Posts Tagged ‘Internal’

Applicable Federal Rate (AFR): What It Is and How To Use It

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Applicable Federal Rate (AFR): What It Is and How To Use It

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What Is the Applicable Federal Rate (AFR)?

The applicable federal rate (AFR) is the minimum interest rate that the Internal Revenue Service (IRS) allows for private loans. Each month the IRS publishes a set of interest rates that the agency considers the minimum market rate for loans. Any interest rate that is less than the AFR would have tax implications. The IRS publishes these rates in accordance with Section 1274(d) of the Internal Revenue Code.

Key Takeaways

  • If the interest on a loan is lower than the applicable AFR, it may result in a taxable event for the parties involved.
  • AFRs are used to determine the original issue discount, unstated interest, gift tax, and income tax consequences of below-market loans.
  • Parties must use the AFR that is published by the IRS at the time when the lender initially makes the loan.

Understanding the Applicable Federal Rate (AFR)

The AFR is used by the IRS as a point of comparison versus the interest on loans between related parties, such as family members. If you were giving a loan to a family member, you would need to be sure that the interest rate charged is equal to or higher than the minimum applicable federal rate.

The IRS publishes three AFRs: short-term, mid-term, and long-term. Short-term AFR rates are determined from the one-month average of the market yields from marketable obligations, such as U.S. government T-bills with maturities of three years or less. Mid-term AFR rates are from obligations of maturities of more than three and up to nine years. Long-term AFR rates are from bonds with maturities of more than nine years.

In addition to the three basic rates, the rulings in which the AFRs are published contain several other rates that vary according to compounding period (annually, semi-annually, quarterly, monthly) and various other criteria and situations.

Example of How to Use the AFR

As of Apr. 2022, the IRS stated that the annual short-term AFR was 1.26%, the mid-term AFR was 1.87%, and the long-term AFR was 2.25%. Please bear in mind that these AFR rates are subject to change by the IRS.

Which AFR rate to use for a family loan would depend on the length of time designated for payback. Let’s say you were giving a loan to a family member for $10,000 to be paid back in one year. You would need to charge the borrower a minimum interest rate of 1.26% for the loan. In other words, you should receive $126 in interest from the loan.

In our example above, any rate below 1.26% could trigger a taxable event. For example, let’s say you gave the same loan, but you didn’t charge any interest. By not charging any interest, you would have “foregone” $126 in interest income, and according to the IRS, it would be considered a taxable gift. Any interest rate charged below the stated AFR for the particular term of the loan would be considered foregone interest and, as a result, be taxable.

Special Considerations

When preparing to make a loan between related parties, taxpayers should consider two factors to select the correct AFR. The length of the loan should correspond to the AFRs: short-term (three years or less), mid-term (up to nine years), and long-term (more than nine years).

If the lender charges interest at a lower rate than the proper AFR, the IRS may reassess the lender and add imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower. Also, if the loan is more than the annual gift tax exclusion, it may trigger a taxable event, and income taxes may be owed. Depending on the circumstances, the IRS may also assess penalties.

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Audit: What It Means in Finance and Accounting, 3 Main Types

Written by admin. Posted in A, Financial Terms Dictionary

Audit: What It Means in Finance and Accounting, 3 Main Types

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What Is an Audit?

The term audit usually refers to a financial statement audit. A financial audit is an objective examination and evaluation of the financial statements of an organization to make sure that the financial records are a fair and accurate representation of the transactions they claim to represent. The audit can be conducted internally by employees of the organization or externally by an outside Certified Public Accountant (CPA) firm.

Key Takeaways

  • There are three main types of audits: external audits, internal audits, and Internal Revenue Service (IRS) audits.
  • External audits are commonly performed by Certified Public Accounting (CPA) firms and result in an auditor’s opinion which is included in the audit report.
  • An unqualified, or clean, audit opinion means that the auditor has not identified any material misstatement as a result of his or her review of the financial statements.
  • External audits can include a review of both financial statements and a company’s internal controls.
  • Internal audits serve as a managerial tool to make improvements to processes and internal controls.

Understanding Audits

Almost all companies receive a yearly audit of their financial statements, such as the income statement, balance sheet, and cash flow statement. Lenders often require the results of an external audit annually as part of their debt covenants. For some companies, audits are a legal requirement due to the compelling incentives to intentionally misstate financial information in an attempt to commit fraud. As a result of the Sarbanes-Oxley Act (SOX) of 2002, publicly traded companies must also receive an evaluation of the effectiveness of their internal controls.

