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The Franchise Prototype Manual

 

Nine out of 10 businesses fail within the first 5 years, 75% of franchises succeed.

Part of that success rate is due in part to having a standard operating procedure (SOP) in place.  That standard operating procedure is detailed within a franchise operations manual.  If you are a small business or a business just starting out, your chances of success will increase exponentially if you take the time to develop an operations manual.  In this document I will refer to our manual as the “Franchise Prototype Manual.”

 

Essentially, the Franchise Prototype Manual “abstracts the successful workings of the business being franchised such that it becomes a ‘replicable unit.’” – franman.net.  For a startup, the manual will document what should be successful going forward and as “production tests” are made, it can be modified accordingly as trial and error discoveries are made.  The business will be a replicable unit (it can be cookie-cuttered across the nation) and the system detailed within the manual will be easily trainable.  You need to treat the business as if you were going to open up thousands of locations across the nation even if you are not. In the end, the first operation must be a success.  It must be the best working system of the model.  It must be firing on all cylinders and the system must be complete. 

 

Q: What goes into the Franchise Prototype Manual?

A: Everything.

 

Whether you like the franchise or not, the next time you walk into a McDonald’s, take a look around and take note of the system in place.  From the décor of the restaurant, to the greeting you receive, to the dress of the employee who takes your order, to the distance between the register and the “burger slides”, to the time it takes to receive a Big Mac from the moment you order it and how it is prepared. You are witnessing the result of the Franchise Prototype Manual in action, the system.  All of this and more has been laid out in a manual and it is easily trainable and easily replicable, from state to state, from country to country.  In theory, the fries you receive in California should be the same fries you would receive in New York.  Within this consistency of operations lies one of the keys to your businesses’ success.

 

Thus, in order to capture the soul of franchising, in theory, you merely have to find a winning business model, detail it and replicate it.

 

Your Franchise Prototype model will contain a large amount of information regarding operations but, in addition to operations, you should also detail organizational role responsibilities (who is accountable for what - typically illustrated in an organizational chart) and an audit/accountability process to ensure that the manual is successfully executed.  The key here is to identify a winning model, replicate that model, audit the model for consistency and execution, and adjust accordingly to outside competitive and economic forces.

  

Specifically, What Goes Into The Franchise Prototype Manual

 

Okay, here it is:

 

1)       Site Selection

 

Quantitative:

 

Foot traffic, drive-by traffic, area demographics (age, sex, lifestyle), population center, distance to employment centers, highway access, distance to complimentary businesses. 

 

Qualitative:

 

Your location will speak volumes about your business.  Is the business a night club that requires a location in a trendy area of town or a gas station that requires a convenience location in a dense, high population area? 

 

2)      Training

 

This aspect is highly critical to your franchise prototype model.  The system must be easily trainable and filled with the lowest skill level possible, still capable of operating the system.  The system compensates for skill, but again, the system must be trainable.

 

Under this section of the franchise prototype manual you need to detail how and when you are going to train (on a regular basis would be nice), the details of the material to be covered (ideally, much of the prototype manual) and new employee orientation.

 

Who will be responsible for the training?

 

3)      Facility Set-up

 

What equipment is necessary in the prototype?  What does the décor look like?  An itemized list of equipment needed with prices would be ideal.

 

4)      Inventory and Supplies

 

If you are a restaurant this is where the food inventory goes: the quality, the supplier, the price, etc.  If an office, this is the paper, the staplers and who supplies them.  You would also want to detail any contracts that you currently have set up or intend to set up with suppliers.  For your initial business, you need to shop around and get quotes for price and convenience (does one supplier carry most if not all of your equipment?)   If the business truly does expand to multi-locations, you would want to revisit these initial contracts.

 

5)      Uniforms

 

What appearance do you want present to your customers?  Should your employees be professionally dressed or are you a casual establishment where jeans would be more appropriate?

 

6)      Marketing Efforts

 

What types of media will you use?  What system will you have in place to follow up on a media campaign to judge its effectiveness?  How will you reach your target audience?  Who is your target audience?

 

7)      Personnel

 

a.      Responsibilities

 

An organization chart will go a long way under this section.  Who is responsible for what (at every level) and what accountability process is in place to follow up on this?

 

b.      Profile of Ideal Employees

 

Who do you want?  What type of personality do they need to have?  Do they need to be a team-player?  Do they need a specific skills set?

 

c.       Job Descriptions

 

Again, building off of the organization chart, what are the key roles in your business (again, at every level) and what are the responsibilities of each role.

 

d.      Job ads and sources of employee candidates

 

For Recruitment, where do you place your ads or who do you call for referrals?

 

e.      Interviewing and background checks

A standard list of interview questions for each responsibility level would be ideal.  Also, you should background check – either learn the ropes of doing this yourself or find a company that will do this for you.

 

f.        Back-ground checks and pre-employment testing

 

Ditto – what’s the policy?

 

g.      New Employee Orientation and Training

 

Never de-emphasis orientation and training.  This should be a standard format to pass along the standard operating procedure of the franchise prototype manual.  It should be packaged, repeatable, and recurring.

 

h.      Personnel Policies and Communicating Work Rules

 

How do you go about communicating the work rules?  What are the personnel policies?

 

i.        Paying Your Employees

 

When and what is the system you use for payroll?  Do you offer direct deposit?

 

j.        Employee Scheduling

 

How do you process requests off, how do you handle vacation time etc.?  If you lay out a plan here you will have consistency and fairness.

 

k.       Employee Management Forms

 

You should create forms for review time and for “coaching” time.

 

l.        Employee Morale / Motivation

 

It’s important to have a systematic morale and team-building factor in your business.  People don’t want to come to a job they dread day in and day out nor will they be productive.  You should consider the following factors:  (Introduction would be a description of the system)

 

i.        Introduction

ii.      Factors of Good Morale

iii.    Signs of Bad Morale

iv.     Improving Morale and Motivation

 

m.    Performance Evaluation

 

When and what is the standard?  What metrics are you judging your employees against?  Ideally, the evaluation would be tied to growth of the individual as well as some measure against the company objectives.

