Business Owners’ Special Series #25
There are many strategies business owners can use to run their businesses. One popular strategy used by many businesses is reducing their tax liability to pay the absolute minimum amount in taxes each year. However, some business owners become so compulsive about minimizing taxes that it begins to have a detrimental effect on the business value. This can cause difficulties for the owners, when they attempt to transition the business to someone else.
Here is an example of a similar scenario BPM’s Value Acceleration and Exit Planning team has seen in the past.
Ronnie owns a business that has been making natural food products for over 20 years. The business would have a $1 million net profit this year. However, Ronnie made several decisions to reduce the profit for the primary purpose of reducing taxes, including:
Ronnie had the business purchase a new Tesla Model X for $125,000. Ronnie justified the purchase because the expense would reduce taxes, the business could afford it and she wanted one.
Ronnie put her significant other and their three children on the payroll. There was no business purpose for this other than reducing the taxable income in the business. These family members preformed no services for the business. Total compensation paid to family members was $275,000, including payroll taxes.
The production facility for the business is owned by Ronnie’s parents, and it does not have a formal lease agreement. Ronnie decided to increase the rent payable to her parents by $5,000 per month. The rental income is her parents’ primary source of income, and Ronnie rationalized the rent increase because it will reduce the business’ income taxes while “keeping the money in the family.”
Ronnie paid for vacations using the business’s travel expense account.
Ronnie charged both the company’s and her personal kitchen expenses to the corporate credit card.
Initially, Ronnie was quite satisfied because she reduced her profit from $1 million to $500,000, which also cut her income tax bill in half. However, Ronnie encountered a few unanticipated surprises.
Ronnie asked the bank to increase the business’ line of credit for operations, and also to provide a new loan to finance equipment purchases. Both requests were denied.
Upon reviewing the business’ financial statements, the bank’s loan officers were not pleased that while sales were steady, profits showed a significant decline. Ronnie’s “tax planning” expenditures had a lot to do with the decrease in profits. Furthermore, the additional auto loan associated with the Tesla purchase pushed the bank’s debt covenants to the point where the bank could not make additional loans to the business.
Additionally, when Ronnie met with her financial advisor to help determine the value of the business, the results were disappointing. Ronnie’s habit of pushing the profit down further each year with tax motivated expenses had additional unanticipated consequences: it resulted in the business’ financial performance appearing subpar when compared to other businesses in the industry.
In terms of its impact on company value, Ronnie could explain to a potential buyer that many of the expenses on the books are “discretionary expenses,” meaning a buyer of Ronnie’s business would not incur these expenses, thereby generating a higher profit for the buyer. A buyer may accept Ronnie assertions. However, the buyer now thinks Ronnie owns a poorly-run operation instead of a “best in class” business. This raises a buyer’s concerns about the overall performance of the business and the reliability of financial information, and it leads to a negative impact on perceived value.
When meeting with lenders, investors or potential buyers of your business, there is only one way you want to present your company’s financial statements: showing strong, sustained earnings and increasing profits. Ronnie’s tax strategy is causing the exact opposite. The result is Ronnie’s tax motivated decisions will make it difficult for Ronnie’s business to borrow, attract investors, or sell for the highest price. In other words, Ronnie’s tax strategy is devaluing her business.
We are not advising your business