Standards for external audits performed in the United States, called the generally accepted auditing standards (GAAS), are set out by Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA). Additional rules for the audits of publicly traded companies are made by the Public Company Accounting Oversight Board (PCAOB), which was established as a result of SOX in 2002. A separate set of international standards, called the International Standards on Auditing (ISA), were set up by the International Auditing and Assurance Standards Board (IAASB).

Types of Audits

External Audits

Audits performed by outside parties can be extremely helpful in removing any bias in reviewing the state of a company’s financials. Financial audits seek to identify if there are any material misstatements in the financial statements. An unqualified, or clean, auditor’s opinion provides financial statement users with confidence that the financials are both accurate and complete. External audits, therefore, allow stakeholders to make better, more informed decisions related to the company being audited.

External auditors follow a set of standards different from that of the company or organization hiring them to do the work. The biggest difference between an internal and external audit is the concept of independence of the external auditor. When audits are performed by third parties, the resulting auditor’s opinion expressed on items being audited (a company’s financials, internal controls, or a system) can be candid and honest without it affecting daily work relationships within the company.

Internal Audits

Internal auditors are employed by the company or organization for whom they are performing an audit, and the resulting audit report is given directly to management and the board of directors. Consultant auditors, while not employed internally, use the standards of the company they are auditing as opposed to a separate set of standards. These types of auditors are used when an organization doesn’t have the in-house resources to audit certain parts of their own operations.

The results of the internal audit are used to make managerial changes and improvements to internal controls. The purpose of an internal audit is to ensure compliance with laws and regulations and to help maintain accurate and timely financial reporting and data collection. It also provides a benefit to management by identifying flaws in internal control or financial reporting prior to its review by external auditors.

Internal Revenue Service (IRS) Audits

The Internal Revenue Service (IRS) also routinely performs audits to verify the accuracy of a taxpayer’s return and specific transactions. When the IRS audits a person or company, it usually carries a negative connotation and is seen as evidence of some type of wrongdoing by the taxpayer. However, being selected for an audit is not necessarily indicative of any wrongdoing.

IRS audit selection is usually made by random statistical formulas that analyze a taxpayer’s return and compare it to similar returns. A taxpayer may also be selected for an audit if they have any dealings with another person or company who was found to have tax errors on their audit.

There are three possible IRS audit outcomes available: no change to the tax return, a change that is accepted by the taxpayer, or a change that the taxpayer disagrees with. If the change is accepted, the taxpayer may owe additional taxes or penalties. If the taxpayer disagrees, there is a process to follow that may include mediation or an appeal.

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Affiliated Companies: Definition, Criteria, and Example

Written by admin. Posted in A, Financial Terms Dictionary

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What Are Affiliated Companies?

Companies are affiliated when one company is a minority shareholder of another. In most cases, the parent company will own less than a 50% interest in its affiliated company. Two companies may also be affiliated if they are controlled by a separate third party. In the business world, affiliated companies are often simply called affiliates.

The term is sometimes used to refer to companies that are related to each other in some way. For example, Bank of America has many different affiliated companies including Bank of America, U.S. Trust, Landsafe, Balboa, and Merrill Lynch.

Key Takeaways

  • Two companies are affiliated when one is a minority shareholder of another.
  • The parent company generally owns less than a 50% interest in its affiliated company, and the parent keeps its operations separate from the affiliate.
  • Parent businesses can use affiliates as a way to enter foreign markets.
  • Affiliates are different than subsidiaries, which are majority-owned by the parent company.

Companies may be affiliated with one another to get into a new market, to maintain separate brand identities, to raise capital without affecting the parent or other companies, and to save on taxes. In most cases, affiliates are associates or associated companies, which describes an organization whose parent has a minority stake in it.

Understanding Affiliated Companies

There are several ways companies can become affiliated. A company may decide to buy out or take over another one, or it may decide to spin off a portion of its operations into a new affiliate altogether. In either case, the parent company generally keeps its operations separate from its affiliates. Since the parent company has a minority ownership, its liability is limited, and the two companies keep separate management teams.

Affiliates are a common way for parent businesses to enter foreign markets while keeping a minority interest in a business. This is especially important if the parent wants to shake off its majority stake in the affiliate.

