If It's Not on the Tax Return, It Did Not Happen

A restaurant owner once told me that his reported sales understated the business by about two hundred thousand dollars a year.

He was not confessing. He said it the way an owner tells you the roof leaks in the back room, as a piece of context he assumed I would need. Then he asked me to help the buyer understand that the real number was higher.

I told him I could not do it.

Not because I doubted him. I believed him, and I think he was telling me the truth as he understood it. I could not do it because I had no way to prove it, and neither did he.

That is the part owners find hardest to accept, so it is worth saying slowly. There is no document that establishes revenue which was never recorded. The deposits are not in the bank. The point of sale totals do not tie to anything. The return says what the return says. When I sat down to work out how I would put that two hundred thousand dollars in front of somebody, there was nothing to put in front of them except his word, and his word is not an exhibit.

Which is the sentence I have come back to more than any other in this work. If it is not on the tax return, then as far as the transaction is concerned, it did not happen.

Why this is not the same as running personal expenses through the business

Owners tend to file these two things in the same drawer. They are not the same thing, and last week’s rule change makes the difference structural rather than a matter of taste.

A personal expense paid by the company is on the books. There is a transaction, a date, an amount, and a general ledger account. When it is time to sell, that expense comes back as an add-back, because an add-back is not a claim about the business. It is a document that says here is a cost the next owner will not carry. Somebody can look at it, test it, and either accept it or not.

Revenue that never reached the books has none of that. There is nothing to add it back to. You cannot adjust a number that was never recorded, because the adjustment has no anchor. The whole apparatus of add-backs, which owners rely on to close the gap between reported profit and real profit, simply does not reach this category.

So one is a discount you can argue about. The other is not a discount at all. It is an amount that never enters the conversation.

What changed on October 1

For most of my career this stayed in the realm of judgment. An owner could tell the story, a buyer could believe as much of it as he chose, and the two of them met somewhere in the middle. An advisor who wanted to be helpful could lean on the story. Some did.

That ended with the rulebook that takes effect on October 1.

On transactions above three million dollars the lender must now commission an independent examination of the seller’s earnings, and that examination must include a Cash Proof. A Cash Proof reconstructs cash receipts and disbursements by reconciling bank statement data to the income statement and to the tax return, across the trailing twelve months and the last two fiscal years.

The rule states its purpose in as many words. It exists to identify discrepancies in income and undisclosed expenses.

Read that as a seller and notice what it is not doing. It is not hunting for hidden money. It is comparing three documents that are supposed to agree, and reporting where they do not. Nobody has to prove anything about you. The gap reports itself.

And below three million dollars, where no examination is required, the lender must still verify the seller’s financial data against IRS transcripts. That applies to every change of ownership at every size.

The arithmetic, and why it is not the arithmetic you expect

Last week I worked through what a failed add-back costs. At a 1.25 coverage floor and a ten year term, every dollar of annual earnings supports a little under five dollars of debt, so a hundred thousand dollars of add-backs that cannot be documented removes about half a million dollars of borrowing capacity.

That is the arithmetic for documented reduction that fails its test.

This category does not get that arithmetic. That two hundred thousand dollars was not worth a million dollars of price. It was worth nothing, because it never entered the record the price is calculated from.

And there is a second cost, which is larger and harder to see. Raising it late does not recover the value. It creates the discrepancy. An owner who volunteers in a data room that the real number is higher has just told the examination where to look, in a process whose stated job is to find exactly that. Every other number in the file gets read differently afterward. You do not lose two hundred thousand dollars. You lose the benefit of the doubt on everything else, at the moment you need it most.

What an advisor can and cannot do for you

There is a version of this work where my job is to make your number persuasive. Owners sometimes arrive expecting that, and the expectation is reasonable, because a good deal of the market sells exactly that and is not shy about it.

It is worth being clear about what you are actually buying.

You are not buying advocacy. Advocacy is cheap, and it does not survive a reconciliation. What you are buying is someone who will tell you, early enough that it still costs you nothing, which parts of your record will survive a stranger and which will not. That is a less flattering service and a considerably more valuable one.

The restaurant owner did not want to hear it. I understand why. He had built something real, the two hundred thousand dollars was real, and it is genuinely painful to be told that a thing you built will not be paid for. But the alternative was to walk him into a process that was going to find it anyway, having spent his money getting there.

If this describes your business

Three honest options, and one of them is not an option.

Start the clean run now. The examination looks at the trailing twelve months and the last two closed fiscal years. That means the earliest fully clean record is roughly three years out, and it does not begin until the first clean year begins. This is not a penalty. It is a calendar. Every month you delay is a month that stays in the window.

Sell against the record you have, at the price it supports. This is a legitimate choice and I will not argue anyone out of it. You take the number the reported earnings carry, and you take it without a discovery landing in the middle of the process. Owners who choose this deliberately do considerably better than owners who back into it.

Ask somebody to carry the story for you. This is the one that is not available. It was a bad idea when it was merely a matter of judgment. From October 1 it is a procedure designed to surface it, running on documents you have already filed.

If this describes your business, the conversation to have is with your own CPA, about the years ahead rather than the years behind. And if you are two or more years from a transition, that conversation is worth having this month rather than next year, because everything in these two issues runs on fiscal years, and the next one starts whether you engage with it or not.

Where this leaves you

Most of what I do is unglamorous. It is making sure the business you actually built is the business that appears in the record, so that a stranger with a rulebook reaches the number you have earned rather than a smaller one.

If you are two or more years out and you are not certain what your record would survive, that is exactly the point at which it is cheap to find out.