interested in buying an EV, despite barriers such as higher sticker prices than internal combustion engine (ICE) models and limited access to charging stations. In China, consumer interest is even stronger than in Europe and the US.

Technology

Both the convergence of technological innovations (e.g., autonomous) and battery development have created the path to an emissions free industry.

Are electric vehicles here to stay?

For many years, lack of product availability, unfavorable pricing, limited charging infrastructure and battery range, and consumer demand have held back the widespread adoption of EV. However, the tipping point in passenger EV adoption occurred in the second half of 2020, when EV sales and penetration accelerated in major markets despite the economic crisis caused by the COVID-19 pandemic. Europe spearheaded this development, where EV adoption reached 8% due to policy mandates such as stricter emissions targets for OEMs and generous subsidies for consumers.

On a global level, a recent McKinsey study projects EV adoption will reach 45% by 2030-2035 under current expected regulatory targets, with the major markets reaching these levels on varying timelines. New regulatory targets in the European Union and the United States now aim for an EV share of at least 50% by 2030, and several countries have announced accelerated timelines for ICE sales bans in 2030 or 2035. By 2035, the largest automotive markets will go nearly entirely electric.

  • Europe may reach 60% – 75% EV sales by 2030, driven by regulatory targets on the low end and on reported consumer preference on the high end.
  • In the US, in Q2 2021, EV sales reached 3.6% of total car sales. The aggressive electrification target for 2030 and US OEMs support of electrification have led to many declaring ICE bans by 2035.

China will also continue to see strong growth in electrification and remain the largest EV market by vehicle volume based on strong consumer demand, despite low EV subsidies and no official end date for ICE sales. Adoption modeling yields a Chinese EV share as much as 70% for new car sales in 2030.

Some OEMs have stated their intentions to stop investing in new ICE platforms and models and many more have already defined a specific date to end ICE vehicle production. There will be 100 EVs offered by over 25 OEMs in the US market by 2024. Many large traditional OEMs are targeting 50%-70% EV in all markets by 2030:


 
Headwinds to transition

While there is strong momentum toward EV transition and bets made by governments and OEMs will only accelerate it, there are significant headwinds which may slow the pace of the transition. Public institutions, businesses, and consumers will need to resolve several issues and overcome some challenges.

Chips

AlixPartners estimates the chip shortage has cost the industry $210B and 7.7 million units in 2021, doubling their forecast in May. And yet, according to Intel CEO, Pat Gelsinger, by 2030 chips will make up 20% of the components of premium cars — five times more than their proportion in 2019. Despite the major announcements of investments in new fab plants in the US and elsewhere, the long development time to bring these operations online begs the question whether this additional capacity will come in time to support the demand for EVs.

Battery prices

The high cost of vehicles based on batteries continues to hold back consumers. As lithium prices soar, reflecting escalating demand and limited sources of production, it’s unclear when battery costs will decline to establish EV vehicle price parity with ICE vehicles. That said, EV motor maintenance is limited to 100,000. While motors and engines last upwards of 20 years, the typical EV battery lasts 200,000 miles — not quite 20 years. Tesla, however, is rumored to be developing an EV battery that will last 1,000,000 miles, which would extend the life of an EV vehicle well beyond the 11.9 years of today’s average vehicle. So, over time, the total cost of ownership of an EV vehicle is likely to decline enough to overcome any consumer resistance due to price.

 Charging infrastructure

The lack of charging infrastructure and limited EV range due to battery life has greatly inhibited EV adoption. The Bipartisan Infrastructure Framework includes $15 billion to speed up adoption of EVs and accelerate the US EV market. The plan sets aside $7.5 billion to construct a nationwide EV charging network. However, according to a report issued in July 2021 by The International Council on Clean Transportation, the total charging units in homes, workplaces, and public stations to support the EV goals set by government and OEMs will require tremendous investments in charging stations, notably in home charging stations, and the electrical grid infrastructure to support demand. It is uncertain whether the required rate of growth in charging stations and grid capacity can be met to support EV goals.

