| Mark Van B: |
Welcome to unsuitable on Rea Radio, the unique financial services and business advisory show that challenges your old-school business practice and the traditional business in culture. You’ll hear from industry professionals who think beyond the suit and tie to offer meaningful modern solutions to help you enhance company’s growth. I’m your host Mark Van Benschoten. |
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We all love a good tax deduction, which is why many of us take our annual filing requirements into consideration when we make financial decisions throughout the year. It’s a great habit to get into, but also got me thinking about this tactic of a deeper level. For example, is it better to endorse some debt just to claim a deduction on your taxes or is it better to pay off debt as soon as possible? |
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Joining me today is Mark Fearon, a principle with Rea and Associates. He has a great name, first name of course. Mark specializes in income tax planning, succession planning, and business consulting. Welcome to Unsuitable Mark.
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| Mark Fearon: |
Thank you, good to be here.
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| Mark Van B: |
I’m glad you said that. It’s February this will come out a little later, but its the middle of busy season?
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| Mark Fearon: |
It is, things are in full swing right now.
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| Mark Van B: |
Appreciate you driving over, time out of your schedule. I know the sacrifice to your clients and to your family.
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| Mark Fearon: |
Gave me a chance to catch up on some phone calls I needed to make.
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| Mark Van B: |
Some Podcast.
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| Mark Fearon: |
Some Podcast.
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| Mark Van B: |
Rumor has it that sometimes you sleep under your desk during busy season. Is this going to cause a few more hours under the desk?
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| Mark Fearon: |
It may. Anything for the show, Mark.
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| Mark Van B: |
I like your attitude. I wish more people had that thought process. Onto our topic, debt verses taxes. Initially I thought those really aren’t one in the same, not to be technical. One’ a balance sheet thing and one is an income statement. How they line up? Then I got to thinking maybe sometimes debt is good. What’s your initial thoughts on that?
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| Mark Fearon: |
It is a common question we get, so many times I hear people say, I can’t afford to pay off that loan I need that interest deduction, interest expense for a tax deduction. On the surface it does sound good, but yeah you do get some tax savings, a tax benefit, from having that interest expense. If you think about it for every dollar you pay the bank in interest expense the government gives you we’ll say 30 cents back in tax savings. You’re still out of pocket 70 cents of every dollar. Is it really, it’s a cost to borrowing, it’s just like any other expense you may have. |
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You see a lot of business owners they got and try to spend money near the end of the year to get those tax deductions. If it’s something you don’t need, an expense you don’t need, you’re still out of pocket at the end of the day. You’re still worse off. |
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If you did not have that interest expense, you paid your loan off. Yeah, you’re going to pay, we’ll say, an extra 30 cents on every dollar in taxes but you didn’t pay the bank any interest. At the end of the day your …
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| Mark Van B: |
Going to be net ahead.
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| Mark Fearon: |
You’re net ahead exactly.
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| Mark Van B: |
I would think there’d be other consideration. I agree with your point I get that. Wouldn’t there be other considerations that go into about paying down debt? I’m a big cash is king guy. I like to carry some debt just so I have some liquidity sitting there.
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| Mark Fearon: |
Absolutely, I find a lot of times it comes down to the business owners personal philosophies, personal beliefs. There’s some business owners that they want to eliminate debt as quickly as possible. There’s others that have no qualms about going into to debt. I think there’s not a one size fits all type of answer, it really depends on your business, your situation. |
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Mark, you referred to liquidity. That’s absolutely one of the things you’d want to consider. There may be opportunities in your business that come about. Maybe an emergency, maybe there’s a down turn in your business where you like to have some cash reserves available. |
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I’ve seen cases where business owners had a great opportunity, a competitor is going out of business and there’s a lot of equipment or inventory, for example, that’s comes on the market at a pretty discounted price. Having that liquidity, extra cash reserves, in your bank account on balance sheet gives you access, the ability to be able to capitalize on that.
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| Mark Van B: |
That’s a great point. I was thinking, as you were talking, about an acquisition of an entity not just equipment comes along that some people are deathly opposed to debt might say, oh, I can’t do that. I can’t afford to do that. It could double, quadruple really exponentially grow their business if they just took on some debt.
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| Mark Fearon: |
Exactly, leverage can be a healthy thing for a business if it’s managed properly. One of my most profitable clients, very very profitable, has a large large debt load, but they’re very strategic about it. When they borrow money it is to buy equipment that’s going to generate them a lot more profit. It’s going to improve their margins. About every 3 to 4 years I see where their debt loads getting reduce and I think they’re finally going to get ahead of the game, and what to they do they go out and borrow more money. Never fails they end up making more money in the long run. They’re very strategic about their use of debt.
