Sign up for our Business Buyer's newsletter!
Receive tips on buying and selling businesses from the BizQuest experts.
Enter Email Address:
We respect your privacy.
Read our Privacy Policy.



Home > Tools and Resources > Running a Business > Business Suicide (How to kill your Business without Really Trying)

Business Suicide (How to kill your Business without Really Trying)
PART II (Second of a Two Part Series)

By Grover Rutter | CPA/ABV, CVA, BVAL
Contact Grover Rutter | Visit Website | About The Author

Print Print   Email Email  

In part one of this series, I started out by saying "Every business owner wants to know HOW to make the most money while paying the least amount of income tax. After all, if you pay too much income tax you might be considered by some to be un-American!"

Hopefully, that jogs your memory somewhat. And, like most red-blooded American business owners-you want to pay the least possible amount in income taxes. Right?

Some business owners (not all) will find that there are times when paying more income taxes actually increases the value of their businesses. No, I haven't been smoking "whacky-tobaccy." It really is true.

Who will benefit by paying more income tax? Right now you are reading this article and probably thinking, "He can't be talking about me!" Well, maybe I am and maybe I'm not. You will have to decide as you continue to read.

As we all know, the IRS frowns on business owners who operate in the "underground economy." They are the business owners who don't report all of their income...because it saves income taxes. (You know who you are.) If that shoe happens to fit you, you might be setting yourself up to loose much more money than you are saving on your income tax bill!

Before I go on, you need to know that I do not condone the practice of "skimming," underreporting income, overstating deductions, or doing anything else that illegally reduces your taxes. My personal belief (for which you didn't ask-but you're going to get it anyway) is that we live in the greatest and best country in the world. I want to pay my (fair and legal share of) taxes because I feel blessed that I can raise my family in America. But that aside, I know that not all business owners feel as I feel about paying income taxes.

Many smaller "main street" businesses, and even some larger ones, find ingenious (but not legal) ways to reduce their income tax bills. As I mentioned earlier in this article, they might just be cheating themselves more than they are cheating Uncle Sam and other taxing authorities. Let'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 Seller's Discretionary Earnings (where the owners have 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, let'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 the seller may anticipate an estimated price of this business (operating equipment and goodwill) to be approximately $270,000 (that is 2.5 times $108,000=$270,000). And, unless this specific business has unique market share, unique products, etc., most purchasers (not synergistic purchasers) will agree to pay approximately the 2.5X SDE.

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. Now, let'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 (reporting the unclaimed $25K)

$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

Let'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

                   $ 62,000

The owners of small and some larger "main-street" businesses shouldn'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 $62,000!

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. Consider this: Assuming the business remains constant (no decline and no growth-hypothetically), it will take 6.2 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, what's worse? Businesses that commonly sell for 5x SDE may have to wait 12.4 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? Because 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. My response is that I have dealt with a number 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 taxes all these many years!"

The reality is that many business owners put off the thought 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 that money is important. More money will be better than less money. And, 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, they'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 isn'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.

One parting thought. I have known people who consistently tried to cheat the government out of taxes. When they were caught they received a "special federal grant" in the form of free room and board for several years. And, their businesses didn't survive while the owners were away. I guess that's how you really commit business suicide.

If you want to learn more about improving the value of your business, I suggest visiting www.Lulu.com/businessadvisor, or also by clicking onto my digital download site at http://www.straighttalkforbusinessowners.com/YBIYGM.html

Print Print   Email Email  
About The Author

Grover Rutter is a CPA and Business Broker who has been dealing with closely held businesses for over 30 years. "Now that the baby boom generation is maturing, the business advice they receive has to be much different from 10 to 20 years ago," Rutter explains.

For this reason, Grover has written a newly released book that provides "straight talk" to business owners so they can learn very quickly HOW to increase and maintain their business values. This book provides an excellent "self examination" for business owners to apply to their own business situations. Your Business IS Your Goldmine! (Learn How to Get the MOST Out of Your Business) delivers an important message that most business owners NEVER hear! HOW TO GET THE MOST FROM YOUR BUSINESS! This powerful (and easy to use) message will help business owners put their business financial well-being into perspective. The tax deductible Guide is less than $20, and should be read by every business owner. Interested readers may find the guide at www.Lulu.com/businessadvisor

Recent Running a Business Articles | View All