 

n.      Employee Discipline

 

Documentation, documentation, documentation … and witnesses.

 

o.      Resignation / Termination

 

i.        Resignation

ii.      Termination

iii.    Post-Separation Procedures

iv.     Final Paychecks

v.       Explaining Termination to Other Employees

vi.     Giving References

 

p.      Summary of Good Employee Management Practices

 

What practices do you have in place for management to follow?

 

DAILY OPERATING PROCEDURES

 

1)      Required Days / Hours of Operation

 

When will you be open?

 

2)      Customer Service Procedures

 

This is a very important piece to the puzzle.  How will your customers be consistently greeted and serviced time over time?

 

a.      Customer Service Philosophy

 

                                                              i.      Customer Feedback

 

How will you judge the effectiveness of your system?

 

                                                            ii.      Customer Complaints

 

If a customer complains how is this processed?  Will your employees blow up or is there a documented procedure and will the complaint be documented?

 

                                                          iii.      Our Customer Complaint Policy

 

Again, this fleshes out the preceding.

 

                                                           iv.      Refund Requests

 

What is the policy?  Are you going to except every return that comes in the door and hand cash back?  Perhaps gift cards?

 

b.      Service Procedures

 

Again, the following will flesh out how you will continually provide consistent service and detail selling techniques.

 

                                                              i.      Greeting Customers

                                                            ii.      Answering the Telephone

                                                          iii.      Atmosphere

                                                           iv.      Understanding the Product Offerings

                                                             v.      Working / Interacting with Customers

                                                           vi.      Job Descriptions

                                                         vii.      Suggestive Selling Techniques

                                                       viii.      Passive Selling Versus Active Selling

 

3)      Merchandising Procedures

 

How will your merchandise be displayed and what does it say about your business.  How does your merchandising fit into the overall image of your business?

 

a.      Visual Merchandising Standards

b.      Merchandising Products

c.       Using Signage

 

4)      Meal Preparation Procedures (This section would apply only to food service businesses)

 

Again, the key here is consistency.  When McDonald’s launches a burger it is made the same from coast to coast, country to country.  Where do the pickles go and how much sauce?

 

a.      Prepping Procedures

b.      Setting Up Preparation Stations

c.       Recipes for All Items

d.      Preparation Procedures for All Items

e.      Maintaining Inventory

f.        Dishwashing / Sanitation Procedures

 

5)      Opening / Closing Checklists

 

Consistency, consistency, consistency.  Would you expect repeat business if you could not consistently keep the place clean?

 

a.      Opening Checklist

b.      Closing Checklist

 

6)      Transacting Sales

 

You don’t want your employees figuring this out on the fly as they are ringing up a customer.

 

a.      Entering Orders Using the POS System

b.      Cash Handling Procedures

c.       Accepting Personal Checks

d.      Accepting Credit Cards

e.      Suggested Prices

 

7)      Gift Certificates

 

It seems that a good policy would be to issue gift certificates for returns instead of cash which can be spent elsewhere.  Be wary of customer service implications here though – some customers will be turned off if you are forcing them to buy with you. But, you are opening yourself up for abuse if all returns are handed cash.

 

a.      Issuing Gift Certificates

b.      Redeeming Gift Certificates

 

8)      Inventory Management

 

Who orders, when is it order, how low do supplies get before an order is placed, who are the suppliers, how much can be spent on inventory, in the org chart, who is accountable?

 

a.      Product Ordering Procedures

b.      Ordering from Approved Suppliers

c.       Changing Approved Suppliers

d.      Product Receiving Procedures

e.      Storing Procedures

f.        Labeling and Rotating Inventory

g.      Spoilage

 

In addition, how will waste be handled?  Will you merely toss waste or should it be tracked to avoid “hand-outs?”

 

9)      Operational and Financial Reporting

 

It is going to be essential that you have timely reports – a weekly profit and loss (income statement) should be at the top of the list.  You also need to be tracking key metrics pertinent to your business – how close are you to reaching your goals, if foot traffic is important, how much foot traffic did you have last week.  In the organization chart, who is responsible for this role?  QuickBooks is a great tool to use for generating profit and loss statements.

 

a.      Features of the POS System

b.      Generating Reports

c.       Analyzing Reports

d.      Sample Reports

 

10)  Franchise Fees and Reporting Requirements (if you are a franchise or plan to franchise)

 

This is what home office wants to get paid and what reports they want to see.  Again, this is relevant if you are planning to franchise soon – not necessarily for our first prototype but if you want, treat yourself as “home office” and ask,  what reports would you want to see from your franchisees?

 

a.      Royalty Payment

b.      Marketing Fee

c.       Required Reports

d.      Financial Statements

 

11)  Loss Prevention Techniques

 

This could also be called “slippage.”  How are you going to audit for theft?  What is the policy for documenting and follow through on suspected theft?

 

a.      Cash

b.      Inventory

 

 

12)  Required Cleaning and Maintenance

 

More than likely, customers are not going to frequent a dirty establishment, especially if you are in the restaurant business.

 

a.      Daily Cleaning and Maintenance

b.      Weekly Cleaning and Maintenance

c.       Monthly Cleaning and Maintenance

 

13)  Safety Procedures

 

This is a biggie since worker’s comp can be a big cost.  An ounce of prevention in your safety programs will go a long way.

 

a.      Preventing Accidents and Injuries

b.      Crisis Management Policy

c.       Reporting Accidents

d.      Worker’s Compensation Issues

e.      Fire Safety

f.        Robbery / Burglary

g.      Unruly Customers

h.      Using the Alarm System

 

SALES PROCEDURES

 

Again, when that customer is greeted and subsequently dealt with in your sales process, how are they handled?  What does the prototype manual say?