New business models

Another issue on dealers’ minds is direct-to-consumer (D2C) sales, the business model that’s fueled Tesla’s marketing of more than 2,000,000 EVs sold to date. Tesla does operate about 160 company-owned showrooms, yet sales are transacted online. At last count, 33 states allowed D2C auto sales, with others’ legislatures debating bills that would bypass the so-called franchise system that has legally connected dealers and manufacturers for more than a century. National Automobile Dealers Association (NADA), state dealer groups and traditional automakers have advocated maintaining the franchise system, claiming that it levels the playing field.

Impact on after-market spending and margins

One genuine concern for dealerships is the fact that EVs don’t require oil changes, transmission repairs and other services owners of ICE vehicles routinely bear —services that account for 50% of dealerships’ gross profits. ICE vehicles have 2,000 moving parts while EVs have 20. Fewer moving parts require less maintenance and repair and lowers vehicle service contract (VSC) attachment rates. While owners will spend more on EV related parts (e.g., tires), BEV owners will likely spend 40% less on after-market parts and service compared to ICE owners by 2030. A 2019 report from AlixPartners estimates that dealers could see $1,300 less revenue in service and parts over the life of each EV they sell.

While this does not bode well for dealership profitability, the US now has a record 280 million cars, trucks, and SUVs registered with state motor vehicle departments. The average age of vehicles in the US has climbed to an all-time high of 11.9 years. One in four cars and trucks on the road are at least 16 years old. So, despite EV sales trending towards 50%-75% of total sales in the largest markets by 2030, the impact on dealership profitability will not be abrupt. With a significant install base of ICE vehicles with a remaining life that will extend well past 2030 and a continuing high volume of ICE vehicle sales over the next three years, dealerships do have some time to plan. 

Implications and key takeaways for dealers

One thing is clear: Dealerships are operating within an increasingly disrupted environment which has affected the bottom line and created some uncertainty for the future. Over the past several years (with the exception of the COVID-19 pandemic) dealerships have experienced margin compression on vehicle sales. With threats to their services business, margin compression could continue. Higher front-end margins, notably in finance and insurance (F&I), will come under further pressure as EV and battery prices decline.

The good news? Most EV OEMs require factory authorized dealership service departments for repair and maintenance. Further, even though 70% of aftermarket service of ICE vehicles are handled by independent shops, franchise dealers don’t want to cede EVs to them, especially as consumers familiarize themselves with battery charging and other peculiarities. “The EV owner might trust the dealers more to perform service than the aftermarket shops earlier in their ownership period,” according to Chris Sutton, Vice President of automotive retail for market research firm J.D. Power. So, the threat of DIY and independent service centers may be limited in the near term.

For reasons outlined in “The Dealership of Tomorrow 2.0” report, prepared in February 2020 by Glen Turner for NADA, the dealership model of store ownership should remain very dominant in the US through at least 2030, even with the disruption caused by EVs. The trend of the decline in store owners, however, will continue with rooftops per owner increasing from two stores per owner before the Great Recession to three stores per owner by the late 2020s. That’s a 50% increase in stores per owner.

Although the margin compression and scale of the investments to counter the disruptive forces dealerships face are significant and would typically suggest greater consolidation, Glen asserts that economies of scale are probably elusive beyond chains of 50-100 stores. So, there may very well be some leaders who emerge as winners in this transition.

The path forward

Many dealerships are embracing the EV transition. While there are fundamentals to guide dealerships over the coming years, there are many uncertainties and unanswered questions. To address these uncertainties and develop a plan to confidently face the future, dealerships should develop a business strategy, shift their operating model, and build a roadmap for change.

Regarding strategy, the key question centers on the degree of scale necessary to compete and grow profitably. Which portfolio of brands to invest in? How many stores to develop and in which markets? Whether to acquire other dealerships?

