Aggressive tax deductions and their affect on valuation

Happy Holidays from The Danto Group

Posted on December 16, 2013 · Posted in Blog

Holiday tip how avoiding taxes can affect valuationThe Danto Group would like to wish everyone a happy holidays as we bring in the new year. We’d also like to take this chance to remind you that this is a great time of year to reflect on the importance of having clean financial records and tax returns.

This is an  especially important topic for business owners considering exiting in the near future because of the implications on the eventual sales price. Many business owners get in the habit of aggressively reducing taxable net income as much as possible, and it may never cross their minds that this could have a dramatic impact on their eventual sales price. Let’s look at an example of how saving a little in taxes now can cost you significantly more in the future:

If a business is valued at 4x net cash flow and the company has $250,000 in taxable income, the valuation might be approximately $1,000,000.  If the business owner decides to run miscellaneous expenses and deductions of $50,000 to save on taxes, he would save about $17,500 at a 35% tax rate. However, if the majority of those miscellaneous expenses are not recognized as “addbacks,” then the new value may actually end up closer to $800,0000 ($200,000 x 4). That’s a potential loss of $200,000 in nominal value, just to save $17,500 in taxes in the prior year.

While certainly there are deductions that are well recognized and justifiable, many other times owners can push the limit on what is acceptable. These can include family members on payroll, product purchases for personal use, client entertainment, other personal benefits, and timing issues like pushing revenue into the next tax year and accelerating expenses. Non-verifiable income that is not recorded on tax returns or financial statements  is rarely counted toward net income either, something to think about for owners of cash-oriented businesses.

While these may be benefits to ownership, when the time comes to sell or value a business they sometimes cannot be recognized as valid income.  Post financial crisis lenders, investors and valuators have a whole new standard of due diligence and income verification requirements. Business owners who push the limits on tax deductions risk losing credibility with lenders, investors and appraisers. While lowering your taxable income may be fine when running a business for many years, be aware of the risks when the time comes to sell or transfer ownership.

However, if you are fortunate enough to be considering the sale of your business at this time, we encourage you to consider negotiating a sale on the first of January instead of the universally frequent December 31st date — this will delay your tax obligation for an additional twelve months to April, 2015.