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| Mark Van B: |
Thinking off the top of my head, kind of going off script as they say. Tell me if you’re going to take on the debt what’s it going to accomplish? Am I going to buy an asset that’s going to help me grow sales. Am I going to grow sales a new market? I would think that should be part of consideration from a new debt.
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| Mark Fearon: |
Absolutely. It may be assets, it may be equipment. It could be investing in a key employee. Sometimes you may be missing whether it’s part of your management team, a supervisor, foreman. There may be a key person that would be a huge addition to your operation that would improve efficiencies. Cut down on costs. Maybe your company’s to the point where you need to buy a purchasing agent that does nothing but work with suppliers and try to get the best deal that they can on your materials. Somebody like that for say a small investment could pay for themselves many times over.
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| Mark Van B: |
By taking on a little debt.
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| Mark Fearon: |
Exactly.
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| Mark Van B: |
You mentioned about buying equipment at the end of the year. Not to have technical term on taxes, but Section 179 you get to accelerate the depreciation. You can buy an asset, not pay for and then write 100% of that off in a year. You see companies do that frequently at the end of the year.
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| Mark Fearon: |
Absolutely, that’s one of the biggest tools that business owners use, is they have profits and are looking to not only save taxes but also grow their business. That’s been around really since 2001 since the 911 attacks. The government has offered some very …
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| Mark Van B: |
Aggressive.
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| Mark Fearon: |
Aggressive tax write-offs accelerated depreciation with the increased Section 179 and bonus depreciation. A lot of business owners have been accustom to that. That was one of those deductions that every year we have to wait and see if Congress is going to extend that. Fortunately, they’ve put that in place permanently as far as the increased Section 179. I think that’s a great advantage to businesses to be able to invest in their business, buy equipment and see an immediate tax saving from that.
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| Mark Van B: |
I guess there’s probably analysis you can do about, you buy a $100,000 piece of equipment. You borrow on that, you got to pay it back with the interest and then take the 170, the accelerated depreciation. There probably is some play there by the time value money getting back to debt verses taxes.
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| Mark Fearon: |
Absolutely, you’re going to see an immediate tax savings. You may not pay that debt off until …
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| Mark Van B: |
3 to 5 year.
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| Mark Fearon: |
3 to 5 years, exactly.
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| Mark Van B: |
You could probably look and say, what’s the true value of that tax depreciation and factor that into your total cost of the equipment.
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| Mark Fearon: |
Absolutely, if you look at more of a present value type. Yeah, it would be very advantageous to take a tax deduction now and pay for it over a long period of time.
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| Mark Van B: |
Time, correct. Good point. Sometimes we see clients take on debt and it’s more survival and those things scare me.
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| Mark Fearon: |
They do. One thing we look at is if your business were to take a down turn. Are you able to carry your debt load? You never want to get into a situation where even if your business slows down 10 or 20%, which we tend to see most businesses are cyclical, you have good time and bad times. You don’t want to get yourself where you’re leveraged so much that you can’t afford to see any reduction in sales. That can be definitely scary if you’re a business owner to get into a situation where you don’t have any leeway. Everybody has that comfort zone that, hey I’ve got a little bit of a cushion in our budget, in our cash flow. If you push a little bit too far it certainly can be a little scary if things do …
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| Mark Van B: |
Your comment about, I can’t afford any down turn in sales. You might force yourself in taking on customers or project at a price you should be because you just need the cash flow. You need the volume.
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| Mark Fearon: |
Exactly.
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| Mark Van B: |
That could be disastrous because you just compounding a problem just trying to make a loan payment when something else probably should be done.
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| Mark Fearon: |
Exactly, you want to be able to make good business decisions and what’s best for your business, not be too dependent on making that loan payment.
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| Mark Van B: |
Talking about debt in your practice, and your clients, and your market do you see banks lending? What’s your feeling of the overall credit market out there?
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| Mark Fearon: |
It has definitely improved since 2008-2009. Prior to that recession I think money was much more readily available. Certainly with the recession in 2008-2009 banks really clamped down looking at things much much closer. I think that as the economy has improved in the last few years I think we’re seeing banks starting to maybe loosen up a little bit. They’re still scrutinizing things more than they were probably 10 or 15 years ago, which I think they probably should. That’s a lot of the reasons we ended up in the situation we did maybe a little too lax with some of the regulations. I think we’re finding that banks are willing to lend money if a business is performing well.
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| Mark Van B: |
Then I would say the same what I see in my market here, my clients that I talk to. Do you see clients looking for take on new debt? Sometimes I see banks saying, there’s no deals out there. Is what they’re saying. Then clients are saying well banks won’t lend money. Well, which ones true? I don’t see clients doing a lot of deals or expansion. I want a new press, I want to add onto my building. I don’t see a lot of that going on.
