Editor’s Note: This article is from the 2021 issue of Northern Nevada Smart Money, a trade magazine of Northern Nevada Business Weekly. Look for this and other articles in the 4th Edition of Smart Money inserted for Subscribers in the NNBW edition on Wednesday, March 24, 2021. You can also view the digital edition here.
Scenario: A business owner asks their CPA, “What can I do to lower my taxes?” The CPA goes through a list of things an owner can do to minimize taxes:
- Board meeting in exotic location – check.
- Hire children for a variety of roles including but not limited to modeling, company spokesperson, etc – check.
- Buy an SUV so the owner can do business.
- Super generous retirement plan to “cram” retirement for business owners, spouses, children, relatives, etc.
- Make a de minimis choice to exceed any cost of capital greater than $ 2,500 – check.
The past few months have been fascinating as I’ve worked through several business owners “tax planning” and showing them how the planning tends to drive down selling prices for sellers and create buying opportunities for buyers.
Let me explain. According to divestopdia.com, “Seller’s Discretionary Income (SDE) is a profit metric that is used to evaluate an organization in order to provide potential buyers with a more accurate picture of the cash flow available. This metric is used more often in evaluating Main Street organizations than medium-sized businesses. The reported income for smaller businesses is often kept low by the owner for tax reasons. Therefore, discretionary, extraordinary and one-time costs are calculated back in order to show the buyer the actual cash flow from operating activities. “
To calculate the SDE, start with the net operating income and add interest, corporate taxes, depreciation and amortization to this amount. The result is the acronym commonly known as EBITDA.
You then increase that amount for expenses associated with an owner. This includes the wages paid to them plus the corporate taxes paid on the wages plus their services, as well as the owners’ perks, also known as perks.
Once the SDE is calculated, we use a service called Bizcomps to find multiples of revenue and what a business owner can expect from the sale. A good rule of thumb is 1 to 3 times SDE. The lower the SDE, the lower the multiple. The higher the SDE, the higher the multiple.
With an SDE of $ 50,000, a sales multiplier of 1 or a sales price of $ 50,000 can be expected. A $ 1,000,000 SDE can pull SDE up to three times or $ 3,000,000. Of course, the type of business, the quality of the revenue, etc. all have multiple effects.
According to Mirriam Webster, “prerequisites are a privilege, gain, or gain associated with regular salary or wages, especially if expected or promised.”
So let’s look at some of the common “tax planning” strategies mentioned above and show how they undermine overall enterprise value, especially when owners try to claim that certain “perks” should be added back to EBITDA in order to gain to SDE reach.
Board meeting in an exotic location
The IRS Code Section 162 allows for deductions that are ordinary and necessary. In clarifying the rule, the IRS asks, “Would a reasonably prudent person pay the same costs?”
Entrepreneurs have adequate leeway for the ordinary and necessary. The ability to deduct this item of expense is designed to be normal and necessary. When a business owner later says that this is more of a benefit to the owner than an ordinary and necessary one, he is saying that he lied on his tax return.
If the trip was of a compensatory nature, it should have been added to the owner’s W-2. If the trip had cost $ 7,500 in travel and accommodation and $ 4,000 in food and $ 4,000 in entertainment, they would have saved about $ 3,400 in taxes ($ 7,500 + ($ 4,000 * 50%) + ($ 4,000 * 0%) * 37% * 80%). . The retail price may have been reduced by $ 46,500 (($ 7,500 + $ 4,000 + $ 4,000) * 3).
Make a de minimis choice to pay all capital costs greater than $ 2,500
Effective for tax years beginning on or after January 1, 2016, the IRS in Notice 2015-82 increased the de minimis safe harbor threshold from $ 500 to $ 2,500 per invoice or item for taxpayers with no applicable taxpayer Annual financial statements.
Many taxpayers chose to record items under $ 2,500 as an expense. They have continued this policy to this day. Unfortunately, if they had activated the equipment, they could still have made a full write-off through bonus write-off.
Remember that the “D” in EBITDA stands for Depreciation. For example, suppose a business owner purchased a laptop for $ 2,000 and recorded it as an expense under Note 2015-82. Had it been activated, the SDE would have increased by $ 2,000 and the potential selling price would have increased by $ 6,000. Note that the $ 2,000 would have been deducted in either scenario.
The list goes on and on. The above two examples are the tip of the iceberg. I recommend that you familiarize yourself with tax planning at least three years before selling your business. There are strategies in place to achieve the same or similar tax results without dampening the company’s ultimate selling price.
Note that the above is a general discussion of a complicated subject. Contact me to discuss how you can maximize your exit and still minimize your tax burden.
Michael D. Bosma, CPA, is principal responsible for Keystone CPAs and business broker at M&A; Business consultant in Reno. Reach out to him for comment at firstname.lastname@example.org.