 

1)      Introduction

2)      The Sales Process

 

a.      Identifying the Customer’s Needs

b.      Building Rapport with the Customer

c.       Handling Objections

 

3)      Understanding Your Competition

 

What do they do better?  Do they have a sustainable advantage that can tear away your market share or do they stink at what they do or are they offering something that will eventually drive them out of business?

 

 

4)      Competitive Advantages

 

What is your sustainable advantage over your competitors?  What do you consistently do well, with margin, that others cannot do or do not perform in as quality a manner that you do?

 

MARKETING

 

1)      Promoting our Business in Your Area

 

For a single unit, you want a consistent marketing message over time (I’ve read that it takes approximately 20 impressions before a message sinks in) and if you are a chain, you want uniformity.

 

a.      Your General Obligations

b.      Guidelines for Using Marks

c.       Marketing Standards

 

2)      Logo Specifications

 

You need a consistent display and it should be trademarked.

 

3)      Required Marketing Expenditures

 

You want marketing effort here – how much should your units be spending per year on marketing?

 

a.      System Marketing

b.      Local Marketing Requirements

c.       Regional Cooperative Advertising

d.      Grand Opening Marketing

 

4)      Local Marketing

 

What mediums will you use to get the message out? How will you judge the effectiveness of each campaign?

 

a.      Introduction

b.      Direct Mail

c.       Radio

d.      Television

e.      Billboards

f.        Magazines

g.      Newspapers

h.      Yellow Pages

i.        Internet

j.        Networking

k.       Word of Mouth / Customer Referrals

 

5)      Public Relations / Community Involvement

 

Some of the most successful businesses are those that give back.  Your top line goal should be to serve as many people as possible.  After that, the money will follow.

 

a.      Press Releases

b.      Better Business Bureau

c.       Local Chamber of Commerce

d.      Team Sponsorships

e.      Community Service / Charitable Activities

 

6)      Obtaining Marketing Approval

 

Again, this would be one of those factor that would be run by the home office if it was an outside the box marketing effort.

 

 

MANAGEMENT DOCUMENTS

 

This is a very important aspect of your business – it allows your managers to have a consistent execution on the policy you have instilled and it provides consistent tools across the board.

 

1)      Daily Cash Sheet

2)      Absence Policy

3)      Applicant Information Release

4)      Sample Applicant Rejection Letter

5)      Sample Applicant Acknowledgment Letter

6)      COBRA

7)      Sample Collection Letter

8)      Time Spent During Work Hours

9)      Customer Satisfaction Survey

10)  Discipline Documentation Form

11)  Drug Test Consent Form

12)  Electronic Funds Transfer Authorization

13)  Emergency Instructions

14)  Job Application

15)  General Work Rules

16)  Holiday / Vacation Policy

17)  Restroom Inspection Worksheet

18)  Sexual Harassment Policy

19)  Smoking Policy

20)  Termination Meeting Checklist

21)  Employee Time Records

22)  Checklist For Handling Workers’ Compensation Claims

23)  Workplace Safety Rules

24)  Employee Data Form

 

 

For many, this manual is going to seem like over-kill but need I remind you of the statistics:  Nine out of 10 business fail within the first five years. Seventy-five percent of franchises succeed.  This can be attributed to many factors such as name recognition, large required capitalization, proven business model, etc., but at the core of all of this lies the standard operating procedure which is culled from the franchise operating manual.  Thus, it is my belief that should you go through the process of creating your own “Franchise Prototype Manual” for your business, you will have laid a strong, fundamental cornerstone for your business and you will be well on your way to success.

 
 


Taxes – Why You Should Turn Your Hobby Into a Small Business

Tax time has always been the time that my wife and I ask ourselves, what the heck could we have done differently to lower our taxes? We don’t have deductions in kids (for the time being) nor do we have deductible interest from a mortgage. The answer? Initially give more to charitable organizations such as Goodwill but we soon found out that that equals a lot of old t-shirts plus, beating the standard deduction is next to impossible.

The solution? Start a small business.

Why Go for the Savings?

Is it really worth all of the headaches that come along with starting a small business, the audit-proofing, documentation maintenance and then the fear of getting audited in order to get tax breaks? The answer is an unequivocal yes. The reason being is that the rich have employed this tactic for years in order to get richer - a strategic, spending move that you will need to employ if you want to accumulate wealth.

The question always comes up, “how do the rich get richer?” This is one of the answers.

Charts are Fun!

Pretend that the chart below represents your income statement, a simple picture of what you take in and what goes out the door, and your balance sheet, a picture of your assets and liabilities or, for our purposes, anything that puts money into your pocket on a recurring basis such as a dividend paying stock or cash-flowing rental property and anything that takes money out of your pocket, such as a car lease, mortgage payment or credit card debt.



The Income Statement portion is represented by the two boxes in the top left and the balance sheet portion is represented by the two boxes along the bottom. If you were following a wealth accumulation protocol, on the road to financial independence, you would use leftover disposable income after expenses to buy assets. This is why tax and expense considerations are so important. If we don’t manage them then our asset buying power will be dramatically eroded. Thus, we will never be able to retire early.

So, let’s see where taxes come into the picture for the average middle class person …


and where they come into play for the rich:


The average middle class individual earns an income, pays taxes on that income and then they spend what is left. In our perfect-world financial model, they would use the eroded scraps to buy assets.

The rich on the other hand, earn an income, spend out of that income and then pay taxes on what is left over, quite the opposite situation. This gives them a higher disposable income to buy and build assets which in turn leads to greater wealth accumulation and an early exit into retirement if they so choose. The way they do this is through a business.

