Beyond Abel: Ability To Pay Guidance


-BEYQN^AfiftL

Ability to Pay
Guidance

Prepared for:

• s

U.S. Environmental Protection Agency
Office of Waste Programs Enforcement
401 M Street SW

Washington, D.C. 10460

Prepared by:

-A

Industrial Economics, Incorporated

2067 Massachusetts Avenue
Cambridge, Massachusetts 02140

28 February 1993

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Beyond Abel:
Ability to Pay
Guidance

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TABLE OF CONTENTS

INTRODUCTION 		CHAPTER 1

ASSESSING THE FINANCIAL CONDITION OF A VIOLATOR 			CHAPTER 2

SUBCHAPTER C CORPORATIONS 		CHAPTER 3

SUBCHAPTER S CORPORATIONS 		CHAPTER 4

PARTNERSHIPS 		CHAPTER 5

SOLE PROPRIETORSHIPS 		CHAPTER 6

INDIVIDUALS 		CHAPTER 7

APPENDIX A: GLOSSARY 	A-l

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INTRODUCTION

CHAPTER 1

BACKGROUND

This manual is intended to provide guidance to U.S. Environmental Protection Agency
enforcement staff on determining the ability of a violator to pay a penalty or environmental
compliance costs. In particular, this guidance will help staff "go beyond ABEL" and assess ability
to pay in those cases where the ABEL model produces a negative or ambiguous result.1 Although
ABEL is a useful screening tool, it is designed to be conservative. When an ABEL run produces
a positive result, staff can be certain that the entity is able to pay. A negative or ambiguous result,
however, does not necessarily indicate that the entity is unable to pay. ABEL may produce a
negative result when, in fact, funds are available. This outcome may occur for several reasons:

(1) The violator might be able to produce a larger cash flow than that predicted
by ABEL. ABEL bases its forecast on historical data from Federal tax
returns. If the violator can pare its expenses, it can generate a larger cash
flow.

(2) The violator might have assets that are not necessary to its business. These
assets could be sold, generating funds for a penalty or pollution control costs.
ABEL's analysis does not assess a company's assets.

(3) The violator might be able to assume more debt, or refinance debt that is
owed to affiliated parties. ABEL's focus on cash flow does not directly
evaluate a company's debt capacity.

This manual gives step-by-step instructions on how to investigate these issues. The manual
contains worksheets to guide the user's analyses and draw attention to key information in the
violator's tax returns and/or financial statements. Please note, however, that this approach will
not produce a definitive ability to pay assessment, nor can any methodology. A final ability to pay

1 ABEL is a computer model designed to assist enforcement staff in determining a violator's ability
to pay a penalty and/or environmental cleanup costs. ABEL's assessments are based on financial data
from the violator's tax returns.

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assessment will require the user's judgment about the entity's financial capability and the degree of (
hardship that should be imposed on the violator. Such judgments are by their nature subjective, and
will most likely be reached through discussion within the litigation team and enforcement staff.

Finally, bear in mind that the approach outlined here may not be sufficient for all entities.
Cases involving entities with complex financial situations may require advice from a financial expert.
Throughout the manual, we highlight those situations that could require this type of assistance.

Type nf Rnrity

This manual focuses on analysis of private for-profit entities.2 Separate worksheets and
instructions are enclosed for:

• Subchapter C Corporations,

• Subchapter S Corporations,

• Partnerships,

• Sole Proprietorships, and

• Individuals.

Federal tax policy is different for each of the entities noted above, and each must submit
different tax forms. The extent to which individual owners may be responsible for the liabilities of
their businesses also varies among these entities. For example, sole proprietors and partners are
personally liable for their businesses. Thus, in a bankruptcy case, creditors could pursue a sole
proprietor's personal assets in order to clear the company's debts. Corporate shareholders, in
contrast, are rarely held personally responsible for the company's liabilities.3 The liability of
individual shareholders in a closely-held Subchapter S Corporation, though, must often be
determined on a case-by-case basis.

: For-profit entities can generally be designated as either "private" or "public." Public for-profit
entities are those whose equity (shares of stock) are traded in some form of open market (usually on one
of the various Exchanges; e.g., NYSE, NASDAQ, and so forth). The equity of private for-profit entities,
in contrast, is not traded publicly but is, rather, held by a group of individual investors (some of which
may be institutions) who control the company.

3 A corporation sets up a legal "veil" that shields its owners from personal liability. Hence the phrase
"piercing the corporate veil" which is used when owners are found personally liable for a corporation's
transgressions.

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For each type of entity, the ability to pay assessment process detailed in this manual will help
staff review ownership and operating affiliations, assets and liabilities, and expenses. Our goal in
this review will be to determine if additional funds may be available. We will use examples
throughout the manual to demonstrate how entities can arrange or use their resources so as to give
the appearance of limited financial resources.

Hnw This Manual is Organi7^

Chapter 2 of this manual outlines the ability to pay evaluation process, from information
collection through final assessment, and discusses the analysis in detail. Chapters 3, 4, 5, and 6
review the analyses for Subchapter C Corporations, Subchapter S Corporations, Partnerships, and
Sole Proprietorships, respectively. In Chapter 7 we discuss financial analysis of individuals, and the
cases in which reviewing an individual's financial position (in addition to that of the business entity)
may be appropriate. Appendix A contains a glossary of important accounting and finance terms and
concepts.

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ASSESSING THE FINANCIAL CONDITION OF A VIOLATOR

CHAPTER 2

GOALS

The primary goal of this guidance is to enable EPA regional staff to further analyze and
make assessments about the ability of environmental violators to pay, penalties. In undertaking this
project, the Agency is aiming to provide a consistent and theoretically sound method for going
beyond the ABEL result. Such consistency will increase the coherence and integrity of ability to pay
analyses across EPA regions. It will also give enforcement staff a better understanding of private
finance and accounting principles, and allow them to review cases more critically.

Another goal of this guidance is to provide a straightforward and relatively simply mechanism
for reviewing an entity's financial position. The worksheets used in the analysis will help staff review
financial information more quickly and will yield a clear and concise record of each case.

