There is cheating on taxes and then there is optimizing to reduce your tax burden. Of course you’re not required to overpay your taxes, but you can overdo this. Choosing to incur expenses to reduce your net is legal, if not always wise. Skimming cash off your business so as not to report it as income — that’s cheating and is illegal. If you are within 3 years of selling it, stop it. Stop it now! It’s not saving you money. It’s costing you a lot of money. Here’s why.

Supreme Court Justice Learned Hand wrote in a 1934 opinion that “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury”. Many owners do just that. They decide to have their businesses undertake a variety of activities and expenses that may be over and above the minimum necessary to generate revenue. After all, should there not be at least some beneficial impact to the business from having more satisfied employees due to the perks that are offered, or having everyone available 24×7 by issuing them cell phones? Who can say whether the ideal major client may be found at a trade show? Instead, if the business pays for them, they become tax deductions to the business, reducing the amount of those overall net earnings and the taxes that would be due at whatever the company’s marginal tax rate is.

Now, where those choices happen to provide owners with things or benefits, they’re not “free”, because if the business had not bought them, there would have been that much more income to distribute to the owners – but that income would have been reduced by the tax burden on the business and the owner would have been taxed some 25-30 percent before receiving what is left of that income. All in all, many owners estimate that their discretionary spending saves about 15% on their tax bills.

All perfectly legal and indeed admirable.

However, when it comes time to sell, buyers look at the business rather differently. Most buyers don’t want a business that loses money or barely makes any, and they pay for a business on the basis of some multiple of its profits. The more profit you have, the more you can ask for the business.

Larger businesses are priced as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), but the investors are typically not the owner-operators so there is less opportunity for discretionary razzle-dazzle. Smaller businesses use a different metric: Seller’s Discretionary Earnings (SDE), which means pulling all those discretionary items out of the total expenses, because a buyer could decide not to continue those benefits and take them as owner income instead. A key role for a broker is to assist business owners in that re-casting of the financial reports to show the true earning potential of the business.

Optimizing for tax purposes works pretty well for a seller: you get the tax advantage of deducting expenses, but those expenses are counted back against the profits when it comes to a selling price for the business.

Then there is cheating.

For a seller, cheaters never prosper. A buyer’s offer will seldom recognize as profits the cash that you say (wink-wink) you have swept off the table and into your pockets. Nobody but you will know how much that is, and no buyer is going to pay you two to four times a number that you just made up. A buyer who is savvy about your business sector may well be aware that some level of assumed transaction is quite common in that sector. They will not pay any more for the business, but they may be more willing to buy such a business in the first place.

Let’s say that you have “protected” $250,000 a year in cash receipts, and thereby saved $50,000 in taxes on your personal income. Sounds like a good outcome … unless you are lining up to sell your business in the next 2 years.

Using cash that way will cause the buyer to suspect that you may also be supplementing the expenses using some of these cash incomes. If that’s the case, the business is a lot less profitable that the books would seem to indicate. During the due diligence period after the sales contract is ratified, the seller will be looking for signs or materials being on hand or used at a pace different from what the books seem to indicate. That’s a sign that the seller is using some of that cash to pay expenses.

By contrast, if those cash receipts had been in the till can counted towards the net profit, the business would have paid perhaps $30,000 in additional taxes per year, so $60,000 over 3 years. But, when it comes time to sell, that $250,000 added to the profit at a multiple of 4.0 means $1 million dollars added to the value of the business at sale (although you would still have to consult your tax professional as to how to shelter this capital gain).

$60,000 in savings versus $1 million in increased sale price? Do the math. Pay the tax!

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I’m an exit planner and business broker, but I’m not a tax professional nor an investment advisor. If you need to work out how to manage your money, we’ll be happy to refer you to an appropriate professional.

If you’re planning to buy or sell a business, look around the website to get more resources about that, or set up an appointment to discuss how to plan those moves.