A business earns an income, spends and is then taxed on what is left over. Thus, your strategy is as follows. Start a small business, perhaps by upgrading a hobby into a small business, and then convert as many personal expenses as legally possible into business expenses. Your chart would thus look like this:





In one sense, it appears that you would still be taxed before the expenses slide over. But this is not the case. The expenses are subtracting from your business income and as you will see later, a business loss can be applied to your normal income for a limited amount of years.

Ultimately, you should apply your newly found savings towards purchasing cash generating assets. The ultimate goal is to purchase enough passive income generating assets to cover your expenses. Once you have obtained this goal, you can kick back and retire. With expenses of $2000 a month and passive income of $2000 a month, your chart would thus look like this:




Financial freedom! Time to dust off the shuffle board mallet or whatever the heck they use to play that game.

How to Start a Small Business

First thing’s first. Check out the Western Kentucky University’s Small Business Development website, http://www.wkusbdc.com/. Click on resources and then “Guide to Writing a Business Plan.” Also, check out online marketing tools available to small business owner’s at http://www.marketingtools.intuit.com/, from the makers’ of QuickBooks.

Here I want to cover the essential, rudimentary, legal, must-have basics: structure, licenses, and filings.

Structure

You need to decide what structure best fits your business needs. You have 5 main options:

• Sole Proprietorship
• C Corporation
• S Corporation
• Partnership
• LLC

The whole key here is asset protection. The simplest and easiest form would be a sole proprietorship. You simply open a business checking account, obtain a city business license and perhaps a state sales tax license if you are selling goods, and at the end of the year, your business income and expenses will flow down to your personal income tax statement. This is the simplest business structure form but at the same time it provides the least amount of personal asset protection. If you own rental property as a sole proprietorship and a tenant falls and injures herself, and your insurance does not cover the liability, they could come after your personal assets in a lawsuit. Your business and you are one and the same under a sole proprietorship.

A C corp is not recommendable unless you are preparing to issue stock (and you can always bump up later) because of the double taxation issues a C corp faces. A C corporation is taxed at both the corporate level and then again on distributions. This one is out.

Any partnership is troublesome because they usually head south of the border and then one partner or the other is left holding the bag. Therefore, in my opinion, this option is out.

An S corp is better than a C corp in that it does not face the same double taxation issues that a C corp faces, but this entity is not as flexible in ownership rights as an LLC.

LLC – the Limited Liability Corporation. This entity, in my opinion is the best structure for most small businesses. It provides asset protection where a sole proprietorship does not, it avoids the double taxation issues of a C corp and the partnership headaches of a partnership, and it has more flexibility than an S corp. An LLC is probably the most common recommendation for entity selection for small businesses stepping up, out of a sole proprietorship.

Licenses and Accounting

To finish up on all of the basic requirements for starting a business, you are going to need a business checking account, potentially a couple of licenses, an accountant and an accounting system such as QuickBooks. If you are an LLC or incorporated, you will have to provide your Federal ID Employer Identification Number to the bank to open your business checking account. If you are operating as the sole owner of and LLC this number will simply be your social security number. If not, you will have to apply for an EIN by going to http://www.irs.gov/.

Also, most municipalities require you to obtain a city business license if you plan on doing business within your city limits. Typically, you can attain information on obtaining one by going to your local chamber of commerce website or your city’s governmental website. If you are selling goods, you will also have to get a state sales tax license and collect sales tax. You can get this by going to your state revenue website.

I recommend getting a good accountant, someone worth their weight in gold who you don’t mind paying a decent amount at the end of the year for finding deductions more than their fee that you otherwise would not have taken and for providing an expert opinion on the types of deductions you can take. I think it will become more apparent as you read into the types of deductions you will be taking why it will be safer to not go it alone. Also, it comes down to what you want to invest your time in. Even if you can do the tax filings at the end of the year, would you want to spend your time doing that or looking for investment deals.

In addition to this, you also need an accounting program to track your income and expenses throughout the year. Although you are paying the accountant to do the end of the year return, you need to be involved at least at the start plus you do not need to hand over a shoe box full of receipts at the end of the year. This will be far more costly for you since your accountant will have to organize all of your crap for you and he or she will charge you for it.

Also, you need to build the one-two team punch in finding an accountant and an attorney. You need the accountant for your deductions and filings and the attorney for the entity formation. I recommend finding a great, thorough accountant rife with tax deduction expertise first and then getting his recommendation on a good attorney. I find that quality people run in packs.

At the end of the year, your accountant will handle filing the appropriate return for you which in most cases of a sole or single owner LLC, its going to flow down to your personal tax return onto your schedule C or E making things much simpler. But remember, the accountant is there to be the expert, so don’t worry if your filings become more complicated. Rely on your accountant’s expertise.

And of course, again the ultimate goal is financial freedom. Through tax deduction savings and new income generated from turning your hobby into a small business, you are going to buy up enough assets to retire at an early age.

 

Now, What Can You Deduct?

“Small business people can deduct with proper documentation their house, their spouses, business vacations, food with colleagues.” – Sandy Botkin, “Reduce Your Taxes.”

The first item I wish to address is business losses. Must you show a profit every year in order to qualify as a small business and take deductions? The answer:

If your business produces a loss in the 1st year, you can use that loss against any other income you have. It can be used against wages earned as an employee, dividends, pensions, interest income or against spouse’s earnings if filing jointly.

Example: Mike makes $50k at a regular job and has a small business loss of $10k. He thus pays taxes on $40k.

So, the answer is, typically, in order to audit proof a hobby now turned small business, you need to show a profit three out of five years. You can apply business loss against your ordinary income.

Meals and Entertainment

Meals and Entertainment deductions are one of the most approachable business deduction categories for small business owners. With adequate documentation and by following business protocol, described below, you will be able to turn your meals into legal, tax deductible business meals.