The basic investigation framework is similar across the entities we discuss here; however,
there are some differences in the depth of the analysis and the financial information required for
each. To accommodate these differences, we have written a separate chapter for each type of entity.
The following segments of this manual are "stand alone" chapters. Each chapter contains
instructions for researching a specific type of entity and completing the related worksheets.

FINANCIAL INFORMATION

Before conducting an in-depth investigation of an entity, staff must gather important financial
information on the entity being analyzed. The amount of information available will likely depend
on the type of entity (e.g., corporation, partnership, sole proprietorship) and its, size. However, in
all instances enforcement staff should obtain the following:

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Federal Income Tax returns from the past three years (these should already
be available if an ABEL analysis has been conducted).1 These returns are
the primary source of financial information on the violator. Be certain that
the returns are signed, and include §11 supporting schedules (these will be
detailed in the entity-specific chapters). The worksheet-based analysis will
be based on the most recent tax return available; however, you should also
review past returns to see if the company's financial position has changed
significantly over the past couple of years.

Financial Statements from the past three to five years. Although tax returns
axe our primary source of financial information, financial statements are also
helpful in that they provide some information generally not included in the
tax returns. In particular, notes to the financial statements often contain
important information on related-party transactions, loans to and from
shareholders, and the company's accounting policies.2 At a minimum, these
statements should include an Income Statement and a Balance Sheet (see
Appendix A for descriptions of these statements and other accounting terms).
Companies might also be able to provide a Statement of Cash Flows
(sometimes called: "Statement of Changes in Financial Position" or "Sources
and Uses of Funds Statement").

If at all possible, obtain audited Financial Statements from the entity.
Audited statements are those which have been explicitly reviewed by a
certified public accountant for their conformance with Generally Accepted
Accounting Principles (GAAP). Audited statements will contain an auditor's
opinion, which will summarize how closely the entity's financials conform
with GAAP, and detail any questionable practices.3 Small, unincorporated
entities may only have unaudited statements.

If an entity has no financial statements awlable, request that they prepare
them. Even the smallest of sole proprietorships should be able to list and

1 Newly-formed companies will not have financial information going back several years. An
ABEL analysis of a new company will probably not be possible because of the lack of historical
financial data. Completing a detailed analysis as outlined in this guidance is particularly important
for such entities.

2 Also, financial statements may provide information on expenses not deducted on tax returns.
For example, EPA or other penalties will appear on financial statements, but not on tax returns, as
they are not tax-deductible.

3 If you are reviewing an entity's audited financials and find a "qualified" auditor's opinion
detailing questionable accounting practices, you should seek assistance from a financial analyst.

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value its assets, liabilities, revenues and expenses.4 Be cautious when you
. compare financial statements to tax returns, as the two can differ
considerably. Tax returns and financial statements often report on a
different time basis (i.e., calendar year versus fiscal year) or may use different
accounting conventions. Keep these differences in mind when you compare
the reponed information.

• Dun & Bradstreet (D&B1 Report Dun & Bradstreet publishes information
about companies as a service to potential investors or creditors/ D&B
reports can be a good source of information on the entity's history, officers,
and affiliations; they can sometimes provide comparative financial data on
the entity as well. This information may help guide further research on the
relationships to other individuals and entities. When you review a D&B
report, keep in mind that companies voluntarily provide the underlying
information. In doing so, companies often try to present a positive picture
of their income position and potential earnings.

D&B can also provide industry profiles. Other sources of information on
industries and companies include Robert Morris Associates Annual
Statement Studies, Value Line. Standard & Poor, and industry associations.

• Additional Financial Information. You might also find it helpful to review
materials prepared by the company to support a recent loan or debt financing
proposal, company forecasts of growth and/or expansion, and company plans
for major capital expenditures. Such information can provide another
measure of the company's anticipated future earnings.

It is important to note that accounting requirements differ for financial reporting and tax
reporting. As a result, a company's tax returns and financial statements may report different
numbers for some items.6 Our analysis is based on the entity's tax returns. Review of the entity's
financial statements is also important, however, as they may provide further detail on company
activities and its relationships with other entities.

4 Note the time periods covered by Income Statements and Balance Sheets; ideally these should
cover a full year of business operations. Statements covering only a portion of the year might not
adequately represent the seasonality of some businesses.

5 The National Enforcement Investigations Center (NEIC) can obtain D&B reports. The phone
number is 303/844-4517.

6 For example, reported income may be different from taxable income because of differences
, in claimed deductions.

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APPROACH AND METHODOLOGY

The approach used in this manual applies commonly used financial analytical techniques to
evaluate the financial condition of private entities. Once you have the necessary financial
information, you can begin an in-depth review of the entity. This review will vary somewhat based
on the type of entity, although the basic approach is very similar for each. Below, as an example,
we review the steps for analyzing a corporation.

Ownership and Operating Affiliations

In many cases, companies closely related to the violator will share its financial liabilities. So,
our first step in investigating an entity's financial position is to research its relationship with other
entities. The goal of this first step is to determine the nature and extent of each affiliate's
relationship, and whether you should also consider its resources in the ability to pay assessment.
Some affiliations may be strong; if the violator is a division, for example, including the parent
corporation is easy. Other cases may be more difficult to judge; for example, a case involving an
American firm that is a subsidiary of a foreign parent. In these cases it will be important to
determine the degree to which the parent company controls the financial health of the subsidiary.
It is not necessary to prove that the parent is in any way liable for environmental costs. Rather, you
are looking for financial resources available to the subsidiary outside its own legal structure.

Depending on the type of entity you are reviewing, the possible business affiliations will vary.
For corporations, parent-subsidiary relationships and joint ventures might be an issue. In addition,
the same person(s) may own "affiliated" corporations, and these might have significant financial
interactions. For partnerships and sole proprietorships, you should look at the financial position of
the general partners and/or the owner(s).

