Cash Sales and Personal Expenses: A Business Owner's Quandary

It’s your business and you’ve always managed it this way. You’ve gotten a certain glee out of minimizing your income taxes. Over the years you’ve employed two common “strategies'' of closely held business owners: under-reporting cash sales and classifying personal expenses as business expenses.

While these actions are illegal under US law, you’ve dealt with that moral conflict long ago in your head. Either way, this piece is not about the legal, ethical, or moral questions of such strategies. Let’s instead discuss how these strategies may impact your exit plan.

Complicating Your Profitability Story

Most simply put, the cleaner your books and records, the better position you are in to sell your business.

By under-reporting cash sales, you understate your business’s true profitability in a way that no prospective buyer can verify. While a buyer may give some consideration to “under the table” earnings, they certainly will not provide full credit based upon the simple fact that they cannot prove or disprove your assertion. In addition to this, if your buyer is partially financing the purchase of your company with bank debt, you can rest assured that no bank underwriter will provide credit for unreported sales!

Similarly, if you have packed your business with every conceivable personal expense, you will have a lot of explaining to do when you present your recast financial statements. To explain, in any company sale the seller usually adjusts the reported earnings to addback things like personal expenses, non-recurring expenses, etc. that do not reflect the ongoing earnings of the business. As a simple rule of thumb, as the share of profits resulting from addbacks increases, a buyer’s trust in the profitability of the business decreases. In an extreme case, take a business with reported EBITDA of $0, but $1 million of Adjusted EBITDA. In this case 100% of the proposed EBITDA consists of add-backs. This will not be viewed favorably by potential buyers.

Trade one Dollar Lost for a Multiple of Dollars at Sale

Yes, you pay a lot of taxes. So, yes, we understand your goal of minimizing taxable income. That said we do not recommend or advise illegal activity, and when it comes to exiting your business, it can be counterproductive.

In addition to the reasons listed above, there is a simple mathematical reason to report your business income accurately.

If you under-report a $1 cash sale (or expense a $1 personal expense) and your marginal tax rate is 40%, this means you’ve successfully avoided $0.40 in taxation. On the other hand, if you report correctly, you do not save the $0.40 of taxes, but instead you now show an extra $1 of profit. Depending on a variety of factors your business will trade at some multiple of EBITDA. So, let’s use a more conservative 4x multiple. This $1 of extra profit yields you $4 (4 x $1) of extra purchase price (which will be subject to capital gains tax). To finish the example, by paying the tax you get an extra $4 in purchase price (you do also pay capital gains tax and the $0.40 of income tax), but $3.60 (less capital gains) is still many multiples higher than $0.40.

For this reason, as well as tax code compliance, you should clean up your books at least a few years prior to selling your business.

If you would like help with preparing to exit your business? Talk to Doescher Group and consider an Exit Audit.