(Comics retailing) Okay, I suppose we can now end the call-to-arms. Weblogger Laura Gjovaag has the latest on Corner Comics owner Paige Gifford's fight with the IRS: it's over. Facing a December 31st deadline, after which the government agency has promised to take legal action, and unable to afford an extended fight, Ms. Gifford has elected to capitulate to IRS demands:
"Paige wants to thank everyone who has responded with good cheer and advice, as well as everyone who linked to this story. While it's too late to save her from the clutches of the IRS, it isn't too late to warn other stores who might be listening to incorrect or incomplete advice from their CPA. She has already contacted a shredding company, and will be shredding much of her inventory before the end of the year. While it's true that most of the stuff that will be going under the grinder really is worthless, it's a really hard thing for a lover of books to destroy any books, even comic books. Yes, her lawyer and new CPA still firmly believe that she is completely in compliance with the law, but she cannot afford to fight the IRS on their terms."
While the professional help hired by Ms. Gifford to defend her against the U.S. government may believe her to be in full compliance with the law, fellow retailers following the news seem almost unanimous in disagreement. Reacting to Friday's report on this weblog, retailers in a thread on the Comic Book Industry Alliance's Delphi forum (don't bother clicking the link; it's password-protected) denounced Ms. Gifford's ignorance and lack of business savvy in neglecting to conduct a yearly inventory and deduct accordingly. The tone was set early on:
"But, this is not a case of the Man coming down on an innocent businessperson. She goofed up, and they are not a very playful lot. I don't like the implication that she is a victim, because she simple has failed to do what all of us are supposed to do. I had to pay twenty grand to the feds last April 15th cause I had a good year. I'm not happy about it, but dems da breaks.
"I do not mean to sound callous, I just think retailers need to be educated. And don't just rely on your accountant, learn it yourself. My accountant got me audited because she ran alot of shortcuts in my return and threw up red flags. Screwing up your inventory is one way to get yourself in trouble."
Another retailer was even less conciliatory:
"I'm suppose to feel sorry and flock to the aid of a poorly educated store owner who broke the law? I'm suppose to listen nicely and nod my head in a caring way as they interpet the law the way they want to?
"Complaining that they simply made up their own explainations of the tax laws and that those explainations don't make any sense... immediately after explaining how they did it... is absurd.
"This is not a travesity. There is nothing to 'rally around'. The only danger for other stores is that they remain as poorly educated as this owner."
Let me acknowledge that the above may be an incomplete depiction of the discussions found in the thread in question; they are based upon fragments emailed to me by two seperate retailers with forum membership by Friday evening, and may not reflect the tone of any conversation that has taken place since then (I should add that this is why I'm not naming names). In any case, perhaps the best example of the attitude retailers following the controversy seem to have assumed -- certainly a more conciliatory response than others I've read -- can be found in this open letter emailed to me early Sunday evening from Massechusetts retailer Jim Crocker:
"I read about the 'plight' of Comic Corner with some interest, as I'm always interested in how other retailers handle their shops.
"Having read Paige's account of events, and having actually read the section of the tax laws she's citing as her defense, it seems to me that the situation is not a case of the big, bad, evil government harassing someone totally undeserving, but a small business owner who did not understand the tax laws. Without actually hearing the government's side of the argument, or any testimony from her accountant or tax attorney, we're only left with Paige's version of events, so I went and looked at the actual paragraph in the Tax Code she's citing in her defense.
"The 'million dollar' exemption that she cites seems on my reading to refer to the necessity of performing an actual physical count of your inventory to verify the figures you report. When business owners pay taxes, they pay it on any profit they make. The government (correctly) doesn't make a distinction about how you spend that profit: if you sink it back into inventory, you still pay tax on it. This means that you still have to report how much inventory you have every year (usually determined by how much you spent on it if you don't perform an actual inventory). This failure to report her inventory is probably what brought her to the attention of the IRS in the first place. (Note that any business with an interest in efficiency or accuracy should be performing an annual physical inventory regardless of whether it's required by law or not.)