We will also want to examine an entity's "related party transactions." These transactions
could include the sale or purchase of goods and services from an entity that is related to the violator
via common ownership or family ties. Extensive related party transactions should be detailed in the
entity's financial statements. In other instances, you might have to do some research on the
violator's primary suppliers and customers to determine whether related parties are involved in the
business. In subsequent chapters we discuss in greater detail the possible business relationships that
different types of entities might have, and how they might affect your ability to pay assessment.

Business Assets

In this part of our investigation, we will look more closely at the assets recorded on the
entity's Balance Sheet, posing a number of questions about their value and use. In particular we
want to identify luxury assets (which may not be required for business purposes), undervalued assets,
and loans to officers or shareholders.7

7 In some instances, a company balance sheet may show few assets as compared to liabilities,
producing poor current and debt to equity ratios. You should review the historical financial
documents of this company closely. If the company is doing poorly, the controlling owners may be

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Luxury Assets

Luxury assets are those not necessary to the company's operations. Examples of such assets
include land (particularly land that the company is holding as an investment or is renting to a second
party), corporate airplanes or boats, and luxury vehicles. In examining these assets, consider whether
selling them would materially affect the underlying business (e.g., What would happen if the
company plane was sold?). If the asset is necessary to operations, consider how replacing it with
a less valuable asset would affect the firm. What funds might become available (net any related
loans) if the company officers replaced luxury company cars with more moderately priced models?

Undervalued Assets

Assets on the Balance Sheet are usually valued at their original purchase price ("cost") less
accumulated depreciation. This net figure is known as the asset's "book value." The book value of
an asset is highly influenced by the rate at which it is depreciated. Because companies can legally
depreciate many of their assets over periods that are shorter than the assets' useful lives, book values
can be considerably below market values. For example, suppose that a company buys a piece of
equipment for $50,000, and that the equipment is expected to last for 10 years. On its tax return,
the entity can depreciate the equipment over five years, with an annual straight-line depreciation
expense of $10,000. After five years, this equipment still hf£ a useful life of five years, and probably
has a positive fair market value.8 On the company's books, however, the asset is valued at zero.

The difference between book value and market value is generally not an issue for a
company's Current Assets. For Property, Plant and Equipment, however, consider asking the entity
-to provide a list specifying both book and fair market values for all its assets worth more than
$5,000. Assess for each major asset whether the stated market value seems reasonable, and whether
it is greater than the stated book value. Any differences represent additional equity for the
company.

Continuing with the example above, assume that the book value of the company's equity (i.e.,
its net worth after subtracting all liabilities) equals $200,000; and your review of the company's
itemized list of assets indicates that the property, plant and equipment are worth $15,000 more than
stated at book value. Add this $15,000 to company equity, increasing the total equity to $215,000.

Note that an asset examination does not imply that the company must use those assets as
a source of penalty funds. In identifying these assets, we are simply indicating that the company has
additional resources that could be used for penalty purposes. The company itself will determine how
it will actually provide those resources.

"liquidating" the firm's assets (i.e., converting them to cash) and distributing the proceeds among
company shareholders. Review the corporate tax return for sales of company assets (located on
Form 4797 • Sales of Business Property).

8 That is, it could be sold for some non-zero price.

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I .nans

Loans to Shareholders

Shareholders or corporate officers sometimes borrow from their companies at below-market
interest rates, or obtain funds from the corporation that they would not be able to secure from a
bank or other lender. Such loans must be reported on the Corporate Federal Income Tax return,
and should always be considered as a source of penalty funds. By calling these loans (and requiring
perhaps that these individuals borrow on the open market) the entity might be able to obtain
resources necessary for a penalty.

Loans from Shareholders

Corporate entities must also report loans from shareholders on their Federal Income Tax
returns. Shareholders can infuse funds into a company in one of two ways: (1) directly transfer
funds to the company; or (2) provide funds as a loan. In the first case, if the company fails (i.e.,
goes bankrupt) the loss that the shareholder can claim on his or her personal income tax return is
limited to $3,000 per tax year. In the second case, however, where the same shareholder makes a
business loan to the company and the company fails, the entire amount of the loan can be written
off as a loss. The potential tax advantages of such loans are obvious. The disadvantage of such a
loan is that the interest the shareholder earns on it is taxable as income. In our analysis we will
reclassify shareholder loans as business equity.

Business Expenses

The final worksheet examines the entity's expenses. A reduction in expenses (without a
corresponding reduction in revenues) will increase an entity's cash flow, thereby improving its ability
to pay. A company's expenses will be generally reported on its tax return, and on its Income
Statement. We base our analysis on the entity's tax return; however, you should compare the tax
return expense figures with those on the income statement (and any associated detail provided with
both) and investigate any significant discrepancies. Companies often state their expenses at the
highest allowable level for tax purposes to reduce their taxable income. If the documents that you
have do not itemize expenses, request that the company furnish detailed information on specific
expenses and service providers. Pay particular attention to officers' salaries, commissions, travel and
entertainment expenses, rent or charges to affiliated entities, dues and publications, and office
expenses. Look at whether any of these expenses (particularly rent, commissions, and sub-
contracting) have been paid to related parties.

Officers' Salaries

Officers' salaries should be consistent with salaries earned by similarly-placed individuals.
Professional societies and/or industry groups often collect statistics on earnings within their
industries. The officers' salaries should also reflect the officers' respective duties, and the amount
of time they spend on the job. Record this information on the worksheet and use it to determine
whether officers' salaries are appropriate.

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Other Expenses

Review the other expenses noted on the worksheet and try to evaluate their level and
necessity. Note especially any expenses paid to related parties. Examples of such expenses include
rent paid to an officer (i.e., the officer actually owns business property, perhaps under the name of
a different entity), and subcontracting or service agreements with affiliates or relatives. Such
"expenses" might actually disguise benefits or funds being paid to shareholders.

Data on average expenses within an industry or business are sometimes available from
Robert Morris Associates Annual Statement Studies (depending upon the industry), or from industry
associations. If you are uncertain about an expense, request additional information from the
company. Evaluating a company's expenses involves judgment, and some familiarity with business
operations. If you cannot determine whether an expense is reasonable, consult a financial analyst.
If you decide that some of the entity's expenses are excessive, estimate the amount by which they
can be reduced, and note these values on the worksheet.

