Fractional CFOs can help optimize your tax strategy so your business can plan on having more cash in hand at the end of tax season.
Fractional CFOs can help optimize your tax strategy so your business can plan on having more cash in hand at the end of tax season.
One mistake many business owners make is that they think about taxes only at the beginning of the year as tax season is just around the corner. But this is not the right way to think about it; instead, founders and CEOs should be planning year-round for their eventual rendezvous with the taxman. This will help them maximize their savings and ensure their company is best positioned to benefit from future savings.
To that end, a fractional CFO can be of great help, showing business owners different ways they aren’t saving on taxes today while helping them adopt different strategies for the future.
When you’re a small company, taxes shouldn’t dictate every decision you make, but they should factor in heavily. After all, taxes affect every business decision you make:
If it’s a business activity, taxes will come into play.
And small business owners need to find ways to be as frugal as possible. For one, they might have a harder time gaining access to capital than larger, more mature firms. Additionally, almost 65% of small businesses fail (with some sources quoting a much higher failure rate), and the biggest reason for failure is running out of working capital.
Accordingly, the impact of proper tax planning can be huge for small businesses, saving you a substantial amount of money. For instance, let’s say you run a small company that brings in $20M in annual revenue. If you can save 0.5% of your annual revenue because of proper tax planning, that’s $100k, which can translate to hiring an extra employee or two to work on the business.
However, to properly tax plan, business owners need to know the answers to nuanced questions such as:
And if you’re not willing to learn these nuances, then it might help to bring someone on board, such as a fractional CFO, who is aware of these little details, knows how to navigate them, and can advise you on the best course of action when the time comes.
You will always need a partner with whom you can have these conversations.
To see how critical these conversations are, let’s explore two different examples.
When starting your business, one of the first questions you have to figure out is what kind of legal structure you want to give it.
On the one hand, you might opt for a pass-through entity, such as an LLC. This means that all company revenue is treated as income to the owners, so they only have to pay taxes on it once, which is taxed at their individual income tax rates.
On the other hand, you could go for a C Corporation, which means that company revenue will be taxed twice: once as company profits and the other time as income to the owners.
Now, given the advantages of an LLC over a C-Corp, mainly that you avoid double taxation, most company owners opt for an LLC whenever they are forming a business.
And that’s entirely sensible.
However, what if, early on, you know that you plan to sell the company eventually?
For instance, if you are an experienced founder who has built and sold multiple companies before, that increases your chances of selling the new one too.
So, how does that change anything?
Well, there is a tax incentive specifically designed for sellers of C corporations so long as the company meets specific rules. The incentive, named Section 1202 or qualified small business stock gain exclusion, allows individual company owners to avoid paying taxes on the greater of $10 million or 10 times what the individual initially invested in the business.
For example, let’s say you put $5 million into the business. Ten years later, you are about to sell the entire business for $60M.
According to our example, your profit is $55M. And according to Section 1202, you don’t have to pay taxes on $50M, which is ten times your initial investment.
You will only have to pay long-term capital gains tax on the remaining $5M.
For reference, Section 1202 just saved you $10M (that’s assuming your long-term capital gains tax rate is 20%).
To be clear, those savings won’t just apply to you; they will apply to every individual who invested in the company.
There are several more factors to consider regarding Section 1202, such as the 5-year holding period requirement on C-corp stock, but the point is that tax planning is a powerful tool for keeping cash in your pocket.
That is a great question.
Here is where the fractional CFO’s expertise kicks in. Based on their experience, they can build a forecasting model that helps you, the company owner, compare the scenarios of creating an LLC versus a C-Corp.
And there are plenty of scenarios where a C-Corp would make more sense.
For instance, let’s say your company has 5 owners, each of whom has invested $4M. You could collectively sell the company for $200M, and none of that would be taxed! And if the long-term capital gains tax rate for each of you is 20%, you just collectively saved $40M net.
While avoiding double taxation might save you money, it won’t save you $40M.
