I’ve spent a lot of time talking with not-for-profit clients and friends of our firm that are frustrated with their existing accounting or enterprise resource planning (ERP) system. Many are convinced, at first, that the problem lies with their technology, but I’m a huge advocate of addressing people and process issues first, before tackling systems. You can have the best technology in place, but if the people haven’t been trained to use it, and the processes aren’t aligned with how the system is set up, the output won’t meet the needs of your organization. After spending time to truly understand the root causes of many not-for-profits’ frustrations, I’ve identified three common themes and solutions below.

Mindset/People

Many not-for-profit staff are already strapped for time to get their daily functions done, which makes taking on additional projects a challenge. I often hear, “I don’t have time for that” or “We’ll deal with it later” when talking about how staff are addressing missing functionality within the accounting system or the communication gaps between departments. However, by spending a little time today, organizations can see time savings and efficiencies almost immediately.

Solution

Embrace a new mantra that investing staff time and effort in the short-term to fix issues will benefit both the organization and its people. By implementing a philosophy of change management — an umbrella term for approaches taken to prepare, support, and help individuals, teams, and organizations make structural change — you can gain long-term benefits with incremental changes. To implement the change management strategy:

• Set up a meeting to specifically talk through a problem or issue.
• Put together a cross functional team with a project champion to tackle a barrier collectively.
• Block time daily or weekly on your calendar for problem solving.

Policies and Procedures/Process

When improving your processes, the first question to ask is, “Are my finance and accounting policies and procedures documented?” About half the time the answer is no. Even if they have been documented, your organization may not have reviewed or updated policies and procedures for a while. Most not-for-profit organizations made adjustments to their processes during the pandemic and some of those changes are here to stay. The most common workflow impacted by the pandemic typically involved accounts payable, which could affect your capitalization policy, signing authority, information retention location, approval process, security protocols, and utilization of ACH capability. To keep your organization running smoothly in today’s environment, it’s time to invest in updating practices! In addition to looking at the impact of a hybrid work model on processes, don’t forget about:

• New accounting standards such as leases and contributed nonfinancial assets, and new procedures your auditors may be required to perform related to your annual report.
• Data contained in spreadsheets that could potentially be tracked within the accounting system.
• Painful reconciliation processes between departments, especially related to donations, grants, and impact metrics.
• Internal controls and new risks that might have emerged due to new funding streams or changes to your operations.

Solution

Reach out to your CPA or consulting firm to discuss the desire to either document, review, or update the organization’s existing policies and procedures. This could include facilitating a conversation between departments to strengthen communication and reduce excess reconciliation of data at month, quarter, or year-end. I recommend putting together a project plan to tackle individual pieces. This would include getting time on the finance committee agenda for policy review and the board of directors’ agenda for policy approval.

Efficiency Review

Typically, after helping not-for-profit organizations identify the required functionality they need in new technology for the entire organization, and comparing those needs with their existing accounting/ERP system functionality, there aren’t as many gaps as originally suspected! These suspected gaps can usually be attributed to not investing in training due to “not having enough time” and not solving the problem before setting up a spreadsheet or buying a new add-on tool as a “quick” fix. Embracing that training, and staying current on updates or enhanced functionality within the accounting system, is a mandatory part of the job and will reduce the band-aid ‘solutions’ that often happen to the systems, chart of accounts, and the creation of reports in Excel.

Solution

Reach out to your software implementer or consulting firm to get an efficiency review on your existing system. This will help identify new functionality, determine if reports need to be written, the chart of accounts updated, or staff trained, etc.

Conclusion

I hope this article gave you time to pause and reflect! Without a change management mindset, even a new accounting/ERP system won’t solve the underlying people and process problems. If the organization isn’t ready to tackle change now, consider revisiting the conversation every three months for progress check-ins. Some topics to discuss are auditor comments, staffing limitations, or if your software support is sunsetting. If you are ready for change, get input from staff on their top three biggest frustrations or time wasters. Then compile the list, identify trends, determine the return on investment of making a change, prioritize them, and tackle one a time. If you are looking to brainstorm solutions, or for thought leadership, please reach out, and I’d be happy to chat.

