Business Alert: When Paying More Income Tax Makes You Wealthier (By Grover Rutter CPA/ABV, CVA, BVAL and Certified Business Broker)
Every business owner wants to know how to make more money and pay fewer taxes. But some business owners can triple or even quadrupile their "investment" in income taxes! Business owners should read this article to find out how paying more income taxes might actually make them wealthier.
(PRWEB) January 17, 2005
Every business owner wants to know how to make the most money while paying the least amount of income tax. But some business owners (not all) will find that there are times when paying more income tax actually increases the value of their business.
I do not condone the practice of “skimming,” underreporting income, overstating deductions, or doing anything else that illegally reduces your taxes. Many taxpayers want to pay their (fair and legal share of) taxes. But not all business owners feel the same about income taxes.
Many business owners find ingenious (but not legal) ways to reduce their income tax bills. However, they might just be cheating themselves more than they are cheating on their taxes.
LetÂ’s look at a couple of examples that will demonstrate my point:
Small Mom and Pop “main-street” businesses generally can sell for 2 to 3 times “seller’s discretionary earnings” or SDE. Larger “main street” businesses can sell for 2.5 to 5 times the SDE. So you might be asking yourself, “What, exactly is SDE?”
Many business brokers will define SDE as Earnings before Interest, Taxes, Depreciation and Amortization (expenses) PLUS owner salary and benefits. Here is one example of SellerÂ’s Discretionary Earnings (where the owner has not reported $25,000 of annual income):
Business Pre-Tax Profit (under reported by $25K) $37,000
Add: Owner Salary already Deducted +36,000
Add: Owner “benefits” paid for and deducted +15,000
Add: Interest Expense Deducted + 5,000
Add: Depreciation Deducted +15,000
Total “Seller's Discretionary Earnings” $108,000
Now, letÂ’s assume that similar businesses in this same industry and having attributes similar to this business have been selling for 2.5X SDE. That means that a potential buyer may anticipate an estimated price for this business (operating equipment and goodwill) to be approximately $270,000 (that is 2.5 times $108,000=$270,000).
But the business owner in the above example knows that the business makes more than what has been reported. Therefore the seller believes the business is worth more than $270,000. LetÂ’s take a look and see why the seller may believe the business is worth more. This time, we are going to use the actual income numbers:
Business Pre-Tax Profit (considers all income) $62,000
Add: Owner Salary already Deducted +36,000
Add: Owner “benefits” paid for and deducted +15,000
Add: Interest Expense Deducted + 5,000
Add: Depreciation Deducted +15,000
Total “Seller's Discretionary Earnings” $133,000
LetÂ’s take a look at the indicated value. That would be $332,500 ($133,000 times 2.5 multiple = $332,500).
What is the difference in indicated value of the company?
•Value having reported all revenues $332,500
•Less: Value having “saved on income taxes” - 270,000
• Indicated Loss in Value by Underreporting $62,500
Business owners shouldnÂ’t fool themselves. When it comes right down to selling the business, potential buyers (and their lenders) will not approve the purchase of a business for more than what makes economic sense. And what do they rely upon to see IF the purchase of a business makes economic sense? Financial Statements and tax returns!
It doesn’t matter if the seller tells the potential buyer, “don’t worry, there’s more income here than what’s been reported.” A smart buyer will ignore the comment, and may even loose interest in the business all together. That’s because buyers and investors are adverse to risk. And telling a potential buyer that the books of the business have been “cooked” to save on taxes…is like telling the buyer that he or she can’t rely on the books, or the reported operations of the business. Potential buyers will either walk away, or offer to buy the business at a discount to account for the added risk factors. In short, in the above examples, the seller has reduced the sales price of the business by at least $62,500!
Okay, now you might be saying, “But look at all the income tax the seller has saved!” Let’s do just that.
•Unreported income $25,000
•Times assumed combined tax rates of 40%
•Estimated tax savings for one year $10,000
Gee, $10,000 seems like a chunk of change, doesn’t it? And it is. But consider this: Assuming the business remains constant (no decline and no growth—hypothetically), it will take 6.25 years (without accounting for the time value of money) for the business owner to save enough in income tax to account for the loss value at the time of sale.
And, whatÂ’s worse? Businesses that commonly sell for 5x SDE may have to wait 12.5 years to save enough income taxes to make up for the loss. Of course, larger businesses that sell for multiples in excess of 5x SDE will have to wait even longer to make up for the loss in value!
Why do I find this interesting? At a recent IBBA (International Business Brokers Association) conference meeting, someone gave the statistic that the average term of ownership for small business in America today is only 4.7 years!
Some business owners may think that they have been “saving on taxes” long enough to offset any price reduction they might incur when it comes time to sell the business. I have dealt with thousands of businesses throughout the years, and I have never found an owner or seller willing to say, “Gee, I think I want less for this business than what it is worth, because I have saved so much in income tax all these many years!”
The reality is that many business owners ignore the fact that they will someday “have” to leave the business. Either because of their retirement, bad health or death. And those three situations present the times in one’s life when money is important. More money will be better than less money.
At retirement, disability or death, nobody ever really thinks “It’s okay that I’m not getting much money for my business interest, because I screwed the government all these years!” (Okay, some very twisted individuals might think that.)
In a perfect world, business owners would pinpoint the date they want to sell their businesses, and then for 3 years prior to the sale, theyÂ’d report every red cent of income, and not fudge on their expenses. They would pay the higher taxes for only three years, get the best price for their businesses, and then sail off into the sunset.
But the world isnÂ’t perfect. Often business owners are faced with the prospect of selling their businesses under adverse conditions. Nobody can predict the future, but everybody should know how to be ready for it.
Where should you go to learn about improving and increasing the value of your business? I recommend you read a new book by Grover Rutter CPA/ABV, CVA, BVAL entitled "Your Business IS Your Goldmine! (Learn How to Get the Most Out of Your Business)".
Please visit www. Lulu. com/businessadvisor (http://www. Lulu. com/businessadvisor), or get a digital download of the book at http://www. straighttalkforbusinessowners. com/YBIYGM. html (http://www. straighttalkforbusinessowners. com/YBIYGM. html).
You can also get additional information at www. gruttercpas. com or call Grover Rutter Business Brokerage, Valuations & Consulting at 419-427-1564 for private business consulting, or about selling your business.
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