As tax season looms again for small business owners, it’s time to think about those deductions.
But wait!
Though common sense may tell you to take as many as you can, that could be a bad strategy long term.
That’s especially the case if you plan to sell your business.
Why?
Because experts say too many deductions may make your company look less profitable to prospective buyers.
“As long as there appears to be profit, and you have successfully taken every business deduction over the years, there is a sense of contentment,” explains Kevin Busch, president of CFOToday in an email interview with Small Business Trends.
CFOToday is a national accounting franchise specializing in small business finance and taxes.
“But truth be told, when you take every tax deduction, your financials don’t leave a trail of smart accounting — they leave a trail of one dimensional financial management,” Busch adds. “In most cases, years of tax returns form the basis of your assessment of the value of your business.”
Too Many Tax Deductions Can Affect Valuation
Unfortunately, Busch says taking those deductions could have an unanticipated side effect.
“The dirty little secret is that every dollar in taxes you save today could cost you two to five times that in lost value when you sell your business,” he adds.
In the end, Busch says too many years of breakeven profits — or, worse yet, losses — on your books will lower the net worth of your company. And that, of course, affects what you may be able to get for it in a sale.
Hence, trying to take every deduction you’re permitted year after year is short-sighted when what you need is a long term strategy.
“Preparing to sell your business is a marathon–not a sprint!” Busch insists.
So it may be better to pay a few more dollars in taxes now. Otherwise, you could lose out in the long run, Busch says. In the end, buyers may only be willing to offer a fraction of what you believe your business should be worth.
That’s not to say you can’t take steps to minimize your tax exposure, of course.
Smarter Tax Strategies for Small Business Sellers
For a smarter tax strategy, Busch recommends adopting a net worth versus net loss tax strategy focused on a long-term period of perhaps 5 to 10 years.
That means shifting away from a strategy of minimizing tax liability. Instead, focus on what Busch calls “smart” deductions — those that are specific, measurable, attainable, realistic and time-based.
Here are two examples Busch shares:
- First, evaluate investing in a depreciating asset or tax deferred retirement plan. (But look for a plan other than a traditional 401K, Busch suggests.)
- Second, if your business is large enough, consider an Employee Stock Ownership Plan, one that allows you to “cash out” at a favorable price, and perhaps even tax free (but at a rate no worse than tax deferred.)
“It may seem counter-intuitive to look at maybe paying a little more in taxes today and next year and so on … to save a lot of taxes when you sell what may be or should be your most valuable asset- your business,” Busch adds.
But the alternative, he says, could be ending up selling your business many years down the road for substantially less than you believe it should be worth.
Stop Image via Shutterstock
But what if the tax deduction is completely legal? Do you still limit it when you are really entitled to it?
Aira-
You are getting to the “essence” of the strategy- it’s about optimizing tax savings vs. increasing the worth of the business. So in any optimization exercise there are limits or constraints.
The nature of most small business tax “planning” is it looks at right now – not next year or the year after, etc…
If you wish to discuss further or have a specific situation please feel free to contact me.
Keeping It Entrepreneurial!!!
Kb
What will happen if you don’t deduct taxes before you sell you business? Will the buyer have to pay these taxes?
Martin-
As the author if the article and CPA (certified not licensed) for 31 years and an entrepreneur for the last 25 years- the taxes referenced in the article are the income taxes of the business. Therefore, its not about NOT paying taxes and thereby creating a liability for the buyer – it’s about optimizing tax savings vs. increasing the worth of the business and thus the owners or entrepreneurs net worth. Generally, weather your a small biz entrepreneur or Bill Gates your business interest(ownership) is your single largest asset.
Feel free to contact me if you would like to discuss specifics!!!
Keeping Entrepreneurial!!!
Kb
Kevin,
Thanks for your reply. I will have your advice in mind, if I will sell a business someday in the future… 🙂
Martin:
When buying a business in this size category you shouldn’t have to worry about paying the seller’s unpaid taxes or any other liabilities from lawsuits or governmental fines. The reason is that most small business sales take the legal form of what is called an “asset sale”. The buyer only acquires a list of assets – the stuff that makes up the business. They don’t legally buy the business itself. Upon completion of the sale the buyer starts up a brand new business – from a legal standpoint. The “new business” just happens to have the same location, products, employees and customers etc. of the old business.
The other form the sale could take is that of a “stock sale”. Here the buyer buys all the shares of stock in the company and inherits all its liabilities. Just like if you bought shares in General Motors and then they got hit with a trillion dollar lawsuit, that would affect the value of your shares. But if you only bought one of their assets – say one of their warehouses – and then they got hit with a lawsuit, it would have no impact on you.
If the owner of a $200,000 business wants to sell it to in the form a “stock sale’ I would view that as a major red flag.
That doesn’t mean you should value or price the business based just on its assets. As a going-concern you should price the business based on its earnings (owner’s benefit). But the legal form of the sale is such that you are only acquiring the assets that make up the business.
Pat,
Thanks for the information. I feel safe now! 😉
That is the worst advice I have ever heard. Anyone who can read financials would not discount your business for showing less taxable profit. If making 300k and not paying taxes makes your business look great not bad.
Matt-
Thanks for the comments-
Not sure what your experience has been in buying & selling small business – i.e less than $2million in revenues
However, in my experience, (25 years and counting!!!) I have seen in the majority of situations the “Emotional” value has a significant GAP from Economic value. Further, the sellers don’t maintain regular GAAP based financial statements.
So unless the buyer is well healed and financed (i.e won’t need bank financing)- most bankers I know (-about 2,500) finance based on Economic value!!!
Typically in these situations the buyers either are not sophisticated enough or don’t have the resources to “Reconstruct and normalize” the financials and thus tax returns which generally don’t have footnotes to explain the economic differences between how the business has been represented from a tax perspective vs it’s true economic perspective.
It is the above scenario that there is an abundance of seller financing – which tends to set the stage for business distress within 18 to 36 months after the sale. Why?! – because seller financing fund the emotional value vs economic value. So to avoid this phenomenon- our recommendations tend to favor using moderate tax liability optimization strategies – where if clients have cash and a profit (I’ve seen lots of profits but no cash -and that’s a whole other story for another day) we would counsel on investing in a tax preferred or deferred retirement program vs depreciating assets -the typical “go to” strategy.
Matt- I’d love to speak with your further – email me at kcb@cfotoday.com– I have lived through in excess of 300 of the situations which forged the knowledge for my otherwise “worst advice” article –
Thanks
I have to agree with Matt here. I’ve been selling businesses for a long time and have never seen a corporation, private or public, that doesn’t attempt to reduce taxes as much as possible. Unless they are increasing taxes in the current year to reduce them in a future year. Any investment bank, M&A advisor, or even business broker can easily recast the financials to maximize the company’s worth. That includes for taxes paid, personal expenses run through the business, etc. On top of that, acquirers understand that businesses are run to reduce tax liabilities. This is not surprising to them, nor penalized by them. They will do the same thing once they purchase the business. To be clear, tax strategy has literally no bearing on the value of a business.
Now if the author is talking about tax strategies to potentially reduce a personal tax liability to the business owner at the time of sale, that is a different matter…
Travis-
Thanks fro your comments-
I replied, in detail, to Matt’s comments-
I am speaking of very small privately held, most single owner business’ where neither the sellers nor the buyers are sophisticated (from a economic value perspective and the budget to conduct the due diligence that goes on larger middle market and public transactions).
As with anyone who comments, I appreciate it , as it signifies that at least you read this and more so it stimulates discussion and potentially change or improvement!!! Feel free to contact me at kcb@cfotoday.com.
Thanks