There is no single bright-line test to determine if one company is affiliated with another. In fact, the criteria for affiliation changes from country to country, state to state, and even between regulatory bodies. For instance, companies considered affiliates by the Internal Revenue Service (IRS) may not be considered affiliated by the Securities and Exchange Commission (SEC).

Affiliates Versus Subsidiaries

An affiliate is different from a subsidiary, of which the parent owns more than 50%. In a subsidiary, the parent is a majority shareholder, which gives the parent company’s management and shareholders voting rights. Subsidiary financials may also appear on the parent company’s financial sheets.

But subsidiaries remain separate legal entities from their parents, meaning they are liable for their own taxes, liabilities, and governance. They are also responsible for following the laws and regulations where they are headquartered, especially if they operate in a different jurisdiction from the parent company.

An example of a subsidiary is the relationship between the Walt Disney Corporation and sports network ESPN. Disney owns an 80% interest in ESPN, making it a majority shareholder. ESPN is its subsidiary.

In e-commerce, an affiliate refers to a company that sells the products of another merchant on its website.

SEC Rules Surrounding Affiliates

Securities markets around the world have rules that concern affiliates of the businesses they regulate. Here again, these are complex rules that need to be analyzed by local experts on a case-by-case basis. Examples of rules enforced by the SEC include:

  • Rule 102 of Regulation M prohibits issuers, selling security holders, and their affiliated purchasers from bidding for, purchasing, or attempting to induce any person to bid for or purchase, any security which is the subject of a distribution until after an applicable restricted period has passed.
  • Before disclosing nonpublic personal information about a consumer to a nonaffiliated third party, a broker-dealer must first give a consumer an opt-out notice and a reasonable opportunity to opt out of the disclosure.
  • Broker-dealers must maintain and preserve certain information regarding those affiliates, subsidiaries, and holding companies whose business activities are reasonably likely to have a material impact on their own finances and operations.

Tax Consequences of Affiliates

In nearly all jurisdictions, there are important tax consequences for affiliated companies. In general, tax credits and deductions are limited to one affiliate in a group, or a ceiling is imposed on the tax benefits that affiliates may reap under certain programs.

Determining whether companies in a group are affiliates, subsidiaries, or associates is done through a case-by-case analysis by local tax experts.

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What Is an Agent? Definition, Types of Agents, and Examples

Written by admin. Posted in A, Financial Terms Dictionary

What Is an Agent? Definition, Types of Agents, and Examples

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What Is an Agent?

An agent, in legal terminology, is a person who has been legally empowered to act on behalf of another person or an entity. An agent may be employed to represent a client in negotiations and other dealings with third parties. The agent may be given decision-making authority.

Two common types of agents are attorneys, who represent their clients in legal matters, and stockbrokers, who are hired by investors to make investment decisions for them. The person represented by the agent in these scenarios is called the principal. In finance, it refers to a fiduciary relationship in which an agent is authorized to perform transactions on behalf of the client and in their best interest.

Key Takeaways

  • An agent is authorized to act on behalf of another person, such as an attorney or a stockbroker.
  • People hire agents to perform tasks that they lack the time or expertise to do for themselves.
  • A universal agent has wide authority to act on another’s behalf, but a general agent or special agent has more limited and specific powers.
  • Agency by necessity is where an agent is appointed to act on behalf of a client who is physically or mentally incapable of making a decision.
  • Most agent jobs require a license and registration with the appropriate state authorities.

Understanding an Agent

An agent is someone that is given permission (either explicitly or assumed) to act on an individual’s behalf and may do so in a variety of capacities. This could include selling a home, executing a will, managing a sports career, managing an acting career, being a business representative, and so on.

Agents often have expertise in a specific industry and are more knowledgeable about that industry’s ins and outs than the average person. For example, if you started gaining attention as a musician, you would hire a music agent to help guide you through getting a record deal, signing record contracts, and arranging your touring schedule.

As you would not have any experience with the record industry, you would need an agent to look out for your best interests and take care of a lot of the work that you would otherwise most likely not be able to complete on your own. This would also free up your time so that you can concentrate on making music.

Types of Agents

Agents come in all types depending on their function and the industry in which they operate. In general, there are three types of agents: universal agents, general agents, and special agents.

Universal Agents

Universal agents have a broad mandate to act on behalf of their clients. Often these agents have been given power of attorney for a client, which gives them considerable authority to represent a client in legal proceedings. They may also be authorized to make financial transactions on behalf of their clients.