Finally, remember that this expense review does not imply that the firm must reduce its
expenses to provide penalty funds. Rather, this review simply identifies alternative sources of funds.
The violator may choose a different approach from all those you identify. For example, the
company may decide to maintain current expenses, and take out a loan to cover the penalty.

CASE DISPOSITION

After reviewing the company's financial information and investigating its holdings and
transactions, you can reassess the violator's ability to pay. This assessment will vary depending on
the entity, but will generally consist of two steps: (1) a simple cash flow calculation; and (2) an
equity assessment. The steps described below focus on a corporation. The assessment of an
individual's cash flow and equity is detailed in Chapter 7.

Cash Flow Calculation

Part of the ABEL Model's ability to pay assessment is a cash flow calculation. ABEL
incorporates into its cash flow calculation several technical considerations, including the inflation
rate, reinvestment rate, and estimates the present value of an entities anticipated cash flows. Our
"manual" calculation is much easier. To estimate cash flow, w'e start with taxable income and add
back all "paper" deductions (e.g., non-cash expenses), and consider the effect of reduced expenses.

As a first step, we add back depreciation, amortization and depletion. These non-cash
expenses allow companies to account for asset value reductions over time (for example, business
equipment or depletable natural resources). Depreciation and amortization are legitimate business
costs, however, they are not cash payments and thus do not increase a company's annual cash
outflows. For that reason, we add these non-cash expenses back into income when computing net
cash flow. Similarly, depletion accounting is a way to allocate over time the original cost of

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acquiring and developing natural resources.9 Although depletion is a legitimate business cost, it
does not represent a cash outflow. Thus, we also add any depletion expenses back into a company's
income when computing cash flow.

As an example, assume that Company ABCs taxable income for a year is $86,000, and the
company claimed $4,115 in depreciation for that year. Adding back the latter amount gives us an
estimated cash flow of $90,115. This last amount, rather than the original taxable income figure,
represents ABCs actual pre-tax cash flow.10

Next, we adjust cash flow for any possible expense reductions that you have identified in your
"Beyond ABEL" investigation, yielding an estimate of cash flow that could possibly be generated if
expenses were reduced (assuming, of course, that revenues do not change). Suppose that your
investigation shows that the company can reduce officers' salaries by a total of $20,000, and other
expenses by another $5,000. Adding $25,000 to actual pre-tax cash flow ($90,115) yields an
estimated pre-tax cash flow figure of $115,115.

The final step is to adjust this figure for taxes.11 We do so by multiplying the pre-tax cash
flow by one minus the marginal tax rate.u Next we must add to this figure the "tax benefit" of any
depreciation, depletion or amortization deductions; plus any net operating losses carried forward
from previous years.13 To obtain this tax benefit figure, we multiply the total of these non-cash
deductions by the marginal tax rate. Company ABC did not claim any net operating loss cany-
forwards on its most recent tax return. Therefore, we estimate after-tax cash flow at $72,380
($115,115 x [1 - 0.385] + $4,115 x 0.385). This estimate does not imply that company cash flow will,
in fact, equal $72,380 next year, it simply provides an estimate of the resources that might be
available to the company if it continues to perform at its "adjusted" current level.

9 For example, a coal-mining company would record depletion expenses every year to account
for the coal that had been mined that year. Each year the mines are less valuable because they
contain less coal. Recording depletion is a way of capturing that loss.

10 Although we refer to this figure as "pre-tax cash flow" you should note that certain state and
local taxes can be deducted from income as a company expense. Thus "pre-tax" here refers to cash
flow before federal income tax payments.

11 Recall from your ABEL calculations that pollution control expenditures are tax deductible,
while a penalty is not. In general we will estimate an entity's ability to pay based on after-tax cash
flows.

u For corporations, we use 38-5 percent as the standard tax rate. For partnerships, sole
proprietorships and Subchapter S corporations we use 33 percent, the. highest marginal tax rate for
individuals.

13 A net operating loss carryforward is an ABEL input, and is claimed on Line 29a of the Form
1120 and Line 25a of the Form 1120A. Companies can claim some prior years' losses as current
deductions. The adjustment we state here accounts for tax effects of the non-cash loss.

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Equity Assessment

In assessing a company's equity we want to determine two things: (1) the value of assets that
could be liquidated without materially changing the business; and (2) the equity of the entity, based
on the value of remaining assets.

Assume that the fictitious ABC Company's equity equals $456,400. First we summarize
information you've gathered about unnecessary or luxury assets. Suppose you discover that ABC
owns and maintains four high-priced vehicles with a total current market value of $110,000, and no
associated loans. While these vehicles arc necessary for business-transportation purposes, you
believe that they could be replaced with more moderately-priced vehicles, which would have a
combined market value of $70,000. Replacing these vehicles would free up approximately $40,000.

Suppose that you also discover that the company has an outstanding loan of $12,000 to one
of its officers. Having the officer repay this loan would also make funds available for a penalty.

Now we want to recalculate the company's equity, based on the market value of its assets
and any possible reductions in liabilities. Based on your review of a detailed list of assets, you
actually decrease the value of the ABC's total assets from $1,205,000 to $1,153,000. This decrease
reflects the $40,000 downgrade in luxury business vehicles, and removal of the $12,000 officer's loan.
The combined amount ($52,QO0) is no longer considered a company asset, but rather becomes
"excess funds" available for a penalty. Your review of ABC's liabilities indicates that they are
legitimate and accurately represented. If we assume that these liabilities equal $748,600, we can
then recalculate stockholder's equity as $404,400, down from an original value of $456,000.
Company ABC may be able to borrow against this amount to produce funds for a penalty.

