In small business owners often fail to fully grasp the bottom line. They sometimes wonder ’Why isn’t it higher?’ In most cases the small business has shifted the ability to earn a higher profit to an outside business which is referred to as external shifting. Often the profit has been shifted to another entity owned by the same person that owns the small business. When this happens the profit is shifted internally.
This article is going to explain the internal shifting of profit. Another article explains and goes into detail related to external profit shifting.
Internal Profit Shifting
When a business purposely transfers value to another company it is called profiting shifting. When this shift occurs using the same ownership for the two companies, it is referred to as internal shifting. The most common example is when a business pays rent to the landlord. It is very common for the owner of the building to own the business using the building.
If the rent exceeds fair market value, that is the tenant pays more than what is traditionally paid, the tenant is shifting profit from their bottom line to the landlord. If the landlord and tenant are basically owned by the same party, internal profit shifting occurs. Here is how this works:
Joe owns a retail establishment that sells trinkets to tourists. For the retail store he owns all of the stock of the company that owns this retail business. In addition, Joe created a limited liability company that owns the shopping strip mall that houses his retail store. Joe charges the other tenants $33 a square foot as the annual rent. But Joe charges his own retail store $39 a square foot for annual rent. This means Joe is charging his own business $6 more per square foot.
Suppose Joe’s retail business leases 1200 square feet of space. On annual basis Joe is charging his retail store $7,200 ($6 times 1200 square feet) more than what he would charge a comparable tenant that would rent the same space.
At year end, Joe’s retail store’s profit was $29,000. Had he charged his retail store the traditional rent amount, his retail operations would have generated a profit of $36,200 ($7,200 more) because rent would be $7,200 less in the profit and loss statement. Basically, Joe shifted profit to another business by agreeing to a higher rent than what fair market value would dictate.
Most of you will right away ask ‘Is this legal’? The answer is ‘YES’. However there needs to be some clarification here. Let’s focus first on the ‘Why’ aspect of this.
Why Shift Profits?
At first any reasonable business person would say, why do this? At the end of the day Joe’s overall wealth position didn’t change. If he charged normal rent to himself, then his retail operation would have greater profit and his land business would have the same amount less in its profit. Combined Joe’s aggregated earnings do not change.
Well, sometimes business owners have a different goal than your traditional thinking. Suppose in Joe’s case he is interested in selling his shopping strip mall. Buyers look at two financial attributes when purchasing commercial property. The first is the fixed asset’s fair market value and the second is of course rents earned over the three preceding years. By increasing his volume of rental income he has purposely made the shopping strip mall look better financially therefore the price paid by an outside buyer is higher than under normal circumstances. In this case the price paid could get higher upwards of $25,000 which is a significant sum.
Joe wasn’t doing anything illegal, it is up to the buyer’s CPA to figure this out and often buyer’s don’t review the details of every lease nor understand that this type of financial manipulation exists.
A second reason might be more personal. In many family operated businesses the head of the family desires to control the overall family financial situation. In Joe’s case, he could be interested in making sure his wealth stays intact by continuing to own the shopping mall but begin to transfer ownership of the retail store to his children. To maintain control, prior to ownership transfer Joe signs a long term lease with the LLC that owns the shopping strip mall. This lease has rates that are quite favorable to his LLC. This makes sure that Joe is getting some of the profits from the retail store.
The two primary reasons to internal shift profits are to manipulate the financial results or to exercise control over all assets.
Sometimes though there are some illegal reasons why shifting occurs.
Quite a few business owners believe that they can shift profits to reduce their overall tax obligation. Remember, in taxation, tax avoidance is perfectly legal. Tax evasion is NOT. Depending on the nature and intent of the shifting of profits determines whether the owner is exercising tax avoidance or evading his obligation.