In redefining the operating model, dealerships must focus on how to create the best customer experience efficiently and effectively. How to enable this through the optimal digital and omnichannel strategy in collaboration with the OEMs? Should subscription services be offered for bundles of brand and vehicle portfolios and/or maintenance programs? Whether, when, and to what degree to invest in charging infrastructure to reduce electricity costs and/or to create new revenue streams by selling electricity back to the grid or by providing a service to customers? What role does solar play in this approach? How to fully utilize the federal, state, and local incentives? How to design the site plan to accommodate battery quarantines? What risks and costs are associated with onsite EV infrastructure? What insurance coverages are necessary and plans for litigation support may be appropriate? How to comply with OEM service department requirements and ensure the number of required and certified technicians are retained?

Once dealerships have answered these questions, the opportunities will need to be prioritized and organized into a roadmap to guide the transition through 2030 and beyond. For any investments required, a clear and tangible business case should be developed to properly filter out those initiatives which should and shouldn’t be pursued.

Written by Bob Gray. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com

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Electric vehicles: Convergence of the industry

Read this if you are a not-for-profit organization.

With springtime upon us, it may be difficult to start thinking about this upcoming fall, but that is exactly what many folks in the nonprofit sector are starting to do. The reason for this? It’s because 2022 brings with it the mid-term election cycle. While technically an off-year election, many congressional and gubernatorial races are being contested, in addition to a myriad of questions that will appear on ballots across the country. It is around this time of year we start to see many questions from clients in the nonprofit sector in the area of political campaign activities, lobbying (both direct and grassroots), and education/advocacy.

This article will discuss the three major types of activities nonprofit organizations may or may not undertake in this arena and will offer guidance to give organizations the vote of confidence they need to not run afoul of the potential pitfalls when it comes to undertaking these activities.

Political campaign activity

Political campaign activities include participating or intervening in any political campaign on behalf of (or in opposition to) any candidate for elective public office, be it at the federal, state, or local level. Examples of such activities include contributions to political campaigns as well as making public statements in favor of or in opposition to any candidate. The IRS explicitly prohibits section 501(c)(3) organizations from conducting political campaign activities, the consequence of doing so being loss of exempt status. However, other types of exempt organizations (such as 501(c)(4) organizations) are allowed to engage in such activities, so long as those activities are not the organization’s primary activity. Only Section 527 organizations may engage in political campaign activities as their primary purpose. 

Direct lobbying

Direct lobbing activities attempt to influence legislation by directly communicating with legislative members regarding specific legislation. Examples of direct lobbying include contacting members of Congress and asking them to vote for or against a specific piece of legislation.

Grassroots lobbying

Grassroots lobbying, on the other hand, attempts to influence legislation by affecting the opinions of the general public and include a call to action. Examples of grassroots lobbying include requesting members of the general public to contact their representatives to urge them to vote for or against specific legislation.  

A quick way to remember the difference:
Political = think “P” for People – advocating for or against a specific candidate 
Lobbying = think “L” for Legislation – advocating for or against a specific bill

Education/advocacy

Organizations may engage in activities designed to educate or advocate for a particular cause so long as it does not take a specific position. For example, telling members of Congress how grants helped constituents would be considered an educational activity. However, attempting to get a member of Congress to vote for or against specific piece of legislation that would affect grant funding would be considered lobbying. Another example would be educating or informing the general public about a specific piece of legislation. Organizations need to be mindful here as taking a specific position one way or the other would lend itself to the activity being deemed to be lobbying, and not merely education of the general public. There is no limit on how much education/advocacy activity a nonprofit organization may conduct.

Why does this matter?

As you can see, there is a very fine line between lobbying and education, so it is important to understand the differences so that an organization conducting educational activities does not inadvertently end up conducting lobbying activities.

Organizations exempt under Code Section 501(c)(3) can conduct only lobbying activities that are not substantial to its overall activities. A 501(c)(3) organization may risk losing its exempt status and may face excise taxes on the lobbying expenditures if it is deemed to be conducting excess lobbying, whereas section 501(c)(4), (c)(5), and (c)(6) organizations may engage in an unlimited amount of lobbying activity.

What is substantial?