Case Disposition

The final section of the worksheet summarizes your results. In your investigation, you
estimated that ABC's after-tax cash flow for the coming year could be as high as $72,380. The value
of unnecessary or replaceable assets equals $52,000 ($40,000 from the vehicle sale plus $12,000 from
the officer loan), and the adjusted equity for the company is estimated at $404,400. The violator's
ability to pay pollution control and/or penalty costs can now be reassessed based on these
approximations.

If the violator is required to pay a penalty only, you can compare your ability to pay
assessment to the penalty figure directly, since a penalty is a "one-time" payment. However, if
environmental compliance costs are also involved (e.g., the company must invest in pollution control
equipment) you will need to consult your original ABEL analysis.

To adjust for required pollution control expenditures, do the following: First, re-run the
ABEL model without entering a penalty figure. Does the result still show that the violator will have
a difficult time paying environmental compliance costs? If so, compare your revised estimate of pre-
tax cash flow and cash available from asset liquidation to the pre-tax present value of compliance

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costs.14 Any indication that the violator will still experience difficulty is a serious issue, as the
violator must, at a minimum, come into compliance to continue operating. If the comparison
indicates that the violator is able to meet compliance costs, note on the worksheet any remaining
funds available for a penalty.

Remember that this summary does not imply that the company must liquidate assets or call
in loans to produce penalty funds. Rather, your review is aimed at more accurately assessing the
resources that the entity has to call upon. Any final ability to pay figure will clearly incorporate the
judgment of the enforcement team regarding what is appropriate given the violation.

GUIDANCE STRUCTURE

The approach described in this manual is organized around the various tax forms that an
entity might file: Form 1120 or 1120A for Subchapter C corporations, Form 1120S for Subchapter
S corporations, Form 1065 (with Schedule K-l) for Partnerships, and Form 1040 for Individuals and
Sole Proprietorships (with Schedule C for the latter).

The guidance is structured around the tax return forms primarily because each return (and
hence each type of entity) requires a "customized" analysis. Also, the tax forms let us reference
specific schedules and line items that are important to the analysis. As you proceed through the
worksheets, you will be able to consult the corresponding tax return forms.

14 The present value of compliance costs is simply the difference between 'Total ABEL Cash
Flow Generated" (column 2 of the ABEL summary analysis) and "ABEL Cash Flow Net of Pollution
Control Expenditures" (column 3). The difference between these figures at any probability level
equals the present value of compliance costs. Divide this amount by one minus the marginal tax rate
to estimate costs on a pre-tax basis.

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SUBCHAPTER C CORPORATIONS

CHAPTER 3

INTRODUCTION

Regular corporations (also known as Subchapter C corporations) can be large, multi-
company organizations or small, "closely-held" companies controlled by a few individuals or a family.
When such a business incorporates, it takes on the legal status of an individual. Therefore,
responsibility for paying debts and meeting other legal commitments rests with the corporation
alone, and does not extend to the corporate shareholders.1 In some respects, this liability limitation
makes a corporate ability to pay analysis fairly easy, as the financial resources of the owners need
not be assessed. However, relationships that corporations enter into with other business entities can
complicate the evaluation, and will sometimes lead to an analysis of these other entities.

You will most likely have completed an ABEL analysis for the corporation you are reviewing,
and are now consulting this document because of a negative or equivocal ABEL result. The
objective of this more detailed analysis is to determine if, despite a negative ABEL result, the
company can provide funds for a penalty by. for example, liquidating assets, reducing expenses, or
borrowing funds.

The first step in this analysis is to gather financial information. The corporation's Federal
Income Tax return Form 1120, and the relevant schedules, will already be on hand if you've
performed the ABEL analysis.2 You should also obtain the company's financial statements (e.g.,
income statement and balance sheet) for the past three to five years. Most corporations should be
able to provide audited statements (i.e., statements that have been reviewed by a certified public
accountant).

Consider also collecting other information on the company (e.g., Dun & Bradstreet or
Standard & Poor reports), as well as information on earning and expense averages, and performance

There are exceptions to this general rule. Under certain circumstances, liability for debts and
penalties can extend to the company's shareholders.

Note that some corporations may fill out the 1120A (Short-Form). The requirements for
completing the short-form are detailed on page 2 of the Instructions for Forms 1120 and 1120A
booklet.

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norms within the corporation's industry. These other sources could provide helpful information on
company affiliations and officers, and on industry trends. Once you have collected the necessary
information, you can begin the ability to pay evaluation using the worksheets at the end of this
chapter as a guide. Be certain, however, to read Chapter 2 before proceeding, as it contains a more
detailed explanation of the worksheet sections.

Section I - General Information

The first section of the worksheet summarizes basic information about the violator and the
information that has been collected:

• Violator's name. On Line 1, enter the violator's name.

• Address. On Line 2, enter the violator's address.

• Principal business activity and product or service. On Line 3, enter the
violator's principal business activity, along with its product or service.3 This
information is on the Corporate Income Tax return Form 1120, Schedule K
lines 2b md 2c.4

• Names of Officers. On Line 4 enter the names of the corporate officers and
the percent of stock owned. This information can be found on Schedule E
on Form 1120.

• Original penalty amount Note on Line 5 the proposed penalty amount.

• Penalty as a percent of sales. Divide the original penalty amount by the
company's total sales (item la on form 1120). Note the result on Line 6.

Section II - Financial Information

In this section of the worksheet we summarize the financial information available.

• Tax returns and schedules available. On Line 7, note the tax returns and
schedules provided, along with the year for each return.

3 Note that an ability to pay evaluation may be particularly difficult for certain businesses; for
example, agricultural corporations participating in government subsidy programs. You may want
to consult an expert for help in assessing these types of entities.

4 Throughout this chapter, references to Form 1120 are for the 1991 version of Form 1120. The
location of items may differ for previous years' forms.

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• Financial Statements provided. On Line 8, list each available financial
statement (e.g., Balance Sheets, Income Statements and notes, Statement of
Change in Financial Position). Is this an audited statement? Note the
period covered by the statement, particularly if the statement covers only a
portion of the fiscal year.

• Other violator or general industry information collected. On Line 9, list any
other material you have obtained. Examples include Corporate Annual,
Reports, Dun & Bradstreet reports, Value Line reports, Standard & Poors
industry data, etc. Note as well the dates covered by the document(s).

