BY ROBERT P. MADER Of CONTRACTOR’s staff
WASHINGTON — The accountants have gotten contractors all riled up. The Financial Accounting Standards Board recently proposed adding an accounting standard, FAS 150, that will affect the net worth of non-public, non-SEC-registered companies, many of which are contractors.
The rule, in its current form, would gut the net worth of contracting firms, at least on paper. That lowered net worth would make it difficult to obtain loans and bonding, even though the financial health of the company really hasn’t changed.
The rules are being battled by a coalition that includes Plumbing-Heating-Cooling Contractors - National Association, Mechanical Contractors Association of America along with the Mechanical-Electrical-Sheet Metal Alliance, Air Conditioning Contractors of America and just about everybody else in the building industry, including general contractors, architects, designers, consulting engineers, ready-mix concrete suppliers and surety bond providers. In a case of strange bedfellows, the food service industry has joined the fight.
The industry has begun a letter-writing campaign to members of Congress to try to pressure FASB to kill the accounting rule change. The letter explains that most privately held companies, such as contractors, have some sort of buy-sell agreement: When the founder dies, his stock would be purchased by somebody, such as his heirs or the company. The new rules would require that the purchase price be listed as a liability and deducted from the net worth of the company.
The proposed rules would cover financial instruments that are “mandatorily redeemable.”
The letter to Congress reads, in part: “Most non-public entities have had agreements with shareholders for many years to redeem the equity interest in the company if a shareholder dies, retires or resigns from the company. The company repurchases the percentage, or ‘share,’ of the company or entity that this person owned and either resells the ‘share’ to the remaining owners, retires the shares or ownership or sells to a new, known person (i.e., current employee or additional family member). In this manner, companies are able to maintain their current ownership make-up, either as a family-owned or an employee-owned company.
“Because death, resignation or retirement are events deemed certain to occur, the company would be required, at some point in the future, to repurchase each owner’s interest in the company; hence the accounting term, ‘mandatorily redeemable’ shares. For most non-public companies, most of the shares are mandatorily redeemable. Therefore, implementation of FAS 150 would require companies to list these shares, equaling 100% of the company, as a liability against the actual net worth of the company, which would falsely cause the company to appear insolvent. Ironically, this new standard inadvertently penalizes those that are doing the right thing by having buy-sell agreements or other business continuity plans for the future of their businesses.
“The financial statements of non-public companies are used to obtain new clients, loans, bonding or insurance. In addition, many states require companies to show positive net worth to obtain a business license. Finally, most federal and state projects require companies or entities to have net worth to bid on jobs. FAS 150 will render a false presentation of the company’s financial position. While a company may have assets and be financially sound, the implementation of FAS 150 will give the appearance of zero or even negative net worth.”
CONTRACTOR tax columnist Irving L. Blackman noted, “It sounds like a perfectly insane thing that the guys in New York that run FASB would do.”
The way it works now, Blackman explained, is that a company will have an agreement with the founder to buy his stock back upon his death for, say, $1 million. If his CPA is sharp and understands the time value of money, he’ll actuarially figure that the founder has 20 years to live, discount it by about 6% a year and record it as a $430,000 liability.
“So, really, when that guy dies, his company has to come up with a million bucks,” Blackman said. “But, so what, most of these are insurance funded, so you collect from the insurance company and pay them.”
It should be a wash. The problem is, he noted, that other FASB rules prohibit the company from booking the anticipated insurance payout as an asset.
Unfortunately, Blackman guesses that FASB will go ahead with these rules because there’s a precedent. For the last 15 to 20 years, companies have listed future costs for health care for their retirees as a liability. The situations are similar from an accounting standpoint.
The best way around the problem, Blackman said, is to get the stock transaction outside the company so it can be kept off the books.
A contractor should go to whatever body governs corporations, such as the secretary of state, and ask to re-capitalize his firm with 100 shares of voting stock and 10,000 shares of nonvoting stock.
The owner can then create an Intentionally Defective Trust and tell the trustee that he wants to sell the trust the 10,000 shares for whatever dollar value the company is worth. The owner also places all his life insurance policies in the Intentionally Defective Trust.
Because the trustee doesn’t have any money, he gives the owner a note. Since the trustee technically owns 99% of the company, he can use the annual proceeds to pay off the note, a process that typically takes seven or eight years. The owner instructs the trustee that upon his death, the trustee should give the 10,000 shares to the owner’s son and give the insurance policy payouts to his family.
If non-family members will be the successors, they can reorganize the company as an S corporation, agree to buy the stock in a private sale and use the annual S corporation dividends that go directly to them to fund the sale.
Either strategy, Blackman said, will get the stock transfer off a company’s books.