Unfortunately, there is no bright line test for determining what is considered substantial versus insubstantial. As an industry standard, many practitioners have taken a position that insubstantial means five percent or less of total expenditures, but that position is not codified and could be challenged by the IRS. 

Section 501(c)(3) organizations that intend to conduct lobbying activities on a regular basis may want to consider making an election under Code Section 501(h). This election is only applicable to 501(c)(3) organizations and provides a defined amount of lobbying activity an organization may conduct without jeopardizing its exempt status or becoming subject to excise tax. The 501(h) election limit is based on total organization expenditures with a maximum allowance of $1 million for “large organizations” (defined as an organization with total expenditures over $17,000,000). 

While the 501(h) election provides some clarity as to how much lobbying activity can be conducted, it may be prohibitive for some organizations whose total expenditures greatly exceed the $17,000,000 threshold. Another item to be aware of is that the lobbying threshold applies to all members of an affiliated group combined, which means the entire group shares the maximum threshold allowed. 

Another option for those engaging in lobbying is to create a separate entity (such as a 501(c)(4) organization) which conducts all lobbying activities, insulating the 501(c)(3) organization from these activities. As previously mentioned, organizations exempt under Code Section 501(c)(4) can conduct an unlimited amount of lobbying activities but can only conduct limited political campaign activities.

What about political campaign activities?

Section 527 organizations, known as political action committees, are exempt organizations dedicated specifically to conducting political campaign activities. If a 501(c)(4), (c)(5), or (c)(6) organization makes a contribution to a 527 organization, it may be required to file a Form 1120-POL and be subject to tax at the corporate tax rate (currently a flat 21%) based on the lesser of the political campaign expenditures or the organization’s net investment income. State income taxes may also be applicable. Section 501(c)(3) organizations may not make contributions to 527 organizations. 

If your organization is considering participation in any of the above activities, we would recommend you reach out to your not-for-profit tax team for additional information. We’re here to help!

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Lobbying and politics and education, oh my!

Read this if you are a community bank.

The Federal Deposit Insurance Corporation (FDIC) recently issued its fourth quarter 2021 Quarterly Banking Profile. The report provides financial information based on Call Reports filed by 4,839 FDIC-insured commercial banks and savings institutions. The report also contains a section specific to community bank performance. In fourth quarter 2021, this section included the financial information of 4,391 FDIC-insured community banks. BerryDunn’s key takeaways from the community bank section of the report are as follows:

  • The banking industry as a whole saw a $132 billion increase in net income from a year prior despite continued net interest margin (NIM) compression. This increase was mainly attributable to the $163.3 billion decrease in provision expense, supported by continued economic growth and supplementary credit quality improvement. NIM declined to 2.54%, a 28 basis-point decrease from 2020 as the growth rate in average earning assets outpaced the growth rate in net interest income.
  • For community banks, full-year net income increased $7.4 billion to $32.7 billion. Despite the increase in annual net income, community banks saw a $719.9 million decrease in net income from third quarter 2021. Higher noninterest expenses continue to place pressure on community banks as inflation rates spike going into 2022. Annual NIM fell 12 basis points from 2020 to 3.27%. The average yield on earning assets fell 42 basis points to 3.58%, while the average funding cost fell 30 basis points to 0.31%. The percentage of unprofitable community banks declined to 3.2%, the lowest level on record. 

    *See Exhibit B at the end of this article for more information on the fourth-quarter year-over-year change in income.
     
