EDITOR'S NOTE: This article is adapted from the 2021 edition of Northern Nevada Smart Money, a specialty magazine of the Northern Nevada Business Weekly. Look for this article and others in the 4th edition of Smart Money, inserting for subscribers in the Wednesday, March 24, 2021, edition of the NNBW. You may also view the digital edition here.
Scenario: A business owner asks their CPA, “what can I do to reduce my taxes?” The CPA goes through a list of things an owner can do to minimize taxes:
- Corporate board meeting in exotic location — check.
- Employ children for various and sundry tasks, including, but not limited to, modeling, corporate spokesperson, etc. – check.
- Purchase SUV for owner to conduct business – check.
- Super generous retirement plan to “stuff” retirement of business owner, spouse, children, relatives, et al – check.
- Make de minimis election to expenses all capital expenses greater then $2,500 – check.
The past few months have been fascinating as I have worked through several business owners’ “tax-planning” and revealed to them how the planning tends to depress sales prices for sellers and create buying opportunities for buyers.
Let me explain. According to divestopdia.com, “Seller's discretionary earnings (SDE) is an earnings metric used to value an organization to provide the potential buyers with a more accurate picture of the available cash flow. This metric is more commonly used in the valuation of Main Street organizations rather than middle market ones. The reported earnings for smaller firms are often kept low by the owner for tax purposes. Therefore, discretionary, extraordinary, nonrecurring expenses are added back to show a buyer the true cash flow from operations.”
To calculate SDE, start with net income from the operations, increase that amount by interest, corporate income taxes, depreciation and amortization. The result is the acronym commonly referred to as EBITDA.
You then increase that amount for the expenses associated with one owner. This includes the wages that were paid to them, plus company taxes paid on the wages, plus their benefits, plus owner “perquisites” otherwise referred to as perks.
Once SDE is calculated, we use a service called Bizcomps to determine the multiple of earnings to arrive at what a business owner can expect from the sale. A good rule of thumb is 1 to 3 times SDE. The lower the SDE, the lower the multiple. The higher the SDE, the higher the multiple.
SDE of $50,000 can expect a sales multiple of 1, or a sales price of 50,000. An SDE of $1,000,000 can fetch as much as 3 times SDE, or $3,000,000. Of course, the type of business, quality of earnings, etc., all impact the multiple.
According to Mirriam Webster, “perquisites are a privilege, gain, or profit incidental to regular salary or wages especially when one expected or promised.”
So, let’s look at a couple of the aforementioned common “tax-planning” strategies and demonstrate how they undermine the total enterprise value, especially when owners are trying to assert that certain “perks” should be added back to EBITDA to arrive at SDE.
Corporate board meeting in exotic locationIRS code section 162 allows for deductions that are ordinary and necessary. In clarifying the rule, the IRS asks the question, “would a reasonable prudent person embark on the same expenses?”
Business owners have a fair amount of latitude for what is ordinary and necessary. The ability to deduct this expense item is centered on it being ordinary and necessary. When a business owner later says that this is an owner benefit, rather than ordinary and necessary, they are saying the lied on their tax return.
If the trip was compensatory in nature, it should have been added to the owner’s W-2. If the trip cost $7,500 for travel and lodging, and $4,000 for food and $4,000 for entertainment, they would have saved approximately $3,400 in taxes ($7,500+($4,000 *50%) + ($4,000*0%) *37%*80%). It potentially reduced the sales price by $46,500 (($7,500 + $4,000 + $4,000) *3).
Make de minimis election to expense all capital expenses greater then $2,500Effective for taxable years beginning on or after January 1, 2016, the IRS in “Notice 2015-82” increased the de minimis safe harbor threshold from $500 to $2,500 per invoice or item for taxpayers without applicable financial statements.
Many taxpayers opted to begin expensing items under $2,500. They continued this policy until the present day. Unfortunately, had they capitalized the equipment, they could have still taken a full depreciation deduction through bonus depreciation.
Remember that the “D” in EBITDA stands for depreciation. For example, let’s say a business owner purchased a laptop computer for $2,000 and expensed it under Notice 2015-82. Had it been capitalized, the SDE would have increased by $2,000, and the potential sales price increased $6,000. Note that the $2,000 would have been deducted in either scenario.
The list goes on and on. The above two examples are the tip of the iceberg. I recommend you get smart about tax planning at least three years before you intend to sell your business. There are strategies to get the same or similar tax results, without dampening the ultimate sales price of the business.
Note the above is a general discussion of a complicated topic. Contact me to discuss how to maximize your exit, and still minimize your tax burden.
Michael D. Bosma, CPA, is Principal-in-Charge of Keystone CPAs. Reach him for comment at mbosma@keystone.cpa.