Section ITT - Ownership and Operating Affiliations

In this section we detail the relationships that the violator may have with other entities. This
section is particularly important for corporations that are connected to other entities through parent-
subsidiary relationships, joint venture agreements or other affiliations. These relationships are
described in greater detail below. You might be able to obtain information on these relationships
through the company's annual reports or its D&B report. In particular, you will want to determine
whether an affiliate is closely involved in the operations or finances of the violator.

Subsidiaries

A subsidiary is a corporation that is at least 50-percent owned by another company (i.e., at
least 50 percent of its common stock is owned by one other corporation). A subsidiary is wholly
owned if the parent company owns 100 percent of its stock. As with all corporations, a subsidiary
is an individual legal entity. As such, it may file separate tax returns. However, if a subsidiary is
more than 80 percent owned by the parent company, the parent may submit a consolidated tax
return that incorporates the subsidiary. For financial reporting purposes, according to generally
accepted accounting principles, a consolidated statement should be prepared if:

• The parent owns more than 50 percent of the common stock of the
subsidiary;

• The parent is able to exert control over the operation and management of
the company; and

• The asset and equity structure of the subsidiary is not significantly different
from that of the parent.

The extent to which parent and subsidiary are related is quite important in ability to pay
cases. A parent company can often enter into purchasing contracts with a subsidiary, or manipulate
its finances, such that its financial condition appears worse than would be the case were the

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subsidiary an independent concern.3 Your evaluation of the parent-subsidiary relationship might
indicate that the parent company should be included in an ability to pay assessment of the
subsidiary. Although it is not EPA's policy to pronounce a parent firm liable for a subsidiary's
actions, it is proper to consider financial links that the subsidiary may have to the parent. It some
instances it might be difficult for enforcement staff to determine how involved the parent is in the
operations of a subsidiary. If you are unsure whether the parent should be included in the ability
to pay assessment, consult a corporate finance expert.

Affiliated Companies

Affiliated companies are those that are owned or controlled by the same individual or group.
Also known as "brother-sister" companies, control is demonstrated if:

• Five or fewer persons (individuals, estates, or trusts) own at least 80 percent
of the voting stock or share value of each of two or more corporations; and

• These five or fewer persons own more than 50 percent of the voting power
or share value of each corporation.

Brother-sister corporations can enter into the same type of purchasing agreements discussed
above for subsidiaries. In some instances, a corporation will choose to enter into a risky venture by
creating an affiliate, thereby limiting the liability for its other concerns. As with subsidiaries, you
should consider the financial links among a group of brother-sister corporations when determining
the ability to pay of a single affiliate.

Joint'Ventures

A joint venture is a business activity collectively established by two or more entities. Each
participating entity invests in the new company and shares in its income. Major decisions for the
company often require the backing of all owners. A joint venture operates as a separate entity, and
will generally submit its own tax returns. However, if an ABEL analysis indicates that a joint
venture is unable to provide funds for a penalty, the resources of the holding companies should be
evaluated.

Worksheet

An audited set of financial statements should include a section in the notes on any related
party transactions. This section will detail sales and purchases of goods and services from the
violator's affiliates. This section in the notes is helpful for two reasons: (1) it helps to identify the
violator's affiliates; and (2) it can be used to assess whether related party transactions were
conducted "at arms length" (i.e., at fair market rates). In this section of the worksheet, we detail

5 See the ABEL User's Guide. Chapter 5, for additional information on this topic.

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related-party transactions. If the notes to the Financial Statements do not provide this information
for the entity you are analyzing, you should request that the company provide the information.

• Additional business concerns. Is this corporation affiliated with any other
business concerns? Check yes or no on Line 10.

• Entity information. For each related entity, note the name and type. For
example:

Affiliate's Name

Type of Entity

MCG Demolition

Corporation

• Relationship and percentage owned. Describe here the relationship between
the two entities. Note also the percentage of stock owned by the affiliate.
Also note transactions between the affiliates. For example:

Relationship and
percentage ownership

MCG Demolition is a 'sister
firm of MCG Construction,
which owns 25 percent of its
stock. MCG Construction
accounts for 20% of MCG
Demolition's Sales. The two
companies frequently
purchase materials or
services from each other.

In the summary portion of this worksheet section (Line 11), discuss whether other entities should
be included in the ability to pay assessment for this violator. In some instances, this determination will
require advice from a financial expert. Continue to work on the ability to pay assessment of the violator
while you pursue information about the corporation's affiliates.

Section IV - Business Assets

In this section of the worksheet, we review the corporation's assets, and investigate their use and
worth. Remember that our intention is to determine the true ("market") value of the company's assets,
and the funds that might be available through liquidation of those that are unnecessary.

Part A - Loans to Shareholders

As explained in Chapter 2, loans to shareholders and officers are among the first assets that
should be tapped to fund a penalty. These loans must be reported on Form 1120, Schedule L. Item 6.

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Request that the violator provide additional information on the terms of these loans before completing the
following section on the worksheet:

• Borrower. Enter the name of the officer or shareholder borrowing funds.

• Date and amount of loan. Note the original amount of the loan and the date on
which funds were borrowed.

• Interest rate. Note the interest rate at which the funds were borrowed.

• Amount outstanding and date. Enter the amount outstanding Ooan balance) as
of the most recent financial statement or tax return.

• Total outstanding loans to shareholders. Total here the outstanding amount of
all loans to officers and/or shareholders and enter this figure on Line 12.

Part B - Luxury Assets

In this section, our goal is to determine whether the company owns luxury or unnecessary assets,
or whether its balance sheet understates its assets, and thereby its net worth. As stated in Chapter 2,
luxury assets might include expensive or unnecessary vehicles, boats, planes, rental property, or other
assets not necessary to the company's operations.