General Agents

General agents are contracted to represent their clients in specific types of transactions or proceedings over a set period. They have broad authority to act but in a limited sphere. A talent agent for an actor would fall under this category.

Special Agents

Special agents are authorized to make a single transaction or a series of transactions within a limited period. This is the type of agent most people use from time to time. A real estate agent, securities agent, insurance agent, and travel agent are all special agents.

Practicing as an agent in a specific industry without the proper license or registration can lead to fines or being prohibited from acting as an agent in that industry in the future. Before working as an agent, ensure that you have obtained the right license, certification, and registration.

Uses of Agents

People hire agents to perform tasks that they lack the time or expertise to do for themselves. Investors hire stockbrokers to act as middlemen between them and the stock market. Athletes and actors hire agents to negotiate contracts on their behalf because the agents are typically more familiar with industry norms and have a better idea of how to position their clients.

More commonly, prospective homeowners use agents as middlemen, relying on the professional’s greater skills at negotiation.

Businesses often hire agents to represent them in a particular venture or negotiation, relying on the agents’ superior skills, contacts, or background information to complete deals.

Loyalty Responsibilities of an Agent

Duty of Avoiding Material Benefit

During the course of business, an agent may benefit. This is especially true when an agent is paid to perform a task on behalf of the principal. For example, a real estate agent commonly receives a commission for their work in selling a house.

When acting on behalf of another, an agent must ensure they do not unjustly benefit from their agency position. This includes receiving large benefits from the relationship or taking advantage of their position to ensure they receive benefits that would not normally as part of a normal transaction.

Duty Not to Usurp

When an agent acts on behalf of a principal, the agent may receive information it would be able to personally capitalize on for personal benefit. For example, an agent may receive information relating to a potential investment opportunity. The agent owes the principal the duty to not steal or supplant the principal’s ability to transact. In this example, the principal retains the right to decide whether or not to invest; the agent must not take the place of the principal without the principal explicitly declining an opportunity to invest.

Duty to Not Compete

On a similar note, an agent may not enter into transactions or business that compete with a principal. This conflict of interest puts the principal at a disadvantage as the agent may obtain trade or business secrets during the course of the business relationship. For example, imagine if an agent was tasked with shipping specific goods to an agent’s manufacturing warehouse. The agent could obtain information related to the principal’s operations that the agent could then use for its personal benefit.

Duty of Transparency

Formalized agent-principal arrangements often include verbiage that the agent must disclose if it has any other principals in which it is acting as an agent for. This includes disclosing a sworn statement that the agent will act in good faith across all principals and will incur fair dealing with each principal.

Duty to Protect Information

During the course of an agent’s relationship with the principal, the agent may not disclose confidential information to unrelated parties. This may defined through confidentiality agreements or may not be explicitly called out. In either case, the agent must take care to evaluate the sensitivity of information and the necessity for other parties to obtain that information. This includes not using confidential information for the personal benefit of the agent (i.e. exchanging the information for personal benefit to an independent third party).

An agent may have express authority (via a written contract) or implied authority (entered into agreement based on actions)

Performance Responsibilities of an Agent

Duty of Contract

All terms of any written agreement between an agent and a principal define the relationship between the two. For many agent and principal relationships, the contract is not explicitly defined upfront. However, custom or deliberate agreements may call for very specific terms that define what is and isn’t allowed.

Duty of Care

An agent is always tasked with acting with care and competence when handling affairs of the principal. The standard is often held that the agent must act as the principal would, using discretion as if it would incurring the personal gain or loss. Though the level of care may not be explicitly defined, the level of care should be equal to what is reasonably expected by local standards.

The duty of care may be complicated when considering the agent’s personal benefit potential. For example, consider a broker that receives a commission for the sale of certain investment products. For some clients, it may not be in their best interest to buy those investments. Therefore, the broker has the duty of care to not sell such products to those individuals, sacrificing personal gain to uphold the sanctity of the relationship.

Duty of Obedience

An agent must comply with reasonable instruction. Though there may be situations where acting on one’s behalf and following their guidance is not reasonable or legal, the agent may have recourse to not follow instruction. Otherwise, the agent is bound to perform tasks as expected by the agreement. This includes situations where the principal may be disadvantaged but has instructed the agent to act in a specific manner.

