TIME FOR AN INTERNAL CONTROL REVIEW

In tough economic times, it's a good idea to review your internal controls. Not only is the risk of employee fraud greater during economic downturns, but small businesses are also at risk for operational problems stemming from inefficient procedures and poor oversight.

Small businesses are especially vulnerable to these problems because they may have limited staff, and key financial duties often rest with one person. Furthermore, when small businesses do experience fraud, the losses are significant.

In its "2002 Report to the Nation," the Association of Certified Fraud Examiners found that small businesses - defined as those with fewer than 100 employees - suffered greater median losses than larger companies. The average scheme in a small business caused $127,500 in losses, compared to $97,000 in the largest companies.

Put Safeguards In Place

Although one of the best internal controls is to avoid giving one person complete control over your financial processes, this may be unavoidable. It's not always realistic to increase staff simply to achieve better segregation of duties.

If this is the case with your company, you'll need to consider other safeguards. Here are some to put in place if they're not already:

• Receive unopened bank and credit card statements at home or work. The owner should be the one to open statements and review them first. Look for unusual activity or transactions - unfamiliar payees, wire transfers, questionable purchases, or unfamiliar endorsements. This increases the likelihood of detecting unusual activity and conveys the powerful perception that someone is indeed overseeing the business.
• Ensure that financial results are compiled and reviewed monthly, and reconcile statements in a timely manner. It's much easier to spot questionable transactions from last month than from last year. When reviewing data, it's a good idea to ask for different types of supporting information to keep employees on their toes.
• Review outgoing checks, possibly even restricting signing authority to just the owner. Owners may want to require that all vendor checks have supporting invoices attached. Signing the payroll also helps deter fraud. You should periodically review payroll data by making sure you have a current employee pay scale and comparing it to pay rates.
• Create manuals for individual jobs explaining the steps involved. This helps avoid the trap of the all-powerful employee who is the "only" one who can do a job. Employees with financial responsibilities should take annual vacations, and someone should perform their duties in their absence. It's common for fraud to be detected this way.
• Periodically review accounts receivable, particularly account aging. A high number of past due accounts, especially from parties who are typically prompt, could signal something amiss. While it could mean that an employee is converting payments to personal use, it's more likely that someone is not pursuing outstanding accounts.
• Use technology to eliminate redundancies and errors. Software can eliminate redundancies, such as manually writing a check and then entering it into a ledger, and it helps catch input errors.

Not only do regular internal control reviews protect against fraud, but they can also verify that your company is operating at peak efficiency and using resources wisely. If you lack the time or resources to conduct an in-house review, you may want to ask your financial advisor to perform one.

Solo 401(K) Increases Savings

If one of your New Year's resolutions is to shield more income from taxes, an individual 401(k) plan is something to consider. These plans allow certain business owners to put away an additional $12,000 in 2003. Those age 50 or over can kick in $2,000 more in catch-up contributions.

Individual 401(k) plans are growing in popularity, thanks to pension reform that became effective last year and led to 401(k) contributions being excluded from existing deduction limits. As a result, some business owners can put away more for retirement than ever before.

Prior to 2002, deductions for retirement plan contributions were limited to 25 percent of compensation for an incorporated business owner. The new rules allow those with an individual 401(k) to put aside $12, 000 on top of that. In addition, the maximum benefit limit for an individual has been changed to the lesser of 100 percent of compensation or $40,000 (subject to inflationary increase).

The chart on this page reflects various income levels and the resulting contribution/deduction that can now be made for an incorporated business owner. Keep in mind that the separate 401(k) limit is $12,000 for 2003, with that limit increased by $2,000 for individuals age 50 and over.

The savings will only get better. The 401(k) deferral rises to $15,000 in 2006, with the catch-up contribution increasing to $5,000.

Restrictions Apply

Individual 401(k) plans are designed for owner-only businesses, which are defined as businesses that employ the owner and immediate family members, or ones that employ the owner and certain other employees who are considered excludable from plan participation under federal laws.

Incorporated and unincorporated businesses, such as sole proprietorships and partnerships, are eligible to establish the plans.

But ultimately your income level will be the determining factor in whether these plans make sense for you. As the chart illustrates, business owners with compensation of $116,000 or less receive the greatest benefit because they can now "max out" their retirement savings at lower income levels. Previously, an individual had to earn a higher income to achieve the maximum $40,000 deduction.