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| Mark Fearon: |
Not as much as we did maybe in the late 90’s early 2000’s. I think in our market we are seeing more that in the last 2 or 3 years. We’re seeing some expansion. Certainly, after a down turn in the economy a recession every bodies a little bit gun-shy about spending money, taking on new debt. It certainly makes you think twice about taking on that burden. I think what we’re seeing in our market is there is some, say an increased appetite, but businesses are looking at taking on a little bit more debt. |
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One thing I tell businesses that you talked about, are you willing to take on debt. Maybe it’s not taking on debt, but it’s just getting access to it with a line of credit. That’s one thing that I tell business owners there’s never an easier time to be able to borrow money when things are going well.
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| Mark Van B: |
When you don’t need it.
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| Mark Fearon: |
Exactly. Had that conversation actually with one of my clients here last week. Someone that just recently bought a business. I think the bank told him he was approved for a line of credit up to a certain amount and he said, no I really don’t need that much. He said, I’d rather limit ourselves to X dollars. I said, if it’s available you don’t have borrow that money at least take the bank up on it. In fact, he went back to the bank and actually got an extra $100,000 more than what they originally had offered. |
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Again, this is a business that has not needed their line of credit for probably 4 or 5 years and they may not in the future but I said, just to have that ability again if an opportunity comes up to grow your business in acquisitions, new equipment or maybe it’s just short-term cash flow to get through a slow period of time 3 or 4 months, it never hurts to have that available to you.
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| Mark Van B: |
That’s a great point. I did a little analysis for a client and then I told them that they had ineffective borrowing. They’re like, what’s that mean. I said, you added debt but I saw no increase in sales. I didn’t see any increase in equipment. What did you do with it? What was the use of the money? They didn’t have a good one. I said, I’d say that’s ineffective. Why did you borrow the money? It wasn’t a line of credit it was term note. They just didn’t quite grasp that. They didn’t quite understand what I was talking about. To me it was pretty evident you just took on debt and somehow the money just went away.
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| Mark Fearon: |
That’s a great point. I do see that a lot. Again, we talked about if you want to borrow, borrow wisely to improve your efficiencies. Improve your profit margins. To expand your sales, or to grow your sales. We have business owners, I think we all have clients, that every 2 years they like to go out and buy themselves a new truck, a new vehicle something that they like to have. If the money’s there that’s great, but probably not wise borrowing. It’s not something that’s going to grow your business, improve your bottom line. It may be a personal reward for owning the business and having a profitable business, that’s fine, but it’s really not effective borrowing so to speak.
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| Mark Van B: |
Other people in the debt, you started oh I can’t afford to pay off my mortgage because I need the interest deduction. Then sometimes you get the question of, well my mortgage rate is 3% but I’m earning 6% in the market I’m better off by staying in the market. You have any thoughts on that?
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| Mark Fearon: |
Exactly, what’s another situation and really I would call that opportunity cost. If you were to take those funds out of the market to pay off your mortgage you may save yourself 3 or 4% interest. If you’re losing the ability to earn 6% in the market that probably doesn’t make sense. This is kind of unique times that we’re in. I’d say the last several years where interest rates have remained rather low. Borrowing rates 3-4% range maybe 5%, but if it’s going to sit in a savings account you’re not going to earn a whole lot right now. You might earn half a percent, 1% if you’re lucky. |
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To be able to earn 4, 5, 6 percent you may have to take a little bit of risk. If you do have that opportunity out there … That’s a perfect example Mark, where you may not want to pay off your debt. If you’re able to use those funds, invest them elsewhere, make more than what you’re paying the bank then it makes perfect sense to keep that debt load.
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| Mark Van B: |
Yeah, I agree with you. I think when I say that that people just don’t quite understand they’re so adverse to debt. Where I’m okay with it.
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| Mark Fearon: |
Sometimes there is a little bit of risk in that case. You look at people that are successful they’re willing to take some chances. Not foolish risks, but educated evaluated risks and make good use of your money.
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| Mark Van B: |
I had a client that took on some debt. It was a 3 year project and they took on some debt and the bank was willing to structure the loan over 7 years, but they said no our project is for 3 years. We want the debt repaid after 3 years, so at the end of the project I don’t owe you money. I thought that was just very insightful of the client to go through with that and have it matched up so that if the project didn’t get renewed they weren’t going to be, we got to pay for this equipment. We don’t have revenue generating from the equipment. I thought that was just insightful of the client.
