California Small Businesses Paid in Scrip

July 7th, 2009
World's 8th Largest Economy Can't Pay Its Bills

World's 8th Largest Economy Can't Pay Its Bills

Just when you thought it was hard enough with lack of access to bank loans, some small businesses in California that contract with the state are being paid for their services in IOUs instead of liquid funds. Owing to a $26.3 billion budget deficit, and the apparent inability of lawmakers to agree to spending cuts or tax hikes, the state does not have sufficient cash to cover all of its payments.  I have spoken with small business owners in California that contract to provide goods and services to the state and cash flow pressures in the summer months are nothing new. The California Legislature has rarely met its own June 30 budget deadline, with the result that the state is often in arrears in making scheduled payments to contractors over the summer months.  However, this is the first time since 1992 that California has printed IOUs against certain of its obligations. State Controller John Chiang has stated that he will issue $3.3 billion in IOUs along with $11 billion in regular cash payments.  Remember, California is the world’s eighth largest economy.

California’s cash flow problems may be disproportionately shouldered by small businesses. When California last issued IOUs for payments, state employees litigated their claims that receiving their paychecks in scrip constituted a violation of the Fair Labor Standards Act. A federal judge agreed, and the workers received their cash payments plus extra vacation time.  So state employees will not receive IOUs for their paychecks this time. And, because the federal government is paying certain of California’s social service obligations to the elderly and disabled, they will not be affected by the lack of cash.  Governor Schwarzenegger reached out to financial institutions to urge them to accept the IOUs, called individual registered warrants, which will be redeemable by October at a 3.75% interest rate. Wells Fargo, Bank of America and Chase Bank have announced that they will accept the IOUs from existing customers through July 10. It is not clear what will happen after July 10 or what other institutions will do.

In Prepare for the Worst, Plan for the Best: Disaster Preparedness and Recovery for Small Businesses (Wiley, second edition, paperback, 2009), I presented a framework for which the California liquidity crisis would qualify as a third-party service failure. Small businesses that depend on clients, such as California, to make timely payments to fund their own obligations are at risk for failure to diversify their client base, just as you would with a vendor or service provider. I am sympathetic to the start-ups in that state, as the market there is brutal.

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FDIC May Extend Coverage of Some Deposits

July 6th, 2009
Follow This News

Follow This News

According to American Banker, the Federal Deposit Insurance Corp. may extend its blanket coverage for noninterest deposits, currently scheduled to expire at year end. Business customers often keep checking account balances that exceed FDIC coverage limits on insured deposits in order to meet payroll and other large obligations. The FDIC provided this guarantee in the fourth quarter of 2008 as the financial crisis deteriorated. The FDIC is said to be concerned that if it fails to provide assurances that it intends to extend the program, business customers might begin to withdraw funds and split accounts across a number of insured banks, creating some unnecessary uncertainty in the banking and business systems. Small businesses that have accounts exceeding FDIC coverage requirements should watch the FDIC website for developments in this matter to ensure that their deposits remain within coverage limits.

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Recovery and Reinvestment Tax Benefits

July 5th, 2009
Something for Everyone

Something for Everyone

While the emergency loan program legislated into effect by the stimulus bill may have limited benefits for small business owners, there are other provisions to encourage capital investment that are worth considering.  The American Recovery and Reinvestment Act provides certain incentives, for a very brief time frame, for small businesses considering capital investment:

  • Faster recovery of certain investments in business property. If your small business invests in new property or equipment in 2009, there are two means to increase deductions related to those capital expenditures:
  • Increased limit on Section 179 expense. You may expense, rather than depreciate, the cost of machinery, equipment, vehicles and other tangible property placed in service in 2009, up to a maximum deduction of $250,000. The cost of property in excess of $250,000 may be depreciated over its life. In 2010, the Section 179 cap will drop from $250,000 to $133,000 (indexed for inflation). After 2010, the cap returns to the prior limit of $25,000. The Section 179 deduction cannot exceed taxable income, but it may be carried over to future years. However, it phases out for capital expenditures above $800,000 and limits the tax break to smaller businesses.
  • Bonus depreciation allowed in 2009. You may deduct up to 50% of the cost of “qualified property” (defined as almost any capital expenditure other than buildings) purchased and placed in service in 2009.  You may take the benefit of both the Section 179 expense and the bonus depreciation. However, the basis for depreciating the property must first be reduced by the Section 179 expense.
  • Extended net operating loss (NOL) carry-back period. Typically, a net operating loss may be carried back two years and forward twenty years to offset taxable income. For NOLs created after Dec. 31, 2007, the Recovery and Reinvestment Act provides a five-year carry-back period. So if your business paid taxes in the prior five years, the NOL may be carried back to the fifth prior year and each succeeding year to offset income and refund taxes. This benefit is available provided that your business gross income did not average more than $15 million in the three years leading up to the NOL. To claim the refund, eligible businesses must file Form 1139 by Sept. 15. Eligible individuals must file by Oct. 15 using Form 1045.
  • Shortened period for taxing S corporation built-in gains. Corporations which elect S corporation status are not taxed at the corporate level. Instead, the income, deductions and credits are reported by the owners. If a C corporation elects S corporation status, any gain inherent in property owned by the corporation at the time of the election and sold within 10 years of the election will be taxed at the maximum corporate rate (currently 35%). The Recovery and Reinvestment reduces the 10-year period to seven years in 2009 and 2010. This will benefit corporations that became S corporations (or acquired property from a C corporation) between 1999 and 2003.  How Congress thinks a backward-looking adjustment will motivate forward-looking investment is beyond me, but I guess the lobbyists have been busy.
  • Benefits for small business owners. You may exclude 75% of the gain from qualified small-business stock acquired after Feb. 17 of this year and before Jan. 1, 2011. To qualify, the stock must be held at least five years and acquired at the original issue date. This provision will benefit individuals after Feb. 17, 2014, upon satisfying the five-year holding period. Certain limitations apply to the exclusion, which is normally 50% of the gain. In addition, if you receive more than 50% of your income from a small business, the required 2009 estimated tax payments are lowered. Normally, estimated tax payments must equal or exceed the lesser of 90% of the current year tax or 110% of the prior-year tax obligation. In 2009, taxpayers who qualify only make estimated payments based on the lesser of 90% of the 2008 tax or 90% of the 2009 tax. This provision benefits taxpayers with 2009 income greater than 2008.

One caveat: I am not an accountant, so print out this entry and discuss this information with your accountant to get the advice that is specific to your unique situation.

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Unbelievable!

July 5th, 2009
Imagination Plus Adobe

Imagination Plus Adobe

The image shown here is that of the home page for the Intranet I had built for Childs Capital LLC. I did all of the work using the products of Adobe Creative Suite (which includes Photoshop, InDesign, Illustrator and Acrobat). Adobe is one of my favorite companies; I absolutely love its products.  So I was stunned to read that it had shut down its North American operations this week as part of a corporate-wide plan to reduce operating costs. Adobe, the world’s largest maker of graphic design software, announced to employees back in March that, in addition to the normal holiday shutdown between Christmas and New Year’s Day, the company would close for one week in the second, third and fourth quarters. Staff were asked to take paid vacation time. This measure is on top of an 8% reduction in the workforce taken last December and salary freezes and bonus reductions imposed on the remaining employees. The company has reduced variable compensation plans and cut travel costs.  Spending on information technology is falling as recessionary pressures force companies to cut spending. Adobe is not immune from these pressures, as its second quarter sales declined 21% as customers postponed upgrading to the latest version of Creative Suite.

I also happened to read the newspapers reports that Crabtree & Evelyn Ltd. has filed for bankruptcy. The company expects a 24% decline in sales from last year and projects a 30% decline in wholesale sales this year.  When I was a high school student, Crabtree & Evelyn personal care products were a favorite of the girls who were my classmates. I never thought I would see the day that companies that make such great products would be in such distress.