Another scenario is when the company is projected to lose money for the first couple of years of its life, so you won’t be able to enjoy the pass-through benefits.
Simply, there is no clear-cut answer here, and a financial professional needs to analyze the situation to help you assess which decision makes the most sense for your circumstances.
As interesting as the above example may seem, it only applies when selling the company. Moreover, if you’ve already established your company as an LLC, then that option isn’t available to you unless you are willing to convert the entity’s legal structure.
So, let’s look at an example much closer to home: expanding operations to a different state.
Now, part of the way state taxes work is that they are apportioned based on your activities, especially if you are operating as a C-Corp (basically, not a pass-through entity). What that means is that the earnings you make are broken down, and different percentages are allotted/ attributed to different states.
For example, if your company’s revenue last year was $1M, and you were operating in three states, then your apportionment could hypothetically look like this:
How a company’s income is apportioned is tricky, and what makes it hard to calculate is that different states might have different rules about how to calculate the apportionment. Some states will consider your company’s payroll, property, and sales. Other states will only look at your sales.
Regardless, if your business is a taxable entity, you need to know how the states you operate in will affect your overall tax bill.
What’s more, it would be in your best interest to be proactive and make business decisions to lower said tax bill so long as you are indifferent about the choices in front of you. For example, if you are considering whether you should open a new factory in state A or state B and feel that both states offer comparable strategic advantages, then you might want to let the tax considerations help you with your final decision.
Over and above, you should be aware of the nuances of each state. For example, if you are hiring a contractor, i.e. a 1099, some states might consider that as part of your payroll, which will impact the apportionment calculation. Alternatively, other states might not see things that way.
As you can tell, when it comes to tax planning, there are plenty of nuances to be cognizant of, and small decisions in the beginning might have a huge impact later down the road.
While you might have a solid accountant or even controller running your finance department, they might not be aware of all those little details. What’s more, some of those details can only come with experience, i.e. having worked with multiple companies at different stages and maturity levels.
More importantly, you don’t know what you don’t know. So, if there are gaps in your knowledge or the knowledge of your controller, you will have a hard time figuring that out until it is too late.
And that is where a fractional CFO can offer value.
For instance, if you want to set up an equipment company, you can reach out to your fractional executive, and they will help you figure out answers to questions like:
Alternatively, if your company does a lot of R&D, they will know what kind of tax credits your business can qualify for.
Simply, having a fractional CFO by your side will not only help you save money on taxes today, but they will also help you be proactive in how you set up and run your company so that you can save on taxes when your company grows.
Consequently, when it comes to taxes, you want to think of a fractional CFO as a two-pronged cash outlay:
So far, we have been exploring tax strategies for small companies. However, as a company grows, it will have even more opportunities to plan its activities to minimize its tax burden.
For example, we discussed earlier how being aware of state apportionment rules can affect decisions such as hiring and buying assets. However, as the company grows, it will have even more occasions to benefit from apportionment rules.
Over and above, when a company grows, it is more likely to operate internationally, e.g. selling to foreign countries or hiring employees from different continents, which opens a whole host of tax optimization possibilities.
Additionally, tax optimization also becomes more beneficial as companies grow. Going back to our example of saving 0.5% of sales, we can see that if your company were to grow to $200M, that same 0.5% would amount to $1M in savings, which is a bit more than the salary of one or two employees.
Even though small businesses would benefit from having a fractional CFO help with taxes early on, we also realize that a lot of business owners are more focused on the survival of their company as opposed to minimizing their taxes.
Let’s set aside for the moment that this mentality is less than ideal because it can backfire if the company becomes as successful as the business owner would like it to be.
Let’s assume that the business owner has no issue paying more taxes in the future, and they don’t see tax planning as an investment because they are too concerned about whether their company will live to see next year.
In that case, if the company stays in business and keeps growing year after year, at what point does it make sense to bring in a fractional CFO (or perhaps even a full-time one) to help with your taxes?