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| Mark Fearon: |
Very much so. Again, it goes back to I say the personality, the appetite, of the business owner. They don’t want to, it’s a mental thing, they don’t want to be paying for debt whenever the end of that project maybe is concluded. Even though it may make sense for them to stretch that debt out if they’re able to use those funds for other opportunities. Again, they want to kind of timing-wise match that up with the project. |
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Anytime you can pay off your debt in good time if you’re a profitable business chances are you’re going to replenish your reserves. Most business owners have a comfortable level. They have to have a cash reserve of X amount of dollars. I’m reluctant to throw a dollar amount out there because it really depends on the size of the business. For a small business that may be $30,000, for a large business that may be a million dollars. Everybody has that kind of comfort level they want to maintain in their business checking account or in their cash reserves. Again, for emergencies or opportunities. |
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You really just want to evaluate where you need to be or where you want to be. Anything beyond that, yeah then I think you really want to evaluate and maybe you should pay down some of that debt. Maybe you should look at investing right and differently.
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| Mark Van B: |
It probably changes over time. This year might have been a million dollars, next year I might only need $750 just because. It might go to 1.5 million just for whatever the rash was. I assume that’s not an ecstatic number you set it at a million it’s that way here for the next 10 years.
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| Mark Fearon: |
Absolutely, as your business grows and evolves that numbers certainly is going to change. Depending on your debt load, just the overall economy. Needs of the business, future needs, that’s certainly a number you want to continue to evaluate.
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| Mark Van B: |
Have you any insight you can provide as to how somebody should maybe approach a banker maybe they haven’t debt in the past? Any comments there?
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| Mark Fearon: |
I think it’s just sitting down with a well-respected business banker in your community. Sit down with your financial statements. Bankers look at a lot of financial statements. I would say talk to your banker and accountant, put a little plug in for us accountants as well.
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| Mark Van B: |
I like the way you think.
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| Mark Fearon: |
We always advise our business clients to take the team approach. You don’t want to just use one advisor, keep everybody on, whether it’s an attorney, insurance agent, banker, an accountant use a team of advisors. |
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Back to your question Mark. You can look at your balance sheet, a banker’s going to be able to sit down and say, okay based on your balance sheet here’s probably a reasonable range for you. Something that we will be comfortable with as far as a debt load for your business. |
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They’re going to look at a couple things. They’re going to look at collateral. I’m seeing banks don’t tend to rely on collateral as much as they used too. It used to be if they had a piece of real estate that was worth as much as the loan they were very comfortable. When we see some of things like real estate markets slow down, and maybe they don’t have the ability to sell that real estate as quickly as they used to. Now they tend to look a little more cash flow. Which again in their shoes might make sense. They’re looking at the cash flow of the business. Do you have the ability to repay that loan. |
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I think sitting down with your financial advisors with your financial statements, your income statement, your balance sheet, just to see, kind of evaluate, the health of your business. What is a comfortable debt load that you can take on? What you should be looking to do.
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| Mark Van B: |
I assume if you want to buy a piece of equipment on Friday you shouldn’t just start sitting down with your banker on Thursday?
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| Mark Fearon: |
Very very good point. I hear that comment a lot from some of our business clients. Boy we used to be able to do exactly that, call our banker and have the money within a couple weeks. We’re finding it certainly does take a lot longer to get that loan processed. Again, part of it is just change and the banking environment, the increased regulations. The scrutiny that banks go through from their regulators. Just a lot more due diligence on their end before they do make a loan. |
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Unfortunately, for the business owner it has elongated that process. It does take longer to get a loan. You certainly want to be kind of forward-thinking, looking ahead and give yourself plenty of time to get that loan in place.
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| Mark Van B: |
Mark, those are great comments about using debt and about saving it just for a tax deduction is probably not the best use, but to be strategic and thoughtful about your debt load are think are great points for our businesses. |
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Before we wrap up there’s a question we ask every guest. If you could have one super power what would it be?
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| Mark Fearon: |
I think the super power I would most like to have is to be able to fly. Let me tell you why there Mark. I’m the guy that always seems to be running late. Before I run to that meeting …
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| Mark Van B: |
You were on time today.
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| Mark Fearon: |
I was actually, I was impressed with myself for being on time today. Whether it’s to a kids sporting event, or to a meeting I always think I can get one more thing done at my desk before I leave, and it never fails that one more thing takes longer than what I expected. I guess if I’m able to fly I can get that one more thing done and still make it to where I’m going on time.
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| Mark Van B: |
We’ll get you a jet pack.
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| Mark Fearon: |
Exactly.
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| Mark Van B: |
Thanks for joining us today Mark. Listeners, I hope we were able to clear up some of your questions about financial planning and debt loads. If you have a question you would like us to cover on an upcoming Podcast send it to podcast@reacpa.com. You can find more information about this episode, as well as archive content and additional resources on our website at www.reacpa.com/podcast. You can subscribe to unsuitable on Rea Radio on iTunes or on SoundCloud. Until next time, I’m Mark Van Benschoten for unsuitable on Rea Radio encouraging you to loosen up your tie and think outside the box. |
