My office manager, Karen, sat with a new restaurant client. Ten minutes later Karen was in my office with the financials of the client.
“She doesn’t understand why she is losing money, boss,” Karen said. “She says business is good, but she loses money every month.”
I looked at the profit and loss statement for less than ten seconds when I asked Karen, “Is this correct?”
Karen named the bookkeeping firm the client used. It was a reputable firm. Karen said the client reported all income daily and reported it to the bookkeeper. The bookkeeper paid all the bills and provided a statement each month.
If the P&L was correct there was only one explanation. “One or more of her employees is embezzling.”
“Can you talk with the client?” Karen didn’t know what to tell her.
I went to Karen’s office and explained to the client she had at least one employee embezzling.
“How do you know?” she asked.
I held up the P&L. “The cost of goods sold compared to wages compared to revenue are off. Someone is either walking out the back door with steaks and seafood or someone is stealing cash receipts.”
The client assured me she had honest employees. With only a glance at her financials I was certain there was malfeasance.
“It might be a waitress. Do people leave money at the table or take it to the checkout person?
“Checkout person.”
“Okay, it probably isn’t her because the amount is too large. And while steak and seafood might be walking out the back door, the cost of goods sold is somewhat in line with employee wages. It is revenue that is off.
“So tell me, do you have a security camera on the cash register?”
She told me she had no security cameras.
“The employee at the cash register might be the problem.
“No,” she said. “That employee has been a friend since we were in kindergarten.”
That was all I needed to hear. With rare exception, embezzlement comes from people you trust the most. Either a family member, close friend or the faithful employee who hasn’t taken a vacation in eight years. There is a reason accountants demand business clients require anyone in their business handling money to take a two week vacation every year. You would be surprised how much embezzlement is uncovered when someone is on vacation.
“Your friend is robbing you blind,” I confirmed.
She still insisted her friend would never steal from her.
“Okay. This is what I want you to do. Go back to your restaurant and call a meeting with your employees. Tell them your new accountant is a real a-hole and demands a security camera be placed over the cash register.”
She did as I asked. Her friend since kindergarten quit on the spot. And profits arrived for the first time at her restaurant.
Unfortunately the theft had gone on for too long and the financial damage too great. A year later she closed her restaurant, deep in debt.
Warning Shot
A few weeks ago I published on the Fleecing of the FIRE Community. Some readers were irritated while others were concerned. I wrote things like:
Since you managed to acquire a respectable nest egg you think you are an experienced investor. It is doubtful you are!
and
Buying into an unconventional investment, which these bike communities are, should never happen unless you are very experienced financially and have the ability the lose 100% of your money without changing your lifestyle one iota.
and
You have no idea of some of the people on my desk I’m helping. These are serious issues; small fortunes completely destroyed unless I can find a way to preserve their wealth. I don’t always win.
When I published:
To keep this short I will close with one last suggestion. If you can’t read and interpret financial statements like a seasoned accountant you have no business being in any kind of exotic investment, real estate included. Stick to index funds and money market accounts.
You might not shoot the moon, but you will not suffer a catastrophic loss sending you back to square one, as a neophyte in the FIRE community once again.
people wanted to hear some of the horror stories, hoping to learn from other’s mistakes.
I stand by my original advice: Don’t invest in things you know nothing about. If you can’t read a financial statement how will you understand if a rental property is a good buy? Or a business?
The next time you are tempted by a slick sales pitch at a conference (this is being published while FinCon is running in D.C.) or camp, come back and read a few of these true stories. Names are changed to protect the guilty (yeah, I think I’m funny); the stories are all true.
Supper Club
I have a group of clients that own several businesses around town. Two from this group with several outside investors own a supper club near my office. They called me in to handle taxes and consulting. It was bad from the start.
Once they bought the supper club they hired a manager. This was a guy they knew from running some income properties they owned.
The manager and his wife handled the books.
The club was open for a bit before I was called in. I would review the books monthly and consult before preparing the annual corporate tax return.
I was to meet with the manager. When I arrived it didn’t take long to know something smelled bad. From the front door to the bar was all it took for me to know embezzlement was rife.
The bartender game me a cold attitude. There is no reason an employee of a business client should ever give the accountant an attitude. This told me the employees knew or suspected the malfeasance. The environment was bad.
I was shown to the office where I waited as the manager was running late.