"Seeing fellow retailers suffer because they make incorrect assumptions about the tax laws, or fail to perform required basic accounting procedures is painful. But when that happens, the blame should fall where it belongs, which is on their own shoulders. The IRS judgment will certainly have a profound effect on her business, but the fact that they gave her an out, even if it is a costly and perhaps painful one, would seem to indicate they understand that this is a case of ignorance and not necessarily malice. As a professional retailer who performs an annual inventory, pays to maintain a point of sale system, and employs a CPA, I appreciate when the IRS makes sure that other businesses who cut corners (deliberately or by inexperience) face the appropriate sanctions dictated by law.
"I wish Paige luck, and hope that she takes the appropriate steps to ensure the health of her business in the future, but can't fault the IRS for doing it's job on this. I believe the powerful force of your righteous indignation and grassroots organizing juggernaut are misplaced, or at least mistargeted: rather than letters to senators or angry blog posts, raising donations to help her hire a good accountant and pay to perform a physical inventory so she has some concrete numbers with which to argue her case would be a more useful effort, both short term and long.
"Also, just to correct a factual error in the column: Of several dozen active threads currently running on the CBIA, there are none that are currently discussing discounting. As a widespread practice of debatable effectiveness in the industry, it is certainly a legitimate topic for discussion among industry professionals, but it isn't something we've had a go at in several weeks, perhaps months. There are two dozen or so active posts with retailers asking for advice and getting good, practical answers of the sort that might have helped Paige avoid a mess like this in the first place, though."
We'll discuss the CBIA in a bit, but let's deal with the main issue on our plate first. Note that Mr. Crocker fully sympathises with the calamity which has beset Corner Comics, but nonetheless believes that by failing to take inventory, Paige Gifford has essentially brought her troubles upon herself. Is this true? I spoke to Ms. Gifford briefly over the weekend, making an appointment for an interview, but was not able to re-establish contact later. Having not heard the Internal Revenue Service's side of the case, nor having seen any documentation about it, I of course cannot make any claim as to her innocence or guilt. That's not the question at hand, however. The question is, is Corner Comics in defiance of the law by default because it didn't inventory its backstock on a yearly basis? After having investigated the relevant legal and accounting issues for several days, I feel fairly certain that I can answer this question: no, it isn't. In fact, Jim Crocker's quoting entirely the wrong law in the above letter. There's an entire side to accounting law that's being ignored here, and it is this aspect of the law upon which Ms. Gifford has based her case.
(Before we go any further, let me acknowledge the obvious right now. Like most of the people currently involved in this debate, I have at best a layman's knowledge of the basic concepts behind business accounting, and what follows should therefore in no way be considered a comprehensive analysis, but rather my best attempt to discern the legal basis for the argument between Corner Comics and the IRS, based upon a few day's research. There are doubtlessly wrinkles in the law of which I'm completely unaware, and areas where I've misinterpreted the law by omission, although I shall do my best to avoid it. In the rest of this essay, I will argue that the public statements made by Paige Gifford and Laura Gjovaag seem to conform with what I've been able to learn about the relevant tax laws; that said, I do not have enough evidence at hand to make an informed guess as to Ms. Gifford's actual guilt or innocence in this matter. Just so that's all clear at the outset, you understand.)
Mr. Crocker, like most (if not all) of the retailers commenting on the CBIA forum, apparently use what's known as accrued accounting to keep their books, and are reacting under what I'm going to guess is the assumption that this is the only legal way for small businesses to handle their accounting for tax purposes. They're mistaken. There are in fact two ways to do the books -- accrual accounting and cash-basis accounting, which is also known as "cash accounting." There's actually considerable difference between the two methods, so before we go any further let's define our terms. The online encylcopedia Wikipedia explains:
"Cash-basis accounting records financial events based on cash flows. For example, when you pay your rent your landlord would record an income event when you make the payment. The landlord records an expense event when he pays the rental agent their fee for your apartment. It is the accounting method used by most individuals, and by some businesses that have limited payables or receivables or whose income and expense cash flows are closely associated with each other in time.
