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Recast Financial Statements
Many small privately held companies summarize their financial performance only for tax reporting purposes. Tax returns are prepared to show profits as low as is legally permissible under state and federal tax codes. The reason for this is simple; companies are taxed on profits, so it is only logical to show profits as low as is legally permissible.
However, financial statements that are prepared for a buyer should show profits that are as high as possible, without being deceptive. This may sound unethical, but it is not. Major corporations and some smaller companies typically will produce one set of financials for tax purposes, and another for shareholders, lenders, prospective investors, etc. The IRS is fully aware of this and has no objection as long as the statements submitted for tax purposes follow the standards set forth in the tax code.
In selling your business, you need to present financials that put the business in the best light (most profitable situation) possible. Buyers are looking closely at profit and compensation to owner through salary, benefits, and perks. It would be well worthwhile to have your accountant put together statements designed for selling the business. Expenses that are on the books that may be permissible but not integral to running the business should be pointed out to prospective buyers. It should be pointed out to a prospective buyer that the depreciated value of a firm's assets as reported on the tax return is probably lower than the fair market value. The IRS allows businesses to accelerate depreciation for tax purposes. But this doesn't mean that the assets actually decrease in value at the accelerated rate.
A sophisticated buyer will examine your statements carefully; don't misrepresent anything. But do point out every dollar and every benefit that is flowing to the owner as compensation. It is best if a company has been producing separate statements for at least a few years, rather than producing the first set of non tax return financials when the company is up for sale. Waiting until that time will arouse suspicion in the buyer's mind and/or the buyer's accountant's mind.
A Note On Cash Businesses
The situation often comes up that a business owner will maintain that he earns a lot more than he reports to the government. No doubt this is often true. However, it is difficult to get a buyer to pay a premium for cash coming off the top, based on the owner's say so. Some people who are sophisticated in buying cash businesses use a number of analytical techniques to estimate what is coming off the top. For example, Laundromat buyers will look closely at utility bills to determine approximate machine usage and derive a sales volume estimate from that information. Buyers of retail stores will look at the store's prices and wholesale costs, and then look at the gross sales and cost of goods sold figures on the firm's tax return. If a store is doubling wholesale cost on each item, but is reporting that cost of goods are 75% of gross sales, the prospective buyer will estimate true sales and profit figures from those numbers. Finally, it is common for a buyer of a cash business to "work" the business for a week or two weeks to get a hands-on measure of actual sales volume.
If you own a cash business, you should keep in mind that the IRS and other taxing authorities have the same (and more) analytical tools available to them. Undoubtedly some business owners do get away with "skimming." Others do get caught though. You are taking a risk with inherent consequences.
Even sophisticated buyers that know your industry will be skeptical of the amount of cash being taken off the top. In one recent instance we reached an impass between a sophisticated buyer and a seller of a transportation business. The seller was skimming money off the top. While the buyer believed that there was really more income than the books reflected, he was worried about whether the seller was being entirely honest with him. The buyer asked, "If the seller is lying to the IRS, why should I believe everything he tells me is true?" The buyer wanted to hold back a portion of the purchase price until he saw how the business performed after the sale. The seller insisted on cash at closing, so the deal fell apart.
If you are planning to sell your business, and if you are involved in taking cash off the top, now might be a good time to end the practice. The increased value of your business based on the new financial records (showing all business income) might more than offset the tax savings and the risk that you are taking with the taxing authorities.
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