I noticed a gap in the security cameras between the back office where I was and the safe.
When the manager arrived he was livid. He made it clear I was never to touch the books unless he or his wife were present.
After the meeting I called one of the owners. I told him he had serious misappropriation of funds issues. I told him it was the manager bleeding him dry.
I was assured the manager was a good guy. I pointed out:
- The bartender’s attitude was unusual to see. Employees should care less if the accountant shows up. They should have been more interested in serving me a drink, hoping for a tip.
- The security camera gap between the office and safe was a serious issue.
- Any manager who is that adamant the accountant not see the books without supervision is practically an admission of guilt. There is only one reason to control what the accountant sees.
I knew who was embezzling (manager), where they were doing it (security camera gap near the safe), when they were stealing the funds (at closing the manager or his wife handled the money with no oversight) and how much (I estimated between $100,000 and $150,000 based on revenue).
When I was not taken seriously I said I was not interested in the account and hoped it would not affect my work on their other accounts.
A year later one of the owners was in my office. It seems I was wrong. The manager was embezzling just as I said he was, except he misappropriated at least $300,000.
I reminded my client he probably did the same when he was managing their rental properties which always seemed to lose money, too.
Fish Farming
The moral of the first story is: If you can’t read a financial statement you have no business being in business.
The moral of the second story is: When your accountant’s BS alarm goes off, listen.
In the second story the business survived and even later thrived. (Though I never got the account, but never lost the accounts of their other businesses.)
Now we turn to an income property story.
This didn’t happen to my client. I was a member of the Fox Cities Apartment Association many years ago when I owned a massive amount of real estate when I heard the story.
It seems a neophyte watched late night TV when he discovered he could be a gazzillionaire buying income property no-money down and cash flow right out of the gate.
This guy bought an up/down duplex, filled the unit and enjoyed his new-found cash flow machine.
As winter approached the tenant called and said the furnace was not working. The landlord went over to see if he could fix the problem without calling an expensive technician.
When he gets to his property he finds the problem right off. The basem*nt is filled with water!
It seems the tenant wanted to raise fish. Thank God he didn’t fill the basem*nt to the electrical panel.
The foundation of the building was shot. Insurance didn’t cover the damage because it was the tenant’s fault. The landlord sued the tenant and won, but the tenant had no money and later disappeared.
The city condemned the property and the bank foreclosed and socked the landlord with the shortage when the bank sold at a fire sale price. The landlord later declared bankruptcy. The stress destroyed his marriage. He lost his easy money investment, wife and had to pay 29% of his gross income in child support. I have no idea how he ever recovered.
The morals of this story are:
- Income property is NOT easy money,
- Always screen your tenants (his tenant had prior litigation with landlords),
- Always check your property, even if you have a property manager. An annual (or more often) personal inspection is a requirement in my opinion,
- Alternative investments, including income property, require a reserve to handle maintenance and excess damages, and
- No-money down deals are rarely a great deal. They are desperate deals.
This guy did everything wrong. He bought a crap property which attracted crap tenants. He put no money down and had no reserve, He never screened his tenants or inspected his property. What did he expect would happen?
Bad Advice
Some readers might notice I have no hair. It’s because I pulled it all out.
What non-bloggers might not understand is that bloggers can see when other blogs link to their site. Usually I’m curious to see what is said; usually I’m sorely disappointed.
For example, a blogger once published she never has an LLC for her income properties and linked to this post of mine as her reasoning. It was a 100% misunderstanding of what I said!
I have no problem with, and even recommend, income properties be held inside an LLC. What I also say is that you should never place real estate inside an S corporation or LLC electing to be treated as such for tax purposes.
The post this blogger linked to is about small businesses and not real estate so she read it all wrong. Which leads us to our last example so I can take an aspirin to dull this throbbing headache resulting from pounding my head into the corner of my office.
When it rains, it pours. I’m not talking salt either.
Last summer I had two consulting appointments with the exact same issue: income properties inside an S corporation.
Since I could kill two birds with one stone I tried my darnedest to find a solution. I even hired a law firm in California to help. Alas, nothing could be done. Once real estate is inside and S corp it stays there, regardless the negative consequences.
(If you transfer real estate from an S corp to an owner of the S corp it is still treated as a sale at fair market value, triggering a capital gain (or loss). )
There are several reasons why you should never, ever, ever put real estate inside an S corp or LLC electing to be treated as an S corp.