To take advantage of this opportunity to shield more income and enhance your retirement savings, speak to your tax advisor.

To take advantage of this opportunity to shield more income and enhance your retirement savings, speak to your tax advisor

Maybe you've heard of employee stock ownership plans (ESOPs), but haven't given them much thought. Perhaps you assumed that they would not apply to your business.

But if you've never explored the possibility of establishing one, you could be missing out on a potentially significant opportunity to defer or avoid taxes, retain profits, and engage in favorable financing arrangements.

Versatile in their uses, ESOPs, are ideal for closely held companies. C corporations and S corporations can establish ESOPs, but they cannot be used in partnerships or in most professional corporations.

An ESOP is an employee benefit plan that a company establishes by setting up a trust into which it contributes stock or cash to purchase stock. The ESOP can also borrow money to buy stock, with tax-deductible contributions. Employees are allocated stock from the ESOP, and shares are bought back when vested employees depart.

ESOPs can be used for many purposes, including:

• A ready-made market for company stock. Existing or departing shareholders can sell all or a portion of their ownership to an ESOP, usually for market value. This ensures shareholder liquidity and is particularly useful when there is not a buyer for a company, or when a company does not like its other options for selling.
  
  Once an ESOP owns more than 30 percent of a company's stock, C corporation shareholders can take advantage of a tax-free rollover as long as the proceeds are reinvested in domestic securities within a year.
  
  Consider the possibilities: If you sold your company to an ESOP for $5 million and deferred taxes on the gain, you've held onto some $1 million that would have been paid in taxes (assuming a 20 percent tax rate). That $1 million invested in domestic securities would likely return 5 percent to 10 percent a year, so you're making money on a substantial sum that would have otherwise been lost to taxes.
  
  S corporation shareholders do not have the rollover option - unless they convert to a C corporation. But S corporations enjoy other tax advantages.
• Competitive advantage. An ESOP - owned S corporation is not taxed on its earnings. For instance, if the ESOP owns 100 percent of a company that grosses $5 million, the company retains the entire amount because it all goes into the ESOP on a tax-deferred basis. This feature provides a tremendous competitive advantage for a growing company. A competitor that is not ESOP -owned, on the other hand, could be paying as much as 30 percent to 40 percent in taxes.
• Raise new capital. Companies can sell newly issued stock to an ESOP to raise cash or can use the trust to refinance debt under favorable terms. Proceeds from these arrangements can be used for almost any legitimate business purpose.
  
  Companies can sometimes maximize the benefits of an ESOP by reaping the rewards of both C corporation and S corporation status. For example, a C corporation could sell to the ESOP and take advantage of the tax-free rollover treatment.
  
  Assuming certain conditions are met, the company could then convert to an S corporation, have the benefit of tax-free earnings, and receive stock again through reallocation.
  

ESOPs are good for a company's well-being in other ways too. Studies have shown that employees are more productive and committed in employee-owned companies because they assume an ownership mentality.

If you think your company might be a good candidate for an ESOP, ask your tax advisor to explain the benefits and requirements in more detail. Although establishing an ESOP can be initially complicated, the tax and financial advantages they provide make them extremely worthwhile.

ARBANES-OXLEY AND PRIVATE COMPANIES

The newly enacted Sarbanes-Oxley Act, which is designed to protect investors by improving the accuracy and reliability of corporate disclosures, currently applies only to publicly traded companies.

TRICKLE-DOWN EFFECT

Even if this does not occur, it's widely assumed that many of the law's provisions will become "best practices" for corporate conduct in the private sector too.

Some private companies may feel the law's impact sooner than others, depending on their size, industry, and other factors. For instance, companies that could go public or be acquired by a public company should closely examine the law for possible ramifications.

Other private companies that could be affected include those with:

• A number of outside investors
• Heavy reliance on lenders or insurers
• Government contracts or those wanting to qualify for contracts
• Business partners who are public companies

Private companies that fit these profiles may find that certain external parties expect them to at least comply with the spirit and intent of Sarbanes-Oxley. To prepare for this possibility, they may want to take some or all of the following actions:

• Adopt internal controls that support financial reporting
• Review accounting policies
• Improve transparency in financial reporting
• Clarify or improve corporate governance procedures

It's important to remember, however, that it's too early to know exactly how the law might affect private companies. Still, you may want to discuss with your tax or business advisor whether you should review or change any business practices in light of Sarbanes-Oxley.