In the past, accounting for rising freight costs wasn’t a primary concern for many organizations. The fluctuations were often mild, and mistakes wouldn’t have mattered as much in the grand scheme of operations. However, as the supply chain continues to rebuild after the pandemic, many companies are facing growing freight complications and the rising costs associated with it. Due to these rapid price increases, ‘traditional’ ways of accounting for freight may not work in these times, and mistakes will quickly and visibly add up if they are not accounted for correctly. Much of the pain stems from companies’ inability to unload containers in a timely manner. As a result, many organizations are receiving thousands of dollars in demurrage, detention, and chassis fees months after the inventory has already been received into the system with sales activity against it. Historically, these charges were typically immaterial and not significant in nature. However, they have recently become significant, and improper accounting could cause errors on the financial statements, including misstatement of inventory and cost of goods sold, resulting in a misstatement of income either now or in future periods.

Proper Freight Accounting Treatment

In general, if the freight costs are a normal part of obtaining the inventory, they should be capitalized, per Accounting Standards Codification (ASC) 330, Inventory. Cost as applied to inventories typically includes the “sum of applicable expenditures and charges directly or indirectly incurred to bring inventory to its existing condition and location.” This means the costs associated with your inventory, including duty, freight, and more should all be reflected in the cost of your inventory. As such, the inflated freight costs should be capitalized into the cost of the inventory.

Exceptions

An exception to capitalizing freight costs would be “abnormal” costs, which should be expensed. However, abnormal is defined as excess or redundant costs (i.e., moving product from one warehouse to another because of an internal error), and an increase in supply costs is, while frustrating, not abnormal. Additionally, it’s important to note that freight costs attributed to economic issues arising as a result of the COVID-19 pandemic are not considered “abnormal.” If you conclude your freight costs are abnormal costs, they should be defined as such, noted that they cannot be capitalized, then expensed. If the freight costs are “normal” but high, then they should be capitalized. Many organizations paid high freight costs in order to stockpile inventory in 2021 to fulfill customer demands in a timely manner. As these inventory levels have normalized in 2022 and 2023, the resulting impact is a drop in gross margin, as the higher cost of inventory flows through the income statement. In the USDA’s monthly reporting on changes to ocean freight rates, we can see that there were modest changes to prices over the period 2014 - 2020. However, the average spot rate to ship a 40 foot container from the West Coast to China, rose dramatically, from $860 in December 2020, to a peak of $1,710 in the fall of 2021, followed by a decline to $1,260 in December 2022.

Conclusion

In most instances, companies should capitalize the high freight costs. If the inventory costs are deemed abnormal, they should be expensed. If you have questions concerning how to account for your rising freight costs, send me an email and I’d be happy to help.

Too often when I ask CPAs or prospective clients if a particular company is subject to the interest limitation rules, I hear the quick answer: “No, the company is a small business and not subject.” However, the analysis is much more complex than that. In this article I will: a) discuss the general rules of interest limitations as laid out by Internal Revenue Code 163(j), b) walk through the analysis that should be completed in determining if an entity is subject to the rules, and c) review common questions and issues that I encounter as a tax practitioner that specializes in real estate taxation.

A) Overview of Internal Revenue Code (IRC) 163(j)

In 2017, The Tax Cuts and Jobs Act included a change in tax law that placed limitations on the ability to fully deduct interest for certain taxpayers after December 21, 2017. The new IRC 163(j) essentially says that a deduction for business interest shall not exceed the sum of:

1. The business interest income of the taxpayer,
2. 30% of the adjusted taxable income of such taxpayer, plus
3. The floor plan financing interest of such taxpayer.

Adjusted taxable income (ATI) is defined as follows; taxable income of the taxpayer computed without regard to:

1. Income, gain, deduction, or loss that is not properly allocable to a trade or business,
2. Business interest or business interest income,
3. Net operating loss,
4. Deductions under IRC 199A,
5. For tax years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.

In most situations, for tax years starting January 1, 2022, ATI can be computed by taking the taxpayer’s taxable income and adding back business interest and expense, plus any items of income that are not allocable to the trade or business. In simple terms, you determine your ATI, multiply it by 30%, add any business interest income, and that is the most amount of interest you can deduct.

Example of Calculating Interest Limitations

Let’s walk through a simple example. An entity constructed a commercial building that was placed in service in 2022. The entire building is leased to a third party. Due to substantial depreciation deductions from a Cost Segregation Study they had on the property, there is an overall loss of $9,000,000. Included in the loss is depreciation deductions of $12,000,000 and interest expense of $1,000,000. The interest limitation for 2022 is calculated as follows: Since the ATI is negative, the entire interest expense of $1,000,000 would be excess business interest and not deductible in 2022. It would carryover until a future year when there is excess taxable income allowing for the deduction. Let’s assume that in 2023, the same entity has taxable income of $5,000,000, which includes $1,000,000 of interest expense. This would result in a full deduction of the 2023 interest expense plus excess taxable income, which could be used to deduct $800,000 of the 2022 excess interest expense.