In general, we will focus on the corporation's most valuable assets. Although it may be possible
to identify these assets using financial statements or tax returns, you might want to request that the
corporation provide a list specifying both the book and market value of assets valued at over $5,000, as
well as their use to the company. Information on asset use is important for determining whether the asset
is essential to company operations. Review the list that you receive carefully. Do the market values
seem reasonable? The worth of some assets can be double-checked against outside sources. For
example, vehicle values are published in industry "blue books," available at car dealerships. County or
local property assessors should be able to verify the value of land and/or buildings in their jurisdiction.
Industry analysts or associations can often estimate the value of business or industrial equipment.

In some instances, an entity will not want to provide detailed information on its assets, or it may
delay in doing so. If the penalty is significant, you may want to invest resources in researching state
transportation files, FAA records, or an asset database for this information.6 Remember that your ability
to pay analysis will only be as accurate as the data you receive. Remind entities that if they do not
provide financial data, you cannot evaluate their inability to pay claim.

6 Information America maintains an on-line asset locator database for a number of U.S. counties.
They can be contacted at 1-800/235-4008 for information on fees and data sources.

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Once you have reviewed a corporation's assets, complete the following block of information for
each luxury asset that you discover:

• Asset and use. Describe the asset (for example, note make and year of vehicles
or equipment, location or property) and its use. In this section you may also
want to explain why you consider this asset to be a company "luxury."

• Estimated market value. Note the market value of the asset and the source for
this information.

• Balance due on loan. Note here any remaining loans outstanding on this asset.

• Replacement cost. Estimate the cost of substituting luxury assets being used by
the company with less expensive replacements. For example; company officers
may need vehicles to conduct business, but they don't necessarily need luxury
vehicles.

• Potentially available. To estimate funds potentially available for this asset,
subtract the outstanding loan amount from its market value.

• Total potentially available net of replacement. Subtract any replacement costs
from the value of luxury assets and enter the net amount available on Line 13.

Part C - Undervalued Assets

In this section, note on the worksheet any discrepancies between the book value of an asset and
its market value:

• Asset. Describe the asset (for example, note make and year of vehicles or
equipment, location of property).

• Book value. Note the value as stated on the company's financial statements or
tax return (Schedule L on Form 1120).

• Estimated market value. Note the market value of the asset and the source for
this information.

• Total estimated excess value of assets. Calculate the difference between market
and book value for each undervalued asset and enter the sum on Line 14.

Section V - Loans from Shareholders

As noted in Chapter 2, loans from shareholders represent investment in the company, and thus,
for ability to pay purposes, can be considered company equity. These loans are claimed as a separate
liability on Form 1120, Schedule L, Item 18. You might also want to request additional information
from the corporation on loan terms and use of these funds.

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Lender. Enter the name of the officer or shareholder lending funds.

Date and amount of loan. Note the original amount of the loan and the date on
which funds were advanced.

Amount outstanding and date. Enter the amount outstanding as of the most
recent financial statement or tax return.

Total outstanding loans. Sum the outstanding amount of all loans from officers
and/or shareholders and enter the total on Line IS.

Revised liability total. Subtract the total loan amount from liabilities and enter
the revised total on Line 16 (Total liabilities equal Items 16 through 21 on Form
1120, Schedule L).

Section VI - Business Expenses ,

In this section of the worksheet we evaluate the level and necessity of the corporation's expenses.
Corporate expenses are listed as deductions on Form 1120, Items 12 through 26. Be certain to examine
any attached statements that detail expenses under Item 26 "Other deductions." Also, it is a good idea
to compare expenses on the tax return to those specified on the company's income statement.7 Any
significant discrepancies between the two should be investigated.

Part A - Officers' Salaries

• Officer. Note each officer's name as it appears on Schedule E, Item la.

• Percent of time devoted to business. Schedule E, Item lc details the time spent
by each officer on corporate business. Enter that information here.

• Salary. Note here each officer's salary as it is claimed on Schedule E, Item If.

• Amount of reduction. Evaluate a reduction in officers' compensation, based on
your review of the duties, time commitment, income, and percent ownership of
each officer.

7 As mentioned earlier, company financial statements may include some expenses that are not
included in corporate tax returns. Penalties payable to any government entity are an example of this
(e.g., OSHA or IRS penalties). You may want to include these expenses in your analysis. Also, be
aware that collection on IRS penalties generally takes precedence over EPA penalties. Finally, in
your comparison of tax returns and financial statements, note that annual tax returns and income
statements may not cover the same time periods. If the periods covered are different, consult a
financial analyst.

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• Total reductions. Sum the reductions and enter the total on Line 17.

• Justification for reductions. If possible, provide some information about each
officer's role or duties in the company and a justification of any possible salary
reductions. This information will not appear on the tax returns; however, it may
appear in the corporate annual report or the company's D&B report.

Part B - Other Expenses

In your review of company expenses, pay particular attention to travel and entertainment or
subsistence expenses, vehicle expenses, rent, office expenses and supplies, and dues and membership fees.
Such expenses can mask funds going to corporate officers or employees (for example, vehicle expenses
may include personal use of vehicles).

Also examine expenses paid to related parties, particularly subcontractor expenses, and expenses
for professional services.

• Expense category. Review the corporation's expenses and list those that you
believe can be reduced without materially affecting the operations of the
company.

• Amount expended. Note the current annual amount for each expense that you
believe can be reduced.

• Possible reduction. Enter the amount by which you feel this expense could be
reduced without affecting company operations.

• Total possible reduction in expenses. On Line 18, sum all possible expense
reductions.

• Justification for reduction. In this space, describe your reasons for each
proposed reduction.

Section VII - Case Disposition

In this section of the worksheet we review the information we have gathered on corporate
holdings and transactions. As explained in Chapter 2, this summary leads to a reassessment of the
company's ability to pay. We will calculate (1) cash flow, and (2) corporate equity.

Part A - Cash Flow

If you conducted an ability to pay assessment of this violator using ABEL, then you already have
an estimate of the corporation's current and anticipated cash flow. In our analysis, we re-calculate cash
flow, using adjusted income and expense figures. This calculation is detailed in the steps below:

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• Taxable income. On Line 19 enter taxable income as reported on Form 1120,
Item 28 (Taxable income before net operating loss and special deductions).