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Too Little, Too Late for NYC Small Businesses

July 4th, 2009
The View is Much Better From Afar

The View is Much Better From Afar

Crain’s New York Business reports that City Hall is taking steps to make doing business less painful for smaller businesses in New York City. City Council Speaker Christine Quinn is introducing legislation to waive penalties for small businesses with outstanding fines owed to certain, but not all, city agencies. She is also pursuing a measure that would require the City to assess the impact of any new regulations on small businesses prior to their adoption. This seems a small step given that in the past, small business owners have proved to the local newspapers that city inspectors smashed lights on their premises and then fined those businesses for not meeting lighting regulations. Presumably this was done to meet quota requirements for city inspectors. It was a shrewd calculus; the cost of appearing to protest such abuse exceeds the cost of paying the fine to make it go away. But it was a Pyrrhic victory for New York City government. The City has issued over $200 million in fines and penalties that it appears unable to collect. But more significantly, small businesses are fleeing the City and new start-ups don’t offset the attrition. Ms. Quinn has proposed convening a panel of legislators to review regulations, one by one, to find those that impede business operations while doing little or nothing to improve the quality of life in the City. I think that is a good first step, but it is too little, too late for New York City which has an extremely hostile small business climate. I suspect that this realization, that small businesses are good for the economy, was likely motivated by the troubles facing Wall Street. With Lehman Brothers, Bear Stearns and Merrill Lynch gone, and other institutions downsizing, who else will hire employees? If the City is really serious, it needs to move beyond the small potato, but extremely irritating issues, of fines and regulations and start looking at the tax structure.

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Isolated from the Digital Infrastructure

July 3rd, 2009
This Way to the Remote Spots

This Way to the Remote Spots

The Pew Research Center found that 63% of Americans have broadband Internet connections in their homes, up from 55% the year before. They are paying on average $39 monthly from this service, up from $34.50 the prior year. The fact that they are paying more suggests the value that they attach to this service. In this difficult economic environment, consumers reported that they were more likely to cut back on cable television or cell phone service to budget for Internet access. However, the news was not all good, as 37% of Americans remain without access to broadband. Income was the largest barrier to access; 82% of those who don’t use the Internet earn less than $40,000 annually. Almost half earn less than $20,000 annually. Only 25% of those without Internet access live in rural areas, where low population density is often a disincentive to building broadband systems. The question is: does lack of broadband access hinder economic development? The Organization for Economic Cooperation and Development reports that the U.S. ranks 15th in per capital broadband deployment, well behind faster-growing Asian economies, such as South Korea.  Certain of the $7.2 billion in economic stimulus funding is targeted for expanding broadband access, which may help those in rural areas, where it is not economically efficient for private providers to expand access. But this may result in low returns for the investment, given the survey findings.  However, for rural areas in the Gulf Coast, expanded broadband access would almost certainly be welcome, as they need fast Internet access for remote operations, particularly during the hurricane season.

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Life In the Entrepreneurial Forest

July 2nd, 2009
It Is Inevitable

It Is Inevitable

Virgin Atlantic Founder Richard Branson had a creative way of describing the phenomenon of creative destruction, the memorable phrase of economist Joseph Schumpeter. He empathized with the pain of employees of British Airways who are forfeiting one month without pay in order to preserve employment at this difficult time. However, he noted that in the forest, old shoots are allowed to die such that new saplings may grow. Absent a compelling threat of systemic risk, such as a legitimate banking crisis, Branson sees government intervention as counter-productive. It simply delays the inevitable, at tremendous cost to the taxpayers, for which our as-yet-unborn great-grandchildren will be paying. And it suppresses or raises the cost of innovation which could provide better services and new jobs. Branson’s interview was thoughtful and we can only hope that policymakers listen to this very articulate and successful entrepreneur.

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Health Insurance Reform a Double-Edged Sword

July 2nd, 2009

Regulatory reform often has unintended consequences; the current debate over health insurance reform is no exception. With proposed government subsidies, as many as ten million low-wage employees may choose to drop their employer-provided health insurance and purchase coverage on the open market. With such attrition rates, small businesses may find their group purchasing power reduced, making it more expensive to insure the remaining employees. This could draw another ten million employees into the individual market, if small businesses are forced to drop their coverage plans due to the crowding out effect of the government exchange. According to a survey of the National Small Business Association, nearly 10% of small business owners are contemplating dropping their medical insurance coverage next year. The uncertainty around health care reform makes a lengthy debate expensive, with the cost falling disproportionately on small businesses.

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Will the Courts Do What Congress Did Not?

July 1st, 2009
There Should Have Been a Better Way

There Should Have Been a Better Way

The website for Advanta Corp. identifies the tagline of that company on the upper left hand corner as “Credit cards for small businesses”. In the center of the home page the company announces “Account closures: We deeply regret that all Advanta Business Credit Card accounts are closed, effective May 30, 2009.” Advanta stopped lending against open credit card accounts last month due to funding problems. On May 11, Advanta announced that it would allow its securitization facility to unwind.