"Accrual-basis accounting records financial events based on events that change your net worth (the amount owed to you less the amount you owe others). Standard practice is to record expenses with the incomes they are associated with. For example, your landlord would record an income event on the day your rent comes due (you owe it to him). He records an expense event when the fee owed to the rental agent comes due for your apartment that month (he owes it to the agent). The details of the actual cash flows and their timing are tracked by bookkeeping."
Put simply: cash accounting is similar to how one might handle financial affairs in one's checkbook -- incoming and outgoing cash are recorded in a two-column straight line, and taxes are calculated accordingly. Think of it as the 1040-EZ of business tax law. You don't deal with a lot of deductions -- while I have no doubt that there are complications involved, it's reputed to be nowhere near as complex as the law surrounding accrual accounting, where backstock is deductable in the short term but must be inventoried, accounted for and declared at the end of each year. Further, accrual accounting can generate tax debts where there's no money to be taxed; because money is taxable when a transaction is logged rather than when cash is actually exchanged, businesses can find themselves in hock for deals that have been signed, but have not yet been successfully billed. In theory, you could save more money with accrual accounting and a creative use of deductions, but cash accounting can save you time in bookkeeping and billing hours by accountants, which is what makes it attractive to very small businesses.
Under the accrual-accounting system, inventory is considered a taxable asset by the IRS. The difference between the value of a given business' inventory at the beginning of the year and at the end of the year is calculated, and the result is either added or subtracted from one's taxable income, based upon whether the result is a plus or minus. For retailers using accrual accounting, taking inventory is indeed essential to dealing with taxes, especially if one intends to depreciate comics that have gone down in value and are now effectively worthless bundles of paper cluttering up the shop. (For other forms of commerce, accrual accounting can lead to even further headaches. Builders and general contractors are an excellent example: the moment a client commissions the construction of a building, the Internal Revenue Service assumes that the builders are liable for the money they're set to earn, even if the contract states that payment will be made at the end of the job. More on that in a bit.)
Using cash accounting, the basic rules are different. When you buy product from someone for later resale, you're spending money that you've already logged as income. Since you never deduct inventory to begin with, there's no need to count your inventory, and thus there's no legal reason for an IRS agent to try to tax it, since you already declared the money you used to buy the product in the first place. See how that works? This is why I believe it's possible for Paige Gifford to be in full compliance with the law, while the retailers quoted above do not: said retailers are basing their opinions on how they themselves handle accounting, using a method which is in fact wildly different than the one used to maintain the books at Corner Comics.
Let's go back to Ms. Gifford's public statement, found in Laura Gjovaag's weblog:
"Now, the law clearly states that if a business makes less than a million dollars a year in gross receipts, they DO NOT have to recognize inventory. Which means that any store that makes less than a million dollars does not have to take a physical inventory of their store's product at the end of the fiscal year. MY STORE FALLS INTO THIS CATEGORY as do most other comic stores and used bookstores in America. So I have never taken a physical inventory of my store as I have not needed to."
This is an accurate statement, at least since the year 2000, if one realizes her to be discussing cash accounting (something I was able to confirm in the brief time I spent on the phone with Ms. Gifford Saturday afternoon). That said, this method of bookkeeping has always been unpopular with the Internal Revenue Service. Remember what I said about general contractors? The IRS has always preferred to be paid now rather than later, and a builder working on a house commissioned in 2003 but not scheduled for completion until 2004 will nonetheless owe taxes on money earned from the job on their 2003 returns under accrued accounting. Again and again, my research has led me past throwaway references to the Internal Revenue Service's desire to limit the use of cash accounting to the extent that it possibly can, for just this reason. In April of 2000, Small Business Legislative Council president John Satagaj testified before the House Committee on Small Business, calling for the rules on cash accounting to be relaxed:
"We are here today because the Internal Revenue Code does not set forth an affirmative rule on the use of cash accounting. Like many issues under the Internal Revenue Code, you find the answer by working backwards. Most determinations of which tax accounting method a taxpayer must use begin with Internal Revenue Code (IRC) Section 448. (Other IRC sections such as IRC Sections 447 and 460 may also come into play, but that is a story for another day.)