  • Net gains on loan sales revenue declined $1.5 billion (50.6%) from fourth quarter 2020. However, growth in net interest income of $1.3 billion (6.7%) from fourth quarter 2020 overcame the $707 million decline in noninterest income. Net operating revenue increased $588.4 million (2.3%) from fourth quarter 2020.
  • Noninterest expense increased 3.4% from fourth quarter 2020. This increase was mainly attributable to higher data processing and marketing expenses. That being said, average assets per employee increased 10% from fourth quarter 2020. Noninterest expense as a percentage of average assets declined 16 basis points from fourth quarter 2020 to 2.51%, despite 69.4% of community banks reporting higher noninterest expense.
  • Noncurrent loan balances (loans 90 days or more past due or in nonaccrual status) declined by $1.1 billion to $11.1 billion from third quarter 2021. The noncurrent rate dropped 7 basis points to 0.58% from third quarter 2021, the lowest noncurrent rate on record for community banks.
  • The coverage ratio (allowance for loan and lease losses as a percentage of loans that are 90 days or more past due or in nonaccrual status) increased 53.7 percentage points from a year ago to 223.8%. This ratio is well above the 147.9% reported before the pandemic in fourth quarter 2019 and continues to be a record high. The coverage ratio for community banks is 49.9 percentage points above the coverage ratio for noncommunity banks. As a result, provision expense declined $914.9 million from fourth quarter 2020, but remained at $320.8 million for fourth quarter 2021, representing a $39.2 million increase from third quarter 2021.
  • The net charge-off rate declined 6 basis points from fourth quarter 2020 to 0.09%.
  • Trends in loans and leases started looking up, as community banks saw an increase of $24.3 billion within fourth quarter 2021. This growth was mainly seen in the nonfarm nonresidential commercial real estate (CRE), which held a balance of $16.3 billion. Total loans and leases increased by $34.2 billion (2%) for the year 2021. Growth of $50.6 billion in CRE loans attributed to the increase. A decline in commercial and industrial loan balances of $62.3 billion (20.1%) from fourth quarter 2020 offset a portion of this increase. This decline was mainly due to Paycheck Protection Program (PPP) loan repayment and forgiveness.

    *See Exhibit C at the end of this article for more information on the change in loan balances.
     
  • More than 75% of community banks reported an increase in deposit balances for the fourth quarter. In total, deposit growth was 2.8% during fourth quarter 2021.
  • The average community bank leverage ratio (CBLR) for the 1,699 banks that elected to use the CBLR framework was 11.2%, nearly unchanged from third quarter 2021. The average leverage capital ratio was 10.16%.
  • The number of community banks declined by 59 to 4,391 from third quarter 2021, a decrease of 168 from December 2020. This change includes six banks transitioning from community to noncommunity banks, four banks transitioning from noncommunity to community banks, 54 community bank mergers or consolidations, and three community banks having ceased operations.

Fourth quarter 2021 was another strong quarter for community banks, as evidenced by the increase in year-over-year quarterly net income of 7.1% ($511.6 million). This quarter concluded another strong year financially for community banks. However, NIMs continue to show record lows, as shown in Exhibit A, which shows the trends in quarterly NIM.

The consensus remains that community banks will likely need to find creative ways to increase their NIM, grow their earning asset bases, or continue to increase noninterest income to maintain current net income levels. In regards to the latter, many pressures to noninterest income streams exist. Financial technology (fintech) companies are changing the way we bank by automating processes that have traditionally been manual (for instance, loan approval). Decentralized financing (DeFi) also poses a threat to the banking industry. Building off of fintech’s automation, DeFi looks to cut out the middle-man (banks) altogether by building financial services on a blockchain. Ongoing investment in technology should continue to be a focus, as banks look to compete with non-traditional players in the financial services industry. 

The larger, noncommunity banks are also putting pressure on community banks and their ability to generate noninterest income, as recently seen by Citi, Bank of America, and many other large banks following behind Capital One Bank in eliminating all overdraft fees. According to the Consumer Financial Protection Bureau, the financial services industry brought in $15.5 billion in overdraft fees in 2019. Seen as a move to enhance Capital One Bank’s financial inclusion of customers, community banks will also need to find innovative ways to enhance relationships with current and potential customers. As fintech companies and DeFi become more mainstream and accepted in the marketplace, the value propositions of community banks will likely need to change. Furthermore, as PPP loan forgiveness comes to an end, PPP loan fees will no longer supplement revenues. Although seen as a one-time extraordinary event, this fee income was significant for many community banks’ 2021 and 2020 revenues.