First, some highlights on the percentage of deductibility for meals and entertainment:

• Entertainment expenses are typically 50% deductible.
• If you report the full amount make sure to tell your accountant it is 100% of the expense.
• No receipts are needed for entertainment expenses under $75 but keep them anyway for every business expense.

You should pay attention to the amount you can deduct. Don’t report the full amount and think you are still following the rules. Meals are 50% deductible.

Also, there are rules of road to follow in order to categorize a meal as a business meal.

“A business meal must be prearranged for the purpose of conducting specific business. Your prospect must reasonably expect a business reason for the meal or entertainment.” – Botkin

Thus, you can’t just run into Joe at Red Lobster, sit down and munch on shrimp scampi with him and then count it as a business meal. You would need to call Joe up before going to lunch and tell him you want to discuss business. This would be considered a prearranged business meal.

You must discuss business before, during or after a business meal to qualify for the business meal deductions and it must be with a legitimate prospect. For meal expense audit proofing, you should have a document that details a clear and specific business discussion. Also, the meal must take place in surroundings conducive to a business discussion e.g. a restraint. Food purchased at a movie theater would not count as well as food purchased at a rock concert.

Again, although receipts are not required for purchases under $75, you must document your meal or entertainment expenses adequately.

There are 5 main questions that need to be answered in your documentation in order to audit proof your meal:

1) Who was entertained and what is the business relationship?

· Id the person or persons, name, occupation, official title and other corroborative info to
establish the business relationship.

2) Where did it take place?

· A receipt will substantiate this requirement. The nature and place must also be described.

3) When did the entertainment take place?

· Note the date and time in a tax diary.

4) Why did the entertainment take place?

· Note the business purpose – state the exact nature of the business discussion or
activity.“Talked about using my services – consulting on property investment.” Be brief but
be very specific.

5) How much did it cost?

· Again, a receipt will cover this.

Also, the IRS would prefer that you record these answers in a timely fashion. You can’t wait a year and then go back and backdate the documentation. Plus, it would not be an easy task.

In addition, if your spouse is not an employee of your company, his or her meal can still be tax deductible if you bring them along in order to entertain an opposing spouse of a business couple. This is called the “Dutch Treat” rule. E.G. you meet with Ralph to discuss business at TGI Friday’s. Ralph brings along his wife Betty and you bring along your wife Sally. During the meal, Sally talks with Betty while you and Ralph discus pork futures. Your spouses’ meal would thus be 50% tax deductible along with yours.

Just make sure to name the other couple in your documentation.

Associated Entertainment/Goodwill Entertainment

Another form of tax deductible entertainment is associated entertainment. Associated entertainment takes place in a non-business setting that precedes or follows a substantial and bona fide business discussion during the same day as the entertainment. Thus, if you follow your TGI Friday lunch with Ralph with a round of golf, the green fees would be considered associated entertainment and would therefore be 50% deductible. Furthermore, it would not be necessary to discuss business on the golf course, this is not a requirement necessary for associated entertainment deductibility. The golf must merely be preceded or followed by a business discussion.

To audit proof your golf round or other associated entertainment, you must have a link showing that you discussed business either before or after the fun on the same day.

For a thorough tax diary that will aid you in documenting all of the necessary details, go to Sandy Botkin’s website at http://www.taxreductioninstitute.com/.

Other associated entertainment location examples include:

· Night Clubs
· Golf Courses
· Theaters
· Sporting Events

Yes, season tickets to a sporting event or other form of entertainment venue can be tax deductible but the percentage of deductibility is based on the ratio of how many games are used for business purposes. For example, if you take a client, Ralph, to 8 out of 10 hockey games, you would be able deduct 80% of your season tickets.

At this point, Ralph is a happy camper since he got to eat TGI Friday’s, play a round of golf and attend a Predator’s game. Of course he is also a broke happy camper but perhaps you can give him some tax tips.

Charity Events

Yes Virginia, you can deduct charitable donations.

If you buy tickets to a charity ball, the tax deduction for the event would not be limited to the face value of the ticket if three conditions apply:

1) The event is organized for the primary purpose of benefiting a tax exempt charity.
2) All net proceeds of the event are contributed to a charity.
3) The event uses volunteers for substantially all the work performed in carrying out the event.

So in essence, it truly has to be a charity event. Also, if you make a business gift, you will hit a $25 ceiling deduction but gifts made to an entire department within a business are tax deductible. This means you can send an entire fruit basket to your favorite IT department at XYZ Corporation or organization and the entire basket would be deductible. Ideally you would send it to the department that employs Ralph so you can ensure he is still living high on the hog.

If you gave a gift of entertainment such as tickets to a concert, they would be 50% deductible.

Home Entertainment

How much home entertainment can be deducted and where is the line on this category? Are we starting to walk a fine line here? The answer is no. Again, by following the rules, maintaining accurate, detailed documentation and by consulting a professional accountant, you should have no fear about the types of deductions you can take.

Yes, you can deduct home entertainment:

Example: Sam has a 5 second discussion about referrals while entertaining friends at his home. One of the friends of course is Ralph. Sam can deduct 50% of the party but I still must emphasize that he had to discuss specific business. As a rule of thumb, the number at the party should be kept under 12. Anything above serves as a red flag to your friendly IRS auditor.

Also, never combine a personal event with a business event. This is a big no-no. Example: a try to write off your two year old’s birthday party by discussing specific business with the other tots’ parents. This does not count.

But, you can give a sales presentation at your home and the food served (shrimp scampi, Ralph’s favorite) would be 100% deductible for the seminar/presentation. Just make sure you answer the 5 questions – who, where, when, why and how much money – and document, document, document.

Entertainment Recap

1. Discuss business when you eat and document who, where, when, why and how much. Make sure this is a premeditated business meal, preferably with Ralph.

2. Deduct theater tickets, golf fees, movies, sports tickets and other associated entertainment
if they are preceded or followed by a legitimate business meeting.