To explain this, let’s go back to Joe’s situation. In my initial description I stated that Joe’s retail operation is a corporation because he owns all of the Stock. Stock is of course a term used in the corporation form of ownership. His shopping center is owned by a limited liability company which is traditionally reported as a partnership for tax purposes. In his LLC the income qualifies as passive in nature due to the tax rules. But with the income from the corporation it is taxed at the corporate tax rate.
The following are the two differences associated with the tax obligation:
Tax Rate 34% 15%
Income ($7,200) $7,200
Savings/Tax ($2,448) $1,080
The difference is what Joe saves by shifting income (profit) to the LLC by charging a higher rent. The net difference is a tax savings of $1,368. Joe’s wealth is better off by shifting the earnings to the lower tax rate entity.
The IRS is well aware of this trick and if audited will assess the difference in taxes and extrapolate for the prior three years. The penalties can be punitive by themselves. If the IRS determines that the goal was to evade taxes then criminal charges can be filed. This usually is not the case but it has happened.
The key to qualify as a legitimate shift is that the rent charged is the fair market value or the amount a third party not connected to Joe would pay for the same space.
Other forms of illegal shifting include transferring value to an entity in order to substantiate a fraudulent application for a loan from a financial institution. This is called bank fraud and this happens more than what many readers may realize. By falsely pumping up the revenues for a particular entity and then applying for the loan you are purposely misleading the lending institution and this is a federal felony.
There are many other forms of illegal shifting but the two above are the most common. As a small business owner you should seek out advice from your attorney and your CPA to make sure you comply with the law.
If you do have the ability and it is legal to shift money and you have a justifiable reason for this; then it should be a consideration in your business model. However, I caution you in making sure you understand your financial reports. Allow me to elaborate with an example.
I had a client that owned an RV dealership. He had five departments on his financial reports. Two of the departments were ‘New’ and ‘Used’ sales. Typically when a used unit was traded in for a new unit the RV would be taken back to the service department for inspection, repairs, cleaning and modernizing. The service department manager figured out that he could get top dollar as revenue for servicing these units. He would charge full price for the service department labor hours and work.
Over time the ‘Used’ sales department started to lose money. Basically, the costs for the units exceeded the sales price associated with the units. This is a form of profit shifting. One department used their own discretion in servicing the unit and if there were some down time for the technicians, the service manager had them perform unnecessary work on these ‘Used’ units.
During the monthly manager’s meeting the ‘Used’ sales manager was called out for the lack of margin from the ‘Used’ sales. Even he didn’t understand what was going on and he came to me to ask why his department all of sudden was generating losses. I just assumed that everybody knew this trick. I was caught off guard by his concern that he would be fired. I explained it to the owner and he was laughing. He explained that he was well aware of this trick. He didn’t use profit from that department to determine the manager’s job security. He used a strict number of units sold per reporting period as his primary guideline. To the owner, used units never made him any money at the end of the day. But without some ability to trade a unit in, the customer would never step up into a new unit. There is very little market for used RV units. In addition he never patted the service department’s manager on the back either. The owner would discuss with the service department manager that it was OK to keep the guys busy during the leaner times but not to focus on replacing marginal parts because parts did cost him actual dollars for repairs.
After lengthy discussion the owner asked that a model of ‘Allowances’ be instituted between the ‘Used’ sales manager and the Service Department. This way the ‘Used’ sales financial report more accurately reflected the profitability of that department and at the same time the service department had a financial report that more closely resembled their real profitability.
For the reader my goal is to explain to you that internal profit shifting is a tool used to transfer value from either one business entity or even a department to another entity/department. However, both entities or departments are still owned or controlled by the same person or owners. Internal profit shifting is legal if the owner complies with the tax code and the banking code. Finally, internal profit shifting is very common within the same company as it relates to departments or divisions. Just as illustrated above, management needs to understand this shifting as it does impact middle management’s performance standards. It is OK to shift but you should understand the values related to the shift and how much is reasonable or normal against those amounts that create misleading financial results. Act on Knowledge.