B) Who is Subject to the Interest Expense Limitation Rules?

Not all companies are subject to the interest expense limitation rules. There is an exemption for certain “small businesses.” A small business taxpayer is a taxpayer that is not a tax shelter and meets the gross receipts test.

Tax Shelter

A tax shelter is defined as:

1. Any enterprise other than a C Corporation registered with a federal or state agency for offering securities for sale
2. Syndicate: partnership with >35% of the losses during the taxable year allocated to limited partners or limited entrepreneurs
3. Tax Shelter: Significant purpose of the enterprise is tax avoidance.

When I first read the new code, I thought, My clients are not tax shelters! I had the general sense that a tax shelter was an entity whose purpose was tax avoidance. However, in the real estate world, many taxpayers fall under the syndicate rules, which makes them a tax shelter for purposes of the small business taxpayer exemption.

Meeting the Gross Receipts Test

If you pass the tax shelter definition you need to see if the entity meets the gross receipts test. A taxpayer meets the gross receipts test if the taxpayer has average annual gross receipts of $27 million or less for the prior three years. However, when making this determination you must determine whether aggregation is needed under the common control rules. These rules include:

Parent Subsidiary Group Under Common Control:

Are one or more chains of the organization connected through ownership of a controlling interest (>50% profits or capital) with a common parent?

Brother-Sister Group Under Common Control:

Do the same five or fewer persons own a controlling interest (80% of profits or capital) in two of more organizations? If your entity falls under the parent subsidiary group or brother-sister group, you must look at the entire group for purposes of determining your average annual gross receipts.

Alternative Options

In my practice, I have found that most real estate entities fail the small business exemption. However, the rules allow for real estate entities to elect out of IRC 163(j). The election is permanent; to elect out you must use the Alternative Depreciation System, which has a slightly longer depreciable life.

Residential Real Estate:

• Instead of 27.5 years for the building, you would use 30 years.

Commercial Real Estate:

• Instead of 39 years for the building, you would use 40 years.
• Qualified improvement property, which is normally 15 years and eligible for bonus depreciation, would be changed to a 20-year life and no longer eligible for bonus depreciation. If you often make qualified improvements that are depreciated under the bonus depreciation rules you need to evaluate the change in expected depreciation before making the permanent election.

C) Common Questions and Issues

Should I Elect Out as a Real Estate Trade or Business?

The answer to this question depends on multiple factors:

New Residential Real Estate Entity

If you have a new LLC that is placing a residential real estate building into service, the answer is generally yes: elect out as a real property trade or business. With proper tax planning you likely will have tax losses for the near term due to accelerated depreciation. Depreciating the building over 30 years rather than 27.5 will cause a small change in depreciation, much less than any interest limitation.

New Commercial Real Estate Entity

If you have a new LLC that is placing a commercial real estate building into service, this is a more complex analysis. By electing out as a real property trade or business any 15-year qualified improvement property will not be eligible for bonus depreciation. This could be a substantial change in depreciation expense.

Existing Entity

If you have an existing entity that has been subject to interest limitations, you will want to analyze how much interest has historically been limited and what you expect in the future. It may make sense to elect out, but any past limitations are stuck until the interest is disposed.

I Should Have Been Subject to the Interest Limitations in the Past, but There Was Not a Proper Analysis. What Do I Do Now?

I see this often when I talk with new clients. In most cases, I inform the client they can amend their prior year return (or file an administrative adjustment request if not eligible to amend), but they are not required to amend. I then move forward with the current year analysis and report it properly going forward.

What if My Entity Is Subject This Year, but I Do Not Expect to Be Subject in the Future?

In some situations, it may make sense to not elect out of the interest limitation rules. Your interest will be limited in one year, but you may have excess business income in future years which will allow the past limitation to be deducted.

Conclusion

Overall, the key takeaway is that these new rules have added another level of complexity onto some already complex tax laws. Make sure that you are working with a CPA that specializes in real estate taxation. That way you can feel confident they are analyzing these rules and coming to you with a knowledgeable recommendation based on your specific fact patterns. If you’re looking for assistance in real estate taxation, send me an email. To discover more tax strategies for real estate investing, check out my What to Ask Your CPA series.