First, if the S corp spent any time prior as a regular corporation (C Corp) it probably has accumulated earning. An S corp with any C corp accumulated earnings and 25% or more of the S corp’s earning are passive (rent, interest, dividends), the S corp is taxed at the highest C corp rate.
I know that is a mouthful and a lot of details are disregarded. (It’s actually more complicated than that tongue twister indicates.) Regular corporations now have a flat 21% tax rate so it might not be as bad as it once was. Still, it causes an S corp—a vehicle for managing a business with fewer taxes—to be taxed at the regular corporate rate.
It also adds complexity to the tax return. Good for the tax professional (if he can keep his sanity); bad for you.
This problem is easily avoided by going straight to an S corp which many do.
The real problem—and this is a big one—involves basis.
I know basis is hard to understand, but it is of vital importance here.
Most people understand they have basis in their S corp if they invest money into their business. What is harder to understand is how loans affect basis.
S corps are unique in that loans by the corporation do not add to the shareholder’s basis unless the loan is from the shareholder. Even if you guarantee a loan taken out by the S corp it does not add to basis!
We will not bog ourselves down today on S corp basis nuances so don’t take my next statements as complete answers; they are not.
The two clients I consulted (and latter prepared their tax returns) have serious S corp basis issues because they had real estate in their S corp and the S corp took out loans.
When this happens it is possible to show a loss (real estate depreciation can cause a loss while still cash flow positive) and use up basis. When that happens it is possible in some circ*mstances to pay a capital gains tax on distributions when the S corp shows a loss.
Accelerating depreciation can really complicate this issue. Current tax law allows faster depreciation in some instances. Repairs and improvements are deducted easier now. And cost segregation studies can super charge depreciation deductions.
When real estate is in an S corp you always have to keep an eye on basis from the corner of your eye.
Nothing is worse than paying taxes on losses! And it can happen in an S corp when the rules are not followed.
The clients’ intentions were never to break tax laws either. They did what they thought was correct or might have even read some tax articles and misunderstood the complex issues surrounding S corp taxation.
To fix this problem I’m working with the client to verify all loan are from the shareholder. Loans are structured so the shareholder takes out the bank loan and lends the funds to the S corp. That does add to basis! (This is the opposite of what banks do so they have to be told the consequences. If they don’t listen, get a different bank!)
The moral of this story is:Always seek the counsel of a competent legal and tax professional before buying real estate and/or starting an entity.
I know people around here love saving money, but you don’t save when you make a serious tax error. A small investment in an attorney and tax professional can yield massive returns and peace of mind.
Coda
Warren Buffett once recommended you focus less on business school and more on taking a few accounting classes. I couldn’t agree more.
You can’t make an investment or run a business optimally without understanding the language of business: accounting.
While business classes are great, a fundamental understanding of accounting will serve you in every facet of your life: personal finance, investing, work, side hustle, small business.
You would be surprised at how many people doing their own books record loan payments as an expense. (The interest portion of the payment is an expense; the rest is principle which is recorded against the liability on the balance sheet.) If something as simple as this is not understood, how can you possibly trust your judgement in running the business or in any investment decision?
My original comments are correct: People have no business making investments in things they don’t understand! My buddy Warren has said at least a googolplex times.
All these crazy ideas brought to conferences and the various FI camps are accidents waiting to happen. You can make informed decisions when you understand the language. You, like me, might enjoy making small investments in strange products just to see how it works and plays out. Nothing wrong with that as long as you understand what you are doing.
Making large investments without understanding the investment is insane. Index funds and bank deposits are what you should limit yourself to if your accounting knowledge is limited. In fact, you shouldn’t even listen to any investments offers. All that could happen is you get sold and then God help your net worth because no one on the earth will.
It is also never too late to learn. Colleges and tech schools around the country have superb accounting classes.The great news is accounting has been around a long time is and virtually unchanged in that time. You don’t need a prestigious college for a good accounting education. Even local night classes will make you a better investor.
It is temping to think you know more than you do when your stash grows. Success gives the illusion of intelligence. When the crisis arrives the illusion evaporates.
Please, kind readers, use common sense. If you don’t fully understand the concept and the financials then take a pass. Better to miss a deal than to go all-in on a scam.
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Acost segregation studycan reduce taxes $100,000 for income property owners.Here is my review of how cost segregation studies work and how to get one yourself.
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