Now irate small business cardholders are seeking class-action status in litigation against Advanta filed in Superior Court in Santa Clara, California on June 16. They allege that Advanta “unilaterally, unfairly and illegally” changed the terms of credit card agreements, “increasing their effective interest rates…in an attempt to unfairly accelerate repayment of outstanding balances and to increase immediate revenues”. Consumer complaints against Advanta rose dramatically last year when the company responded to the spike in charge-offs by re-pricing accounts, sometimes by as much as 30 percentage points. The documents filed in court state that last year “Advanta imposed new APRs on plaintiffs’ credit cards…increasing the promised fixed rate to as high as 29.99%….These new terms were not previously disclosed in any form to Advanta’s customers and were not the result of any breach of the contract by the consumer”. The plaintiffs are Advanta cardholders who believe that they and other customers have been harmed by “having to pay interest and finance charges with interest accrued at higher rates than Advanta promised”. The lawsuit is seeking $75,000 per cardholder plus interests and costs.

Given that Advanta has terminated all of its small business accounts, what do the plaintiffs hope to gain, besides compensation which, even if awarded by the court, may not justify the time and effort invested in the process of litigation? According to American Banker, Arthur D. Levy, the attorney for the plaintiff, wrote that “Advanta’s lending moratorium does not affect this case. This is to make customers whole for past illegal rate increases. We are monitoring Advanta’s financial situation and so far….they appear to have sufficient capital to repay their customers in our case.” In effect, they are litigating over past abuses that credit card reform legislation was meant to correct. However, as I wrote in an earlier blog posting, the legislation Congress passed aids individual consumers and is of no benefit to small businesses. In choosing inaction, Congress likely left small business owners to pursue justice in the courts, at expense to all taxpayers.

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Fed Chairman Bernanke Should Visit Small Businesses in Harlem and the South Bronx

July 1st, 2009
Alexander Doll Company in Harlem

Alexander Doll Company in Harlem

On June 17, Chairman of the Board of Governors of the Federal Reserve Bank System Ben Bernanke addressed the Global Financial Literacy Summit in Washington, D.C. He spoke about the challenges and opportunities facing community development financial institutions (“CDFIs”). Such organizations reach consumers in traditionally underserved markets, helping them to manage credit, buy homes and start small businesses. There are more than 1,000 CDFIs holding about $25 billion in assets and like everyone else, they are affected by the economic downturn. Philanthropic funding to these institutions has declined as foundation endowments and investment earnings have declined in value. At the same time, support for CDFIs from state and local governments and more traditional institutions are also declining. In particular, banks that sought to avail themselves of Low-Income Housing Tax Credits saw the value of those credits decline as tax credits declined in value commensurate with their deposits.

I read Chairman Bernanke’s speech in its entirety and my reaction to his remarks is mixed. On the one hand, I am always glad to see the issue of financial access on the radar screens of regulators. But at the same time, I am troubled by the philosophy implicit in the Chairman’s remarks and in the Obama Administration’s financial regulation white paper. Their view appears to be that banks have to be bribed and cajoled by tax credits or regulatory fiat into doing business in low-income areas. In fact, low-income areas are often vibrant entrepreneurial communities, creating opportunities for themselves after larger corporations have moved employment elsewhere.  As long as banks perceive the stick as the inducement to enter these markets, they will not stay for long, when the stick becomes less menacing, as it does in an economic recession. However, when banks see the carrot, the profit opportunity for reaching under-served markets, their commitment will be sincere and longer-lasting.

For a more forward-looking perspective on the purchasing power, due to income density, of under-served urban areas, check out the Initiative for a Competitive Inner City (“ICIC”). When I was in business school, I received an award from the ICIC for a case study I had written on the Alexander Doll Company. The award provided for my participation in ICIC’s annual program for MBA students. The Alexander Doll Company is based in Harlem and manufactures the Madame Alexander line of dolls that I was given as gifts as a little girl. No one who would tour the doll company (and I encourage you to do so!) would see under-served communities as economic basket cases. I think that the future belongs to institutions like CheckSpring Bank in the South Bronx and the Alexander Doll Company that act on opportunities to build their workforces in very motivated communities.

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