The importance of the efficiency ratio (see Exhibit D below) is also magnified as community banks attempt to manage their noninterest expenses in light of low NIMs and inflationary pressures. Although noninterest expense as a percentage of average assets declined 16 basis points from fourth quarter 2020, such expenses increased 3.4% from fourth quarter 2020. And, inflationary pressures will likely be exacerbated as a result of Russia’s invasion of Ukraine. Inflationary pressure was already seen in fourth quarter 2021, as net income decreased $719.9 million from third quarter 2021, despite only a $39.2 million increase in provision expense from third quarter 2021. Banks with manual processes can improve efficiency and support a remote workforce with increased automation.

Furthermore, many of the uncertainties that we have been discussing quarter-over-quarter, and that have thus become “themes” for the banking industry in 2021, still exist. For instance, although significant charge-offs have not yet materialized, the financial picture for many borrowers remains uncertain. Also, payment deferrals have made some credit quality indicators, such as past due status, less reliable. Payment deferrals for many borrowers are coming to a halt and many community banks had nominal amounts of borrowers that remained on deferral as of December 31, 2021. So, the true financial picture of these borrowers may start to come into focus. The ability of community banks to maintain relationships with their borrowers and remain apprised of the results of their borrowers’ operations has never been more important. This monitoring will become increasingly important as we transition into a post-pandemic economy.

The outlook for office space remains uncertain. Many employers have either created or revised remote working policies due to changing employee behavior. If remote working schedules persist, whether it be full-time or hybrid, the demand for office space may decline, causing instability for commercial real estate borrowers. As noted in a recent FDIC article, “the full effects of changing dynamics in the sector are still developing. Office property demand may take time to stabilize as tenants navigate remote work decisions and adjust how much space they need.” The FDIC article further mentions reduced office space could also have implications for the multifamily and retail markets that cater to those office employees. Similarly, the hotel industry remains in flux and the post-pandemic success of the industry is likely dependent on the recovery of business travel and gas prices for hotels dependent on summer tourism. If virtual conferences and meetings become the new norm, the hotel industry could see itself having to pivot. Even a transition to a hybrid model, which is more likely to occur, could have significant implications for the industry. Banks should closely monitor these borrowers, as identifying early signs of credit deterioration could be essential to preserving the relationship.

The financial services industry is full of excitement right now. While the industry faces many challenges, these challenges also bring opportunity for banks to experiment and differentiate themselves. Bank customers arguably need the assistance of their bank more than ever as they navigate continued financial uncertainty. This need allows community banks to do what they do best: develop long-lasting relationships with customers and become a trusted advisor. If there is anything this pandemic has shown to the financial industry, it is that community banks are truly one of the leaders of their communities. As always, please don’t hesitate to reach out to BerryDunn’s Financial Services team if you have any questions.

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FDIC Issues its Fourth Quarter 2021 Quarterly Banking Profile

Read this if you have a cybersecurity program.

This week President Joe Biden warned Americans about intelligence that indicated Russia may be preparing to conduct cyberattacks on our private sector businesses and infrastructure as retaliation for sanctions applied to the Russian government (and the oligarchs) as punishment for the invasion of Ukraine. Though there is no specific threat at this time, President Biden’s warning has been an ongoing message since the invasion began. There is no need to panic, but this is a great time to re-visit your current security controls. Focusing on basic IT controls goes can make a big difference in the event of an attack, as hackers tend to go after the easy, low hanging fruit. 