"As a general rule, IRC Section 448 requires corporations to use the accrual method of accounting. There are three basic exceptions. There is one for farming and another for certain qualified personal service corporations. There is a third exception for corporations with less than $5 million in gross receipts. But, as it turns out, the small business exception may not quite be the exception we thought it was.
"The Department of Treasury is in the early stages of a new effort to force small business service providers using the cash method to convert to accrual accounting. As we understand it, it is the Department's position that IRC Section 448 does not necessarily guarantee a small business the right to use cash accounting, rather, the Treasury asserts, IRC Section 448 only prevents large corporations from using cash accounting. It is the Department's position that if it can otherwise require a small business taxpayer to be on accrual accounting, it may do so, notwithstanding IRC Section 448. While we believe the intent of Congress at the time of enactment of the $5 million gross receipts test in IRC Section 448 was to allow small businesses to use cash accounting regardless of circumstances, the actual language of the section can be read to support the Treasury's views."
The above passage's implied confusion in the use of cash accounting prior to the year 2000 is reflected in my research; I was unable to discover the rules for its use prior to that date, or indeed if there were widely-accepted and agreed-upon rules prior to the turn of the 21st century. The first definitive clarification of the rules occured in Spring of 2000, when the Internal Revenue Service allowed any business earning under $1 million a year in total gross receipts the use of the cash-accounting method, so long as they used the method consistently and exclusively throughout the year. The next year, the IRS further loosened the regulations, as noted by Milton Zall in the June 2001 issue of the general-contractors' magazine Walls and Ceilings:
"Recently, the IRS changed its position by dropping the book-conformity requirement. The IRS now says it will permit use of the cash method even if a firm's books and records are on accrual method as long as the firm grossed $1 million or less in average revenue over the past three years. Thus, consult an accountant or tax adviser to determine whether taxes would be lower using the cash method of accounting. If the cash accounting provides better results, switch to the cash method of accounting for the 2000 tax year. A contractor who has already filed a 2000 return using the accrual accounting method needn't despair: He or she can file an amended return using the cash accounting method."
For those businesses earning over $1 million, the rules are trickier. Writing for The CPA Journal in September of 2002, tax accountant Thomas Chiavetta noted yet another change in the rules, granting businesses earning between $1-10 million in gross receipts the right to use cash-accounting methods, but only if said businesses were not principally involved in certain farming, mining, manufacturing, information, retail or wholesale trade industries. Covers most of America's businesses, does it not? Like I said, the IRS doesn't like cash accounting, and accepts its legality only grudgingly, despite repeated attempts by legislators and the courts to force them to allow it and even expand its usage to benefit businesses which find the method advantageous.
Okay, we're entering into overkill territory, here. Suffice it to say that yes, there is a method by which any small business earning less than $1 million can avoid the need to perform a yearly inventory of their backstock, that it's perfectly legal, and that if Paige Gifford is telling the truth, there's reason to believe that the Internal Revenue Service may well be violating her rights as a taxpayer by attempting to tax her inventory anyway. That's a big "if" there, of course -- if Ms. Gifford declared her inventory as a deduction in ways not permitted by the rules governing cash accounting, then it can indeed be said that she brought her problems upon herself. If this is the case, however, why use cash accounting in the first place? As I said many paragraphs back, every statement made by Gifford and Gjovaag concerning the rules by which Ms. Gifford handled her bookkeeping seem to be supported by the basic principles of her chosen form of accounting. Whether you believe there's a story here, therefore, depends upon whether you're inclined to give Ms. Gifford the benefit of the doubt.