3. Deduct season tickets by taking clients (Ralph) to games. Only deduct the percentage of
games you took him to.

4. Deduct your spouse’s food and entertainment expenses if it falls under the “Dutch Treat”
provision where he or she is entertaining another couple.

5. You can also deduct entertainment at 100% if it is considered business promotion – you are
a professional movie critic and go to the movies, you are golf pro and take a client on a round of golf.

6. Deduct at home entertainment expenses by discussing specific business at small parties or by giving a presentation or sales seminar. And don’t try to deduct your two year old’s birthday party – Ralph would be ashamed.

Vacations

A vacation can be deducted if combined with the appropriate amount of business thus turning it into a business trip. Vacations or business travel can be a great source of tax deductions (and fun). Of course, this is the area you want to make sure you cross your Ts and dot your Is documentation-wise.

As a rule of thumb – an overnight business trip is a trip that requires you to sleep overnight on the trip. To qualify a trip as a business trip, the majority of days spent on the trip must be for a business purpose. To qualify a day as a business day, your presence must be required for part of the day for a bona fide business purpose. For example, you deliver a document to a business partner in Portland Oregon. This would qualify as a business day. Or say you are in San Francisco and you attend a meeting that lasted 30 minutes with an investment property realtor. This would qualify as a business day. You can the rest of the day sightseeing or traveling across the golden gate bridge while still maintaining business day status. Also, you must make sure the majority of your days are business days in order to reach business trip status.

Example: You go for a five day trip to Denver, Monday thru Friday, with meetings scheduled on Tuesday and Wednesday. Since Friday is considered a travel day, and Tuesday and Wednesday are business days because of the meetings, the trip would thus be considered a business trip since the majority of days, three out of five, are business days.

In addition, the IRS counts weekends sandwiched in between business days as working weekends and thus, the weekend days count towards the business day majority criteria even if you spend the days surfing.

Example: You go to Hawaii for seven days, leaving on a Thursday with meetings scheduled on Friday and Monday. Five out of the seven days are thus considered business days and you therefore have a bona fide business trip. (Friday and Monday are meeting days with Saturday and Sunday sandwiched in between totaling four business days. The Thursday return is considered a travel day for a total of five. Thus, you meet the majority business day criteria.)

 

Document, document, document

The chief tactic to make your business travel audit proof is to schedule appointments in advance and keep the documentation proving that you made and kept those appointments. For example, if you e-mail a real estate office setting up an appointment in order to discuss investment property, you need to print and keep your sent e-mail as well as the acceptance reply you receive from the realtor. Also, when you meet with the realtor, make sure to obtain his or her business card along with sample property listings in order to substantiate your business meeting.

The Expenses that Can be Deducted

If it is a business trip, you get to deduct 100% of

· Hotels on business days
· Dry cleaning
· Tips

And 50% of food on business days.

Transportation Expenses

These are costs incurred traveling on the road to and from the destination; airfare, car costs. 100% of transportation expenses are deductible on a business trip.

On the Road Expenses

As a rule of thumb, these are all costs necessary to sustain life on the trip: lodging, meals, laundry, dry cleaning. You can deduct the first laundry and dry cleaning expenses when you get home as long as the clothes were soiled on the trip.

You are allowed to deduct on the road expenses for each day you are on business travel status. You may deduct 100% of on the road expenses but when it comes to meals, only 50%.

You may not deduct the cost of entertainment where there was no business nature or prospecting.

• To make your spouses business travel expenses tax deductible, hire her or him as anemployee of your business. Otherwise you deduct the cost of one.

All of your business car expenses are deductible, even with non business riders.

Deduct a hotel at the single occupancy rate if you are the only deductible one on the business trip. Grab the rate card off of the back of the door for documentation purposes.

Business Trip Expense Recap

Again, clear business intent must be established before you leave for the trip. Make sure to hold on to copies of e-mails for appointments that were made at least a few days prior to departure noting the day time and place of the scheduled meeting. Also obtain documentation that you were there – business cards and paper work. Again, document, document, document.

Remember also that more than one half of the days must include either:

• Business travel
• Appointments for at least 30 minutes
• Weekend sandwiched in between
• Document delivery

Because of this status:

•100% on the road expenses are deductible (hotel, dry cleaning, tips)
•100% travel expenses (airfare, car rental)
•50% on the road expenses (applies to food)

To audit proof your travel, document the following:

1.) The amount that you spend daily for such things as transportation, meals and lodging.

2.) The dates of your departure and return home from each trip and the days spent on business while away from home.

3.) Where you traveled, describe the name of the city, town or similar destination.

4.) Why you traveled, including the business reason for your travel or the business benefit derived or expected to be gained (as specific as possible).

5.) Preexisting business intent: correspondence sent to prospects, documented phone calls, appointments in advance, etc.

Home Office

According to Soliman vs. the US Supreme Court – the leading precedence on home office business deductions, anyone who truly works out of his or her home and performs his or her most important functions at home can take the home office deduction. This would include network marketing, freelance writers, musicians who do most of their practicing out of their homes and consultants who do most of their important work out of their homes.

First and foremost, you office must be used solely for business purposes. You cannot have a guest bed, a book shelf containing books not related to your business a treadmill or a box of the kids’ toys. The IRS is pretty stringent about this and yes, it is possible that they will check and disallow your deduction if you do not meet the requirement.

There are three methods that you can use to figure out how much you can deduct.

• Method One: the amount of office square feet divided by the total usable square footage of the house.

• Method Two: the number of rooms the office occupies divided by the total rooms in the house.

• Method Three: Net square footage method (similar to method one except you subtract out the common areas such as hallways, entranceways, landings and stairways.)

Run the numbers and use the approach that leads to the biggest deduction for your situation. You might want to consult your accountant on the home office business deduction since you run into home depreciation recapture complications when you go to sell your home if you take this deduction.

