Year End Tax Strategies May be Costly for Some Business Owners
The “one size fits all” approach to year-end tax planning can actually cost some business owners up to ten times the amount they save in income taxes!
Business owners who are considering selling their businesses may actually lose up to $10 for every $1 they “save” by implementing some of the more common year-end tax saving strategies.
What types of business may be at risk?
If you are using the “ Cash Method “ of accounting (like many privately owned businesses) for income tax purposes, some of the standard “vanilla” type tax tips you read about may not be for you. The Cash Method of accounting is where the business reports income on their tax return in the year it is received (not when it is invoiced). Expenses are deducted in the year actually paid (rather than when the expense is incurred).
What are some of the tax strategies that can cause problems?
The two tax strategies that may cause a problem are known as “Acceleration of Expense” and “Deferral of Income” tax strategies.
EXAMPLE: The owner of XYZ Services has been thinking about selling his company in the coming year, and moving to a warmer climate. XYZ has experienced a very profitable year, and the owner asks the company’s CPA to perform a tax analysis and provide tax saving strategies that can be implemented before the current year ends.
The CPA advises the owner that income from the company is taxed at a combined tax rate of 40% (federal, state and local tax rates combined). So, for every $100 of profit the company will pay out $ 40.00 in taxes.
The CPA suggests that the company “defer” (until next year) billing customers (who would otherwise pay the bill in the current year) for services in the amount of $15,000, causing the income to be received in the next taxable year. This is a “Deferral of Income” tax strategy. The CPA also suggests that XYZ prepay newspaper advertising for next year, thus earning a vendor discount and “Accelerating the Expense” into the current year. XYZ buys about $17,000 of next year’s advertising by prepaying $15,000 this year. The CPA points out that by deferring $15,000 in income, and accelerating $15,000 in expense, the owner of XYZ has reduced current year profit by $30,000 and has saved $12,000 in taxes. (Profit of 30,000. multiplied by tax rate 40% equals $12,000.)
Early the next year the owner of XYZ consults with a business intermediary (broker) about selling his company. The broker advises that this type of business generally sells for around 4X EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization). Additionally, the broker explains that most buyers, while they look at the recent five years’ past earnings history, will usually only pay the 4X multiple on the most recent year’s results; Meaning the $30,000 reduction in net profit—had it been reported on last year’s tax return, would have been worth approximately $120,000 in a higher sales price! ($ 30,000 profit multiplied by 4= $120,000.) Those tax savings tips that saved $ 12,000 in taxes last year ended up costing the owner of XYZ an increase in selling price of $120,000!
Businesses are valued and purchased based upon profits and cash flow. The sale and financing of a business relies heavily on what profit has been reported on the income tax returns---and anticipated in future years. In fact, lenders verify with the IRS that the income tax returns (given to the lenders) are actually the ones that were filed with the IRS! If a buyer cannot borrow enough money to buy your business, then you probably won’t sell the business for as much as you anticipated.
Business owners who are thinking about “cashing out” of their business need to be very careful before implementing certain tax saving strategies. While nobody likes to pay taxes, isn’t it worth paying $1,000 in tax to bolster the value of your business by $10,000?
For more information about selling a business, go to www.gruttercpas.com and www.lulu.com/businessadvisor.