All of this leads us, in roundabout fashion, back to the Comic Book Industry Alliance. Friday's weblog entry on the subject resulted in a flurry of email over the weekend, most of it by retailers (A) angered that I would issue an "action alert" for someone "so clearly in the wrong," and (B) outraged that I would question the usefulness of the CBIA as an active trade association. Just so we're all up to speed here, this is what I wrote about the CBIA that got so many people upset:
"Of course, in an ideal world this would be a task best co-ordinated by an industry trade group, sufficiently organized to offer legal, moral and financial assistance to a fellow retailer in need -- you know, a "comic book industry alliance" of some kind. Sadly, if such an organization did exist, it would probably be too busy, I dunno, whining about discounters on a message board somewhere to be of practical use. Still, one can dream..."
Let me state here and now that I have no problem with the CBIA's individual members, many of whom are among the most farsighted and forward-thinking retailers in the Direct Market -- proprietors of exactly the kind of shops that I have argued again and again in this weblog should be emulated by others. Hell, I admire many of the people involved with the CBIA. That said, I'm afraid that I find it tempting to break out the scare quotes every time I refer to the CBIA collectively as a "trade group." Most industries have such organizations looking out for their common self-interest, and such groups engage in a wide variety of tasks to achieve just this purpose. Through membership fees and fundraising efforts, they retain legal counsel, legislative lobbyists, publicists and other such functionaries to follow trends that affect their businesses and react accordingly. They join forces with other, like-minded organizations in an effort to increase their weight among people legislators and media outlets. They serve as clearing-houses for information useful to their membership, and advertise its availability to the industries they serve. Some even pool their resources to provide health-care options for small-businesses and professionals who might otherwise not have access to such things.
These are all costly, difficult and time-consuming tasks, and I have no doubt that the CBIA would argue in response that most of its members simply don't have the money to fund such activities, even if they were to pool their resources. Given the profit margins under which most retailers operate, this is almost certainly true. That said, there's much that even the most cash-strapped of industry alliances can do to protect each other. One could keep a lawyer and CPA on retainer to offer the occasional advice when difficult situations arise. When a member finds him-or-herself in trouble, a single letter of concern, written on stationary identifying the writer as a representative for a trade organization with a nationwide membership, can have the same effect as a hundred letters from individual business-owners. That's the point. If the CBIA were a functional trade group, it could have afforded to seek professional advice as to whether there was some measure of merit in Paige Gifford's claims, then fired off an angry letter to the IRS Washington-state office, demanding clarification on the situation, rather than sitting around on a walled-off message board telling each other that she undoubtedly deserved everything she got.
A functional trade organization, in short, would be one capable of doing something rather than nothing. I see no evidence that this describes the CBIA in any way, shape or form. This is a shame. If there's one set of businesses in these United States that needs a trade organization to offer its members a collective voice and source of business leverage, it's the shopowners whose hard work keeps the Direct Market functioning, day in and day out. Perhaps it's unfair to single out the CBIA for failing in this regard, but it's the closest thing to a trade organization we currently have -- and that's just sad. It's too late to save Corner Comics, of course, but what about the next retailer to face a similar situation? Is it possible to build something that might help them? If the Comic Book Industry Alliance isn't the organization for the job, shouldn't someone be thinking about a trade group that could fill this badly-needed role? Why isn't anyone trying?
(Postscript: a tip of the hat to Jesse Walker, Tim O'Shea, Sean Collins, Alan David Doane, David Fiore, Jim Henley, David Allen Jones, Jason Kimble, Jason Marcy, NeilAlien, Chris Puzak, Elayne Riggs, Bill Sherman, Eve Tushnet, Todd VerBeek, Rob Worley, and of course Laura Gjovaag for working to keep the Corner Comics story in play over the weekend. We can't win 'em all, kids, but that's no excuse not to try. I've undoubtedly missed a few, to whom apologies are of course extended for the omission.)