Also, don’t forget you can deduct more rudimentary things such as office supplies, computer DSL, broadband, phone used for business and of course the cell phone bill used for business. In my opinion, these are more of your straightforward, typical business deductions and should not be subject to intense securitization. Still, keep those receipts.

Audit Proofing, Recapping and of course, Ralph

Just to restate the initial premise of why you should turn your hobby into a small business, the rich are getting richer through legal, justifiable tax breaks via their businesses and now, after reading this piece you can do the same. By aggressively shifting as much of your personal expenses into legitimate business, tax deductible expenses, you can take advantage of a plethora of tax breaks allowing you to retain more income in order to acquire assets that will provide you the ability to exit the rat race at an early age.

By taking action on the information detailed above you can deduct meals and entertainment, associated entertainment, charity events, home entertainment, vacations and your home office. If you are considering starting a small business, these tactics alone will give you an immediate initial leg up in your venture – you will already be employing a money making strategy off the bat or at least, a money saving strategy. If you are looking to increase your net worth or cash flow, this strategy of starting a small business will allow you to keep more of your income in order to build your assets.

 

Audit Proofing

In real estate the most overused, expert advice catch phrase is “location, location, location.” In small business tax deduction strategy, it should be “documentation, documentation, documentation.” If you are going to be aggressive about your tax deductions (and you should be) then you need to ensure you can sleep well at night by having ample documentation to backup your deductions.

 

Documentation requirements:

• Keep All Receipts

Although you are only required to keep receipts for expenses over $75, keep them all. I actually like to keep all receipts, personal and business, noting on the receipt whether it is personal or business and then what category it falls under. According to Robert Allen in “Multiple Streams of Income,” by doing this, in addition to verifying that the receipt is accurate, you can save tons of money over the years.

 

• Log Your Time

Keep a business journal denoting what date you worked on your business, how much time you spent and what activity you performed. The whole key here, along with creating a business plan and financial projections, is that you want to prove you are running your business as a business. One of the biggest tactics of the IRS is to classify your business as a hobby thus disqualifying most, if not all of your deductions. You want to insure against this by documenting the time you spend in your business – and don’t backdate a journal at the end of the year. Log it as you go along.

Also, it is better to work an average number of healthy hours per week, say 15 to 20, rather than cramming in 40 hours all at once at the end of the month. The first communicates that the individual is putting steady time into growing their legitimate business. The second communicates that person might not actually be tracking their time and is instead bulk loading it at the end of the month thus a red flag. Don’t do this.

 

• Audit Sheet for Expenses

As I said earlier, there are 5 questions you need to answer for deducting business meal and entertainment expenses. Again, these are:

1) Who was entertained and what is the business relationship? Id the person or persons, name, occupation, official title and other corroborative info to establish the business relationship.

2) Where did it take place? - get a receipt. The nature and place must also be described.

3) When did the entertainment take place? Note the date and time in a tax diary.

4) Why did the entertainment take place? Note the business purpose – state the exact nature of the business discussion or activity. “Talked about using my services – consulting on property investment.” Be brief but be very specific.

5) How much did it cost? A receipt will cover this.

Also, you should track travel details including hotels and overnight expenses. For a really great log sheet product, visit Sandy Botkin’s website at www.taxreductioninstitute.com. This site has a tax log product that will help you document the 5 questions for meals and entertainment as well as travel expenses.

• Mileage Log

Make sure you track business mileage in any standard mileage log book you can get at any of your local office supply warehouse.

• Documentation for Travel

Again, with business travel, make sure you capture supporting evidence proving business intent for the trip; business appointment e-mails, business cards from the trip, MLS listings, room rate cards, etc.

• Show a profit 3 out of 5 years

You can lose money and apply the loss to your regular income but you must show a profit for 3 out of 5 years to prove profit intent. If you run it at a loss for many years it will prove to be just that, a tax write off and your deductions will be disqualified.

•Intention to Make a Profit

Through documents such as a business plan a financial plan showing growth and eventual profit, you need to prove that your intentions are to make an eventual profit. These supporting documents would serve as the proof in the pudding.

Books and Resources

•Lower Your Taxes - Big Time! 2007-2008 Edition (Lower Your Taxes Big Time) – Sandy Botkin

• Western Kentucky University’s Small Business Development
website, chock full of resources on how to write a business plan, steps to starting a
business, how to develop a financial plan and a cash flow statement. The development
center also provides free one on one consulting to help small businesses increase
profits, expand client volume, grow sales, reach funding sources, market research, cash
flow analysis and strategic planning.

Next Steps

• Find an accountant – tell him or her what you are up to and that you plan to use him at the end of the year. See how he responds when you tell him the types of deductions you want to take. If he’s favorable or favorable but somewhat cautious, then he is probably a good candidate. If he has no clue as to the tax deductions you are talking about, move on to the next person.

• Read up on starting a small business and what applicable tax deductions you can take.

• Open a business checking account. Remember you need a federal EIN number if you are not a sole proprietorship or a single owner LLC. In those cases a social security number will suffice.

• Write a business plan. This along with financial projections, is great audit proofing documentation. It shows business and profit intent. There are reams of books on this subject.

• Get on a budget – find your monthly expenses and figure out how much passive income you need to become financially independent. Set a goal for when you will be out of the rat race. Do not count on your employer to take care of your finances. It is up to you.

• Take Ralph to TGI Friday's, tax deductible of course.

•Contact WKU’s SBDC  and setup a free one on one consultation.

 

 


Real Estate Versus Stock Investing

 

Ten Advantages of Real Estate

 

1)      Cash Flow

 

The chief thing here is that the property is self-maintaining as far as expenses go.  It is a business model in itself – the income minus the outflow equals the cash flow.  The expenses should first all be covered for the investment to make sense and secondly the property should generate a cash flow in order to add icing to the cake of property appreciation.  When comparing real estate investing to stock investing, it is important to not only compare the national average real estate appreciation rate of 6% to the historic average stock market return of 10%, you must also factor in the cash flow received.

 

In addition, this is passive cash flow.  Although you might have to handle tenant issues or arrange for repairs or do them yourself, your physical presence is not required 100% of the time in order to generate the income.  In the stock universe you would have to generate this via dividends.  Although this is not impossible to do, you must find healthy yields to match the cash flow return you would receive on a piece of real estate and monitor the stock for dividend cuts or “going out of business” drops. 

 

Once your passive cash flow is equal to or greater than your expenses, you are financially free.

 

2)      Control

 

In the stock universe you do not have much control over how the companies you own are managed – unless of course you are Warren Buffet.  Sure you get a proxy vote but unless you own a large percentage of shares, this won’t amount to much.  If you own Coke stock you could buy up all the Coke at your local super market in an attempt to ratchet up sales but I think we would both have to agree this would be futile.

 

In the real estate universe you can manipulate rents, you can screen tenants, you can landscape, you can throw a new coat of paint on the walls, you can physically drive up to the property.  If rents drop in the area by $25 you can adjust accordingly to keep your vacancy rate low.  If they go up, you can raise.  In real estate you have much more control over the investment.  In stocks, you can monitor and maintain control over the buy and sell decisions. 

 

This also seems to comment on the passivity of the investment.  Without a property manager, the more control you exude over your piece of real estate, the less passive it becomes.

 

3)      Appreciation

 

Real estate on average appreciates 6% nationally.  Although this has not been the case recently, when comparing apples to apples I am taking the long-term view for both stocks and property.  Stocks appreciate by an average, long-term rate of 10%.  Real estate at 6%.  Also, the beauty of real estate is that a tenant is paying down the mortgage and essentially buying the asset for you over time.  The problem with the simple 10% versus 6%  rate comparison, from a property investors point of view, is that it does not take leverage into consideration.

 

4)      Leverage

 

If you put $20,000 down on a $100,000 property and it generates $3000 a year in cash flow, what is your rate of return?   It is 3000/20000 or 15%.

 

If the property increases in value by 6%, how much have you gained?

 

Answer:  $100,000 x 6% = $6000.  

 

How much of a rate of return is this over your initial investment?

 

Answer:  6000/20000 = 30%

 

When you add this to your $3000 of cash flow, your true rate of return is $9000/$20,000 or 45%.

 

If you took that money instead and invested it in a stock mutual fund, how much rate of return would you expect?  Answer:  10% over the long haul.

 

Stocks 10%

 

Real Estate 45%

 

‘Nuff said.

 

5)      Depreciation

 

This is one of those lovely phantom tax deductions you get to claim at the end of the year that will turn your rental money into 0% tax money – your earned income is taxed at 50%, your portfolio income or dividend income is taxed at 15 – 20%, your passive or rental income can be taxed at 0%. This is how.

 

You get to depreciate residential real estate property over 27.5 years and commercial over 39 years.  If you cash flow $20,000 out of your property but have depreciation of $25,000, you have a tax loss of $5000 and no tax is paid on income.  Sure, one could argue that the property is actually depreciating and generating a real repair cost, but that should already be factored into your income statement under repairs and maintenance.

 

The Depreciation Equation:

 

(Total Asset Value – Land Value) / Depreciable Years = Annual Depreciation

 

6)      Refinance

 

If you increase the property value you can refinance it and withdraw the money tax free.  Say you finance a $200,000 property and through a property improvement plan (you lower the vacancy rate, you increase rents based on a rent premium for ground floor apartments) the property is now worth $250,000.  You can now refinance the property at $250,000 pay off the initial $200,000 and withdraw the $50,000 tax free.

 

7)      Asset Protection

 

Two things here:  insurance and incorporation.  If a stock drops 50% in value, what protection do you have?  Perhaps a stop loss order or a put option?  If your investment property burns down, what protection do you have?

 

Answer: insurance

 

Also, the second form of protection is incorporation.  Traditionally an LLC has been the most advantageous for property investors.  By placing your property in this bucket you shield your personal assets should any one come after you with legal action.

 

8)      1031 Exchanges

 

You can roll over property gains tax free by buying bigger properties using a 1031 Exchange.  The capital gains do not go away – they are still there.  But, by using a 1031 exchange, you can continue to roll those gains into bigger and hopefully better properties tax free.  If you finish and choose not to hold the last property or roll it, you will have tax consequences.

 

9)      Hedge Against Inflation

 

Because real estate is a tangible asset, it will generally rise at the rate of inflation or higher.  Historically inflation has been 4.1%.  That means real estate, with its average, historical appreciation of 6% has beaten inflation by nearly 2%.

 

10)     A Physical Asset

 

You can actually walk up to a piece of property.  You can inspect it, you can visit the tenants, you can see cracks forming in the walls.  With a stock, in a lot of respects, it exists out in the ether.  Sure if you own Coke you can drink a Coke and you can go visit Coke headquarters in Atlanta.  But the investment truly lives throughout the intricate business model which you do not directly manage.  A property on the other hand, can be managed directly by you.

 

To sum up there are many advantages to real estate investing over stock investing and many analysts neglect to make a fair comparison between the two.  Many merely compare the 6% appreciation in real estate to the 10% return in stocks.  What they are chiefly leaving out are the benefits of passive cash flow, leverage and depreciation.  Once these three factors alone are included in the mix, it is clear that real estate has some unique advantages over stocks.  I do not wholeheartedly endorse real estate investing alone.  I believe one must have a diversified investments strategy and for me, diversification does not mean investing in an assortment of mutual funds.  It means investing across asset classes including both real estate as well as stock investing.