• Depreciation, depletion and amortization expenses. In Chapter 2 we explained
that depreciation, depletion and amortization are expenses that do not affect a
company's cash flow. We therefore add these expenses back into company
income. Sura the amounts claimed on Form 1120, Lines 20 and 22 and enter the
sum on Line 20 of this worksheet.

• Pre-tax cash flow. Sum the amounts on Lines 19 and 20. This total represents
the company's pre-tax cash flow.

• Reductions in officer's salaries. On Line 22, enter the amount from Line 17
in Section VI, Part A of this worksheet.

• Reductions in other expenses. On Line 23, enter the total from Line 18 in
Section VI, Part B of this worksheet. Recall from Chapter 2 that this amount
must be converted to an after-tax figure.

• Estimated pre-tax cash flow. Add the amounts on Lines 22 and 23 above to
pre-tax cash flow.

• Tax adjustment. Multiply this amount by one minus the corporate marginal tax
rate (1- 0.385) and enter the result on Line 25.

• Non-cash deduction tax benefits. Add together the amount on Line 20 and any
net operating loss carry forward that has been claimed, and multiply the total by
the tax rate (0.385) and enter the amount on Line 26.

• Estimated after-tax cash flow. Add lines 25 and 26 for estimated after-tax cash
flow.

As an example, assume that the MCG Construction Company's most recent tax return lists taxable
income before special deductions as $63,790. MCG has claimed a total of $44,500 in equipment
depreciation. Adding this to the company's declared taxable income gives us an adjusted income figure
of $108,290. This total represents MCG's pre-tax cash flow for that fiscal year.

Next we summarize possible expense reductions. According to its return, MCG is not currently
compensating it officers, so this expense cannot be reduced. Most other expenses also seem reasonable,
with the exception of the company's $178,211 insurance expense. You are not sure what policies are
included in this expense, so you ask the company for a list specifying the policies it holds. The
information provided indicates this expense includes whole-life insurance policies which the company has
purchased for its officers. These policies are not really a cost of doing business, but are rather a form
of officer compensation. You estimate that the company's insurance expense could be reduced by
$25,000 if officers were responsible for their own life insurance policies. If income remains fairly
constant and these expenses are reduced, then MCG could generate an estimated $133,290 in pre-tax cash
flow.

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To adjust for taxes we first multiply this amount by one minus the corporate marginal tax rate
(1-0.385 = 0.615) for an tax-adjusted subtotal cash flow of $81,973. We then add back the tax benefit
of MCG's $44,500 depreciation deduction, which equals $17,133 ($44,500 x 0.385). MCG has not
carried forward any losses from previous years, so it final estimated after-tax cash flow equals $99,106
($81,973 + $17,133).

Part B - Equity Assessment

In assessing MCG's equity we want to determine: (1) the value of assets that could be liquidated
in order to provide penalty funds; and (2) the true equity of the company, based on the value of
remaining assets.

Asset Liquidation

We determine funds that the corporation may be able to readily produce to fund a penalty as

follows:

• Value of loans to shareholders. On Line 28, enter the amount from Line 12
in Section IV, Part A of this worksheet.

• Estimated excess value of luxury or unnecessary assets. On Line 29, enter the
amount from Line 13 in Section IV, Part B of this worksheet.

• Estimated funds available from liquidation. Sum the figures on Lines 28 and
29 and enter the total here. This estimate represents resources that could
possibly be directed towards a penalty payment.

Equity Valuation

Here we summarize other information gathered on company assets and liabilities in order to more
accurately estimate company equity.

• Adjusted company assets. Enter the total value of company assets. To
calculate this figure, subtract the value of assets liquidated (Line 30) from the
value of company assets as it appears on Form 1120, Schedule L, Item 15.

• Estimated incremental value of undervalued assets. Enter the value on Line
14 of Section IV, Part C of this worksheet.

• Adjusted total assets. Sum the figures on Lines 31 and 32 for an estimate of
the company's assets.

• Adjusted liabilities. Enter the revised total for company liabilities from Line 16
in Section V of this worksheet.

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Estimated adjusted equity. Subtract Line 34 from Line 33 and enter this figure
on Line 35. This is an estimate of the company's equity, based on adjustments
to assets and liabilities.

Continuing with our example company, MCG Construction, we illustrate the equity assessment.
MCG's assets, per its balance sheet, are $542,700; its liabilities equal $346,960, for total equity of
$195,740. Your review of the company's assets indicates that MCG does not have any apparent luxury
or unnecessary assets. However, several years ago the company lent $15,000 to one of its officers.
Approximately $11,000 is still outstanding on this loan, which was made at an annual interest rate of
three percent. Liquidating this loan (i.e., calling it in) will reduce notes receivable (a company asset) by
$11,000. We assume that this amount will be directly applied to a penalty or environmental costs, and
therefore include it in assets to be liquidated. Subtracting the $11,000 loan from our original asset figure
of $542,700 gives us a revised asset figure of $531,700. All liabilities on the company statements appear
legitimate, and you calculate a new equity total of $184,740. MCG could potentially borrow funds
against this amount.

Part C - Case Disposition

The final section of the worksheet summarizes your results. In your investigation, you estimated
MCG's after-tax cash flow at $99,106 (enter this amount on Line 36). You also determined that MCG
could furnish $11,000 by calling in a loan made to one of its officers (enter this on Line 37).
Adjustments that you made to the company's assets indicate that equity in MCG Construction equals
approximately $184,740 (enter this on Line 38). Compare these amounts to the assessed penalty figure
and/or environmental compliance costs as discussed in Chapter 2. As a final step, note whether this
investigation completes the analysis or if analysis of affiliated entities is required.

Remember that this summary does not imply that the company must produce funds through the
sources you have identified. Rather, your review is aimed at more accurately assessing the resources that
the entity has to call upon. Any final ability to pay figure will clearly incorporate the judgment of the
enforcement team regarding what is appropriate given the violation and original penalty amount.