When asked, Michael Eitler, a CFO with more than 30 years of experience working with companies in different industries and at various stages, had this to say:
“To figure out the threshold at which you need to bring in a CFO, I think of it as a little chart. On one axis, you would put the annual revenue. And for me, the breakpoints would be $10 million, $25 million a year.
At $10 million, you're probably starting into it. I would say that maybe that number is small for a certain type of business, and maybe I would think about it less.
For others, I'm like, no, 10 million. You're a hardcore manufacturer because there's a lot of tax advantages. You want to have somebody focused on proactively discussing taxes with you.
At $25 million, we have moved from the should-consider and into the need-to-have territory.
On the second axis of the chart, the threshold is crossed the minute you cross state lines, and you find yourself doing business in a second state, especially if you’re a C-Corp. It doesn’t matter whether that's sales, you buy a pickup truck, hire somebody in another state, give them a car allowance, or send them a computer to work on.
The minute you start doing things like that outside of your state, you might want to consider asking a fractional CFO for advice. You should have them help you with your company’s multi-state tax reporting requirements.
Similarly, if you start operating internationally, then a CFO to help with your tax strategy becomes a necessity.”
Aside from saving you money now and in the future, a fractional CFO ensures that your company remains compliant as far as the tax man is concerned. In doing so, they protect you from unnecessary compliance risks and ensure you stay on the right side of the law.
Many CFOs come from an accounting background and were exceptional CPAs (Certified Public Accountants) at one point in their careers. As a result, a fractional CFO can be a great asset in setting up internal controls along with your company’s internal accounting team to ensure that the accounting process is maintained at a high standard, giving you confidence in the reporting mechanism. Additionally, the controls they set up should make it easier for third parties to attest to the validity of your financial statements.
Risk mitigation is a critical part of running a business, one that several first-time founders might neglect till they receive a harsh lesson on its importance.
Regarding taxes, one of your biggest risks will always be poor documentation. For instance, if you have an employee in a different state yet failed to report that, this might cause your company to miscalculate the amount of taxes owed, leading to either underreporting or overreporting taxes, which are less than ideal.
Fortunately, with all of the controls set up by your fractional CFO, the likelihood of making such a mistake goes down.
In most cases, you don’t need your fractional hire to have industry experience that aligns with your company. Instead, you want to focus on their problem-solving abilities and whether you can work together or not.
Furthermore, a fractional CFO should be able to do the job well as long as they have experience actively managing federal and state taxes for other multi-state entities that were similar in size to your company.
That being said, there are some industries, such as healthcare, with particular regulations, where it might make more sense to hire a financial professional from that industry. You will want someone familiar with the ins and outs, and a complete outsider will need a lot of time to learn those little details.
On a separate note, if you have a company that operates in multiple countries, and the fractional candidate in question has no international experience, then they might not be the best fit for you.
When it comes to company size, you are always better off with a fractional CFO experienced with companies of your size and maturity stage. This applies doubly if you are a large organization and are considering a CFO who has only worked with smaller companies.
Another element relates to what you plan to do with the company. For instance, if you plan to sell it, you want a CFO with plenty of M&A experience. Alternatively, if you intend to make it a family business and pass it along to your children, you need a CFO with a solid background in succession planning. (Succession planning is tricky, and it is not always easy involving the next generation in the business.)
The right fractional CFO can help your company save on taxes. They will help you structure your activities and arrange your assets so your company can minimize its debt load. Moreover, as your company grows, they will be able to keep up with its changing needs, ensuring that at each stage, you are taking advantage of all of the benefits offered by the tax code.
As a result, the bigger your company gets, the more imperative it becomes that you bring in a financial leader to help with your taxes. This growth can either be monetary or geographical.
Accordingly, you want a fractional CFO who has experience with companies similar in size to yours. And while industry isn’t a big factor when choosing a fractional leader, experience with different exit plans matters a lot.
All that being said, if you want to learn more about how to find the right fractional CFO for you, or you just want to learn about how you can better manage your company’s taxes, please do not hesitate to reach out for a free consultation. We would love to help you in any way we can.
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