Your Tax Returns Are Now Your Price

The first issue of this newsletter, back in March, made an argument about tax. It was that owners of private companies spend twenty years optimizing for the lowest possible reported profit, and then spend ninety days trying to convince a buyer that the real number was always higher. I said the habit costs more at the end than it saves along the way.

That issue was well received. Nobody argued with it, and in hindsight that tells you something, because an argument that costs nothing to agree with also costs nothing to ignore.

Everything that made it easy to nod at was still true. A dollar of tax deferred is a real dollar. Add-backs are a normal part of how private companies get priced. Every experienced buyer already knows the reported number understates the business. So the whole thing sat where advice usually sits, as a matter of professional judgment.

It stops being a matter of judgment on October 1.

On that date the rulebook governing most small business purchase loans in this country is replaced. I have now read the replacement. It contains a sequence of five requirements that, taken together, do something no advisor’s opinion could do. They convert your tax return from a piece of evidence into a constraint.

The first link: Your reporting is ranked, and you are probably on the bottom rung

Start with the sentence that surprised me most.

The lender’s financial analysis of a business being purchased must be based on the three most recent year ends, "using the highest level of financial reporting available." The rule then defines what that means, in order, and the order is the point:

1.  Audited financial statements

2.  Reviewed financial statements

3.  CPA compiled financial statements

4.  Corporate tax returns

Four tiers, ranked by thoroughness, worst last. Most owners of businesses worth two to ten million dollars have exactly one of them, and it is the fourth. Not because they were careless, but because a tax return is what an owner-operated company needs, and paying for a review of statements nobody outside the company reads is a hard expense to justify in any year when you are not selling.

That is not a criticism of your accountant. It is a statement about what a tax return is for. A tax return is prepared under a body of law whose purpose is to compute a tax. It was never trying to represent the economics of your company to a stranger. It was trying to be correct under the Internal Revenue Code, which is a different task and often the opposite one.

You just found out it will be doing the second job anyway.

The second link: It gets checked against the IRS

The next requirement removes the softest part of the old process.

The lender must obtain and verify the corporate tax returns against the tax transcripts. And in a change of ownership, the rule is explicit about whose returns those are. The lender "must verify the seller’s financial data." Elsewhere the same rulebook says tax transcripts are "an extension of the financial due diligence requirements" and exist "to validate the information reported by the seller."

Your buyer’s credit is his problem. Your tax filings are now part of the underwriting.

Most owners picture a negotiation. The seller hands over financials, the buyer’s team asks questions, and the two sides argue about what the real earnings are. From October 1 a third party pulls your transcripts from the IRS first, reconciles them against everything you provided, and the negotiation happens afterward, from whatever survives.

The third link: On larger deals, someone reconstructs your cash

Above a purchase price of three million dollars, measured before any buyer equity or seller financing is applied, the lender must also commission an independent examination of earnings. The rule requires that examination to reconcile four things into one number: accountant-prepared statements, tax returns, internal financial statements, and IRS transcript data.

It also requires a Cash Proof, which reconstructs cash receipts and disbursements by reconciling bank statement data to the income statement and to the tax return. The rule names the periods. The trailing twelve months, and the last two fiscal years.

That is not a spot check. It is a reconstruction.

Below three million dollars there is no required examination. Two things still apply at every size. An independent valuation by an accredited professional is required on every change of ownership, with no small-deal exemption, and it must be commissioned by and prepared for the lender, so a valuation prepared for you may not be used. And the transcript verification of the seller’s data applies regardless of price.

The fourth and fifth links: What the number is attached to

Here is where it turns into money.

The earnings figure that comes out of that examination is the figure the lender must use to calculate debt service coverage. If that coverage does not support the valuation and the proposed debt structure, the rule does not invite a conversation. It says the loan amount must be reduced accordingly.

And total debt is capped at the valuation amount.

Run it once with numbers, using the same ones I used in March. Two owners of identical businesses, each producing a million dollars of true economic profit. The first reports seven hundred thousand, because the other three hundred thousand is absorbed by the ordinary machinery of tax minimization. The second reports all of it. I argued the first receives two and a half times earnings and the second five, a difference of $3.25 million against roughly a hundred thousand dollars of tax saved.

Every step of that rested on what a buyer would choose to do. Here is the same situation with the choosing taken out.

The examination arrives at the three hundred thousand dollars of add-backs with a single question for each: is there a document. Whatever fails does not enter the coverage calculation. And at a 1.25 coverage floor, a ten year term, and an interest rate around ten and a half percent, every dollar of annual earnings supports a little under five dollars of debt.

So every hundred thousand dollars of add-backs that does not convert removes about half a million dollars of borrowing capacity. If none of the three hundred thousand converts, the number is roughly $1.5 million.

The buyer has two ways to close a hole like that. Put in another $1.5 million of his own money, or pay $1.5 million less. In my experience they pick the second, and they are not being unreasonable. They are being financed.

Notice what that does to the March argument. Close to half of the $3.25 million gap now falls out of the arithmetic before anybody forms an opinion about your business at all. The multiple story still sits on top of it. It is simply no longer carrying the weight.

Every dollar of earnings the examination will not certify costs you close to five dollars of price. That is the whole article in one sentence.

What has changed since March

March was five months before this SOP was published, so none of what follows is a retraction. It is the rulebook moving under an argument that was already there.

The line moved. March framed this as a trade between taxes and value, and left the resolution to a buyer’s judgment. The line now runs somewhere more specific, between reduction you can document and reduction you cannot, and a stranger applies that test on a schedule rather than across a negotiating table.

Documented reduction survives. Owner compensation set above market with something to compare it to, a one-time legal matter, a vehicle coded correctly with a log behind it. Those come back as add-backs and they come back intact, because an add-back is a document rather than a claim. Undocumented reduction does not, and it now carries a price of roughly five times the annual amount, paid once, at closing.

The bridge got longer. March put the rebuilding period at six to eighteen months, which was defensible against a rulebook that did not name a window. This one names it. The trailing twelve months and the last two closed fiscal years, which puts the honest figure at two to three years. That was last week’s issue and I will not repeat it here.

And there is a third change, which needs an article of its own. The rule does something specific to one category of suppressed earnings, and it is not the category most owners worry about. That is next week.

What to actually do

Move up one tier, and start the clock on it. Going from tax returns to a CPA compilation, and later to a review, moves you up a ranking the lender is now required to use. A review is the practical top of that ladder for most companies in this range. Have the conversation early, because the tier only helps you for the years it covers. Commissioning a review three months before you go to market gets you one year of the three.

Keep a management record alongside the tax record. The rule asks for the highest level available, and separately requires interim statements compared against the same period a year earlier. An accrual internal statement, produced monthly and consistent year over year, is cheap, and it is what makes the other three years legible. It is also where you code the add-backs you intend to claim, while they are still happening.

Stop the undocumented spending first. Not because of the tax. Because of the multiple.

Find out what your last two returns say about your price

Not what your business is worth in the abstract. What the record you have already filed will support when a lender runs it through the sequence above.

The estimator uses real transaction data from your industry and your size, and gives you a range for a business like yours along with a read on how ready you look today. Fifteen minutes, no financial statements, nothing sensitive.

Next week, part two: the one category of suppressed earnings with no route back, and a conversation I could not have on an owner’s behalf.