  1. Access controls
    Review and understand how all access to your networks is obtained by on-site employees, remote employees, and vendors and guests. Make sure that users are maintaining strong passwords and that no user is connecting remotely to any of your systems without some form of multi-factor authentication (MFA). MFA can come in the form of a token (in hand or built-in) or as one of those numerical codes you have delivered to your phone or email. Poor access controls are simply the difference between leaving your house unlocked versus locked when you leave to go somewhere. 
  2. Patching
    One of the most common audit findings we have to date and one of the biggest reasons behind successful attacks is related to unpatched systems. Software patches are issued by software providers to address vulnerabilities in systems that act as an unlocked door to a hacker, and allow hackers to leverage the vulnerability as a way to get into your systems. Ensuring your organization has a robust patch management program in place and that systems are up-to-date on needed patches is critical to your security operations. Think of an unpatched system like a car with a broken window—sure the door is locked, but any thief can reach through the broken window and unlock the car. 
  3. Logging 
    Account activity, network traffic, system changes—these are all things that can be easily logged and with the right tools, configured to alert you to suspicious activity. Logging that is done correctly can alert management to suspicious activity occurring on your network and notifies your security team to investigate the issue. Consider logging and alerting like your home’s security camera. It may alert you to the activity outside, but someone still needs to review the footage and react to it to mitigate the threat.  
  4. Test backups and more
    Making sure that your systems are successful backed up and kept separate from your production systems is a control we are all familiar with. Organizations should do more than just make sure their backups are performed nightly and maintained, but need to make sure that those data backups can be restored back to a useable state on a regular basis. More so than backups, we also often hear in the work we do that our client’s test only parts of their disaster recovery and failover plans—but have never tested a full-scale fail-over to their backup systems to determine if the failover would be successful in the event of an event or disaster. Organizations shouldn’t be scared to do a full-scale failover test, because when the time comes, you may not have the option to do a partial failover and just hope that it occurs successfully. Not testing your backups is like not test driving a car before you buy it. Sure it looks nice in the lot, but does it actually run? 
  5. Incident Management Plan 
    We often review Incident Management Plans as part of the work we do, and often note that the plans are outdated and contain incorrect information. This is an ideal time to make sure your plans are current and reflect changes that may have occurred, like your increasingly remote work force, or that systems have changed. An outdated Incident Management Plan is like being sick and trying to call your doctor for help only to find out your doctor has retired. 
  6. Training—phishing attacks
    Hackers’ most common approach to gain access to systems and deploy crippling ransomware attacks is through phishing campaigns via email. Phishing campaigns trick a user into either providing the hacker with credentials to log into systems or to download malware that could turn into ransomware through what appears to be legitimate business correspondence. Training end-users on what to look for in verifying an email’s authenticity is critical and should be seen as an opportunity that benefits the entire organization. Testing users is also critical so management understands the current risk and what is needed for additional training. Security teams should also have other supporting controls to help prevent phishing emails and detection tools in place in case a user does fall for an email. Not training your employees on security is like not coaching your little league team on how to play baseball and then being surprised you didn’t win the game because no one knew what to do. 

In the current environment, information security is an asset to any organization and needs to be supported so that you can protect your organization from cyberattacks of all kinds. While we can never guarantee that having controls in place will prevent an attack from occurring, they make it a lot more challenging for the hacker. One more analogy, and then I’m done, I promise. Basic IT controls are like speedbumps in a neighborhood. While they keep most people from speeding (and if you hit them too fast they do a number on your car), you can still get over them with enough motivation. 

If you have questions about your cybersecurity controls, or would like more information, please contact our IT security experts. We’re here to help.

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Cyberattack preparation: A basics refresher

When we meet with hospital boards to review the results of their audit, we are most often asked to share what we are seeing in the industry—and how their hospital compares with others in our client base. As we (hopefully) emerge from the COVID-19 pandemic, I wanted to see where we are as an industry after two challenging years. In reviewing our own benchmarking data, and reading this very comprehensive CFO Outlook Survey by BDO, it reinforced that these are challenging times indeed. 

The pressures of top line sustainability, cost containment, and recruitment and retention of talent are very real. And while healthcare providers are seasoned to the continual challenges and opportunities, the difference going forward, post-pandemic, will be what this looks like for rural providers without the influx of stimulus funds and beyond the initial surge of postponed surgeries. Based on the BDO survey, 69% of healthcare organizations surveyed expect an increase in profitability. Is your organization prepared to take the steps to make it happen? What is your financial resilience outlook?

You can read the survey here. If you would like to discuss further, please contact our Hospital Consulting team. We’re here to help.
 

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Healthcare survey: A comprehensive look at the industry