Reprint permission granted “Partner” On-Call Network LLC
by author Toby Tatum,
The Danger In Minimizing Your Income Tax Liability
“Call me Ishmael.”
With that introduction, one of the greatest works of fiction about adventure on the high seas begins. Through the eyes of Herman Melville’s fictional character Ishmael, we see Captain Ahab’s pursuit of the great white whale, Moby Dick, and through this literary experience learn an important object lesson: the folly of blind obsession. In the end of course, Captain Ahab is killed and his ship the Pequod is sunk. And all because he abandoned common sense and good judgment in his overwhelming need to kill the white whale.
In the course of my work as a business broker and business appraiser, I occasionally encounter business owners who remind me of Captain Ahab. This is to say, I see them consumed in an apparent overwhelming need to kill their white whale. The white whale is the same in every case. What I’m talking about is their need to avoid paying income taxes; to put cash in their pocket at the end of the day, but show a loss on paper. In other words, to put one over on the I.R.S.
Among this genre of small business owners, there is one individual whom I met that stands out from all the rest. He was the epitome of one obsessed with a need to minimize his reported taxable income. I was amazed at the lengths he went to, to distort his sales revenue and expenses on his financial statements. You name it, he did it: pocket cash sales and never enter them on the books, bloat reported expenses by recording personal purchases such as travel, meals, magazine and newspaper subscriptions, personal auto expenses, home repairs and maintenance and so forth as business expenses. He held back credit sales in November and December and didn’t book them until January; he stuffed his postage meter in December with enough postage to last him until August but reported the total purchase as an expense in December, and on and on. Moreover, he was quite proud of this accomplishment. He told me that he met with his CPA several times a year to “brain storm” new ways to minimize his reported income. The energy he put into this practice was enormous. He was truly consumed not with just a desire, but it seemed to me, a compelling need to avoid paying income taxes.
The reason he was explaining all of this to me was because he had to sell his business. About a year earlier he suffered a very debilitating injury and was not recovering well. He was not a young man and he was in constant pain. He even had a cot set up in his office so he could lie down and rest periodically throughout the day. He doubted he would ever recover fully. He told me he must sell his business and retire—and, the sooner, the better.
His business was quite unique and thus, it was unlikely I would be able to find many interested buyers. However, I found two individuals who showed an interest—until. That is, until they saw his actual financial statements and not the earnings I advertised based on the adjustments I made according to his explanations of what his real revenue and expenses were. Mind you, I never doubted that his explanations were true and that his business really was fairly profitable. I never doubted that he wasn’t lying to me or to the prospective buyers. He only lied to the I.R.S.
However, the enormous difference between his advertised earnings and what appeared on his financial statements and tax returns didn’t sit well with the buyers. As he explained to prospective buyers the differences between reported sales and actual sales and reported expenses and actual expenses, I could see the buyers’ eyes sort of roll back in their heads. Clearly, they were thinking to themselves, “oh brother!”
Neither buyer made an offer. Ultimately, after several months of trying to sell his business but racked with pain and unable to carry on, the owner closed it down and walked—actually limped—away. All he got was the liquidation value of his operating equipment. This was truly unfortunate, because he had a profitable, viable business. This is the only consistently profitable business that wouldn’t sell (assuming it is reasonably priced) that I have encountered and it was all because the owner’s official historical records of revenue, expenses and earnings were so distorted. I can only estimate what I think this owner could have sold his business for had he been able to present accurate financial statements. It is my guess that the selling price would easily have exceeded five times the amount he probably saved in income taxes over the years by under-reporting earnings.
My recounting of this incident is not to suggest that small business owners should turn a blind eye to ways of minimizing reported earnings on their income tax returns. There are legitimate ways to do this and I’m sure your CPA will be more than happy to discuss them with you. And, based on my personal experience, I can say that most prospective buyers are willing to add back some additional cash flow to reported earnings arising from artificially bloated expenses such as meals & entertainment and auto expenses when making their determination of what a business is worth. Few buyers, however, seem willing to add back the seller’s claim of skimmed cash sales revenue or add back earnings concealed through other egregious tax avoidance schemes when computing a business’s value.
In addition to the negative affect that distorted financial performance reporting has on a business’s market value, such statements also become less useful—and in many cases useless—as a business planning and control tool. This is dangerous because there comes a point in a growing business where the absence of accurate financial reporting becomes the kiss of death.
There also comes a time in most growing businesses when the need arises to borrow money to finance new operating equipment, leasehold improvements, the purchase of real estate, inventory perhaps and so forth. Without good financial statements (and accompanying tax returns) that demonstrate a history of solid earnings, the ability to borrow the needed money becomes significantly more problematic.
And finally, one always runs the risk of being audited by one or more taxing authorities. If they should discover that you have been deceptive in reporting your company’s earnings, they can make you wish you hadn’t. In fact, I asked the business owner who I have told you about here if he was at all concerned about an audit. He assured me he was not. He said he was confident that he was much too clever to get caught by an auditor. I had my doubts about that. After all, he readily spilled the beans to both prospective buyers. One of those buyers could have been an under-cover I.R.S. agent. They really do stuff like that. Now there’s something else to think about—especially if you are also obsessed with killing the same white whale.
Toby Tatum, Alliance Business Appraisals and Toby Tatum Business Brokerage, LLC,
Virginia City Higlands, NV 89521, 775-847-7481