For some small closely held businesses (particularly those where there are a lot of cash transactions) there is the temptation to under-report income and over-report expenses on tax returns. Besides the obvious legal and ethical issues, there is a very practical reason not to do this: it will likely prevent your business broker from getting an optimal sales price for your business. Many buyers believe that tax returns tell the most conservative but realistic story about your business’ financial performance. So how does under-reporting income affect your total financial situation when you are getting ready to sell a business? Consider a business that under-reports $20,000 per year for two years and then sells. If the income tax rate is 30%, the business would save $6,000 per year (if they don’t get caught by the IRS!), for a total tax savings of $12,000 for the two year period. Not bad, but it is only a fraction of the financial benefit that the business owner would likely receive through a higher sales price resulting from a value derived from fully reported income. Consider the same business using the assumption that the company has a constant growth rate of 6% and its weighted average cost of capital is 18%. Using a capitalized earnings approach to value, the likely difference in value of reporting vs. not reporting the $20,000 of income would be $166,667 (calculated by dividing the under-reported amount of $20,000 by a capitalization rate of .12, which is the difference between the weighted average cost of capital of .18 and the constant growth rate of .06). Of course, there would likely be capital gains tax on the $166,667, but at a 15% rate a business seller would still likely keep $141,667 in additional after-tax sales proceeds.
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A few books on related topics:
How to Save on Your Taxes Without Cheating
The Cheating Culture: Why More Americans Are Doing Wrong to Get Ahead
Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition
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Codiligent Business Brokers – Portland, Oregon based business brokers representing sellers of businesses with $500k – $20 million in annual revenue. To schedule a free consultation to discuss the possible sale of your business you may contact Eric Williams at 503-535-8817 or E@codiligent.com
[...] How cheating on your taxes can impact business sale price Portland Business Broker Thoughts Yet another reason why you should be honest. Small understatements in revenue can have tremendous impacts on future valuations of your company. [...]
By: Small Business Links for 8/04/08 | PortlandSmallBusiness.com, LLC on August 4, 2008
at 8:07 pm
Great article! I don’t see that much cheating (and if it happens – I don’t want to), but I do see small business clients using aggressive tax planning at year-end that can cause the same problems . We try and give the client balanced options and anticipate sales of businesses, but most clients struggle with it because they want to minimize their tax liability foremost and don’t see the long-term affect. Even with clients that we prepare compiled or reviewed financial statements for – the tax return is definitely given a lot weight by buyers like you stated.
http://pdxcpa.wordpress.com
By: pdxcpa on August 5, 2008
at 2:28 am
Thanks Brian! Great point that even being overly aggressive on things that are legal can still create valuation problems. Of course, when I assist clients with putting a value on their businesses we re-cast their financials to show the add-back of non-recurring, more personal/discretionary expenses – but I think one of the things that business sellers forget is that just because they can explain something, doesn’t mean that a buyer will be comfortable with the explanation. For example, a business owner may run charitable donations through the business and then seek to add them back because they were discretionary. However, buyers may make the argument that the charitable donations had a PR/marketing benefit and thus contributed to business generation.
By: bizsale on August 5, 2008
at 4:27 am
Our first few years in small retail were very slim and my wife tried skimming to save a few tax dollars. (Statute of limitations long since expired!) Well it turned out to be a bad idea for an even more basic reason than you guys are talking about: When you are not recording your sales, you are not recording the items sold. The items that are selling are the ones you need to be replacing, but unless you go around and do a physical inventory every Monday morning you are simply not going to know what is selling so you cannot order more. If you don’t have it, you can’t sell it. Get it? We quickly figured out that skimming was very bad for our ongoing business.
Now that we are thinking of selling (15 years later) it is good to know that there is another advantage to our honesty.
BTW, 0urs is a gift store; our customers are mostly women, our staff are all women, our distributors and reps are mostly women, and it will very likely be a woman who buys the business. If you think a man can sell this business as easily as a woman, please let me know why you think so. Otherwise, anyone know a good, professional, female business broker?
By: Breezely on August 16, 2008
at 9:18 pm