Duty of Disclosure

As the agent gains sensitive information that may influence the decision-making process of a principal, the agent has the duty to disclose that information in an accurate, timely manner. Consider the example of Los Angeles Dodgers’ player Freddie Freeman. Freeman’s agent reportedly did not disclose to Freeman that his former team, the Atlanta Braves, wanted to re-sign him. By withholding such information, Freeman reluctantly signed with a different team.

Duty of Separation

An agent also has the responsibility to keep the agent’s and the principal’s affairs separately. This includes ensuring that any transactions entered into on behalf of the principal are still legal property of the principal. This also ensures that any resources or capital used to transact are maintained in separate bank accounts and that separate reporting ledgers are maintained.

When acting as an agent, you are often protected from liability as long as you act with care, reasonableness, and transparency.

Agent Liability

An agent is often liable to their principal if they violate their duty or deviate from a reasonable, expected action performed on behalf of the other party. This may be the result of exceeding the authority they’ve been given, acting in misconduct, being unreasonably negligent, or any other situation where the principal may incur a loss that could have potentially been avoided.

In some situations when the agent performs a task for another without disclosing they are an agent, they may be considered liable because the agent was presumed to be a principal. An agent is also commonly liable when the agent expressly incurs a personal liability by entering into an associated agreement.

Agency by Necessity

There is also “agency by necessity,” in which an agent is appointed to act on behalf of a client who is physically or mentally incapable of making a decision. This is not always a case of incapacitation. Business owners, for example, might designate agents to handle unexpected issues that occur in their absence. For example, if a CEO was on a flight and unreachable yet an emergency business decision needed to be made, agency by necessity could be used.

Agency by necessity is most often executed in times of emergency or urgency when the primary party is not available to make a decision. In these situations, courts would recognize a third party making the decision if that party was given power by the primary party to do so. The third party would be responsible for acting in the primary party’s best interest.

Estate planning often sees agency by necessity. Though an individual may have created a will outlining how an estate should be disbursed at their time of death, there could be situations where the person became incapacitated before needed adjustments to the will were made. Here, agency by necessity could be used by a trusted party.

What Is an Enrolled Agent?

An enrolled agent is one that represents taxpayers in front of the Internal Revenue Service (IRS). To become an enrolled agent, one needs to pass an IRS test that covers individual and business tax returns or through experience by being a former IRS employee. Enrolled agents can represent any type of taxpayer over any tax matter in front of any tax department in the IRS.

What Is a Registered Agent?

A registered agent is an individual that is authorized to accept legal documents on behalf of a limited liability company (LLC). All LLCs require a registered agent and they are legally allowed to accept tax documents, legal documents, government documents, compliance documents, and any other documents pertaining to the LLC.

A registered agent for an LLC is known to be an “agent for service of processes.” If an LLC does not have a registered agent, it may be fined by the state, not allowed to file a lawsuit, be denied financing, and not allowed to expand out of state.

How Do You Become a Real Estate Agent?

To become a real estate agent, you need to obtain a real estate agent license. There are a few qualifications for this, and they can vary from state to state. In general, a person needs to be 18 years of age, be a legal resident of the U.S., complete the required relicense education, and pass the real estate exam. Individuals can enroll in relicensing courses before taking the real estate exam.

How Do You Become an Insurance Agent?

The first step in becoming an insurance agent is deciding what kind of insurance agent you want to be, as the type depends on the path to becoming one. You can choose to be either a captive insurance agent or an independent insurance agent. From there, you will need to decide what insurance products you would like to sell to clients.

The next step is becoming licensed in your state. The products that you decide you would like to sell will depend on the type of license you will need. You will take your licensing exam and from there you will have to submit a background check and license application to your state’s licensing department. Once this is complete, you will need to find an insurance company to work with.

How Do You Become a Sports Agent?

To become a sports agent you will need to obtain a sports license and register with the state. Not all states require this. The sport or league that you will want to join will require certification as well. Typically, a bachelor’s degree is required before becoming a sport’s agent, and advanced degrees, such as law, help in becoming one so that you can understand the legal language of the contracts of the clients you manage. Once you have been certified and received your license, you will need to join a sports agency and from there start building a client base.

The Bottom Line

An agent is anyone that has been entrusted to act on behalf of another individual. People usually call upon an agent when they need someone with more expertise or when they don’t have the time to complete a task.

Agents are commonly used in the finance, law, real estate, insurance, acting, and music industries, yet they can be found in almost any situation when advanced knowledge on a topic is needed. Agents can save people a lot of time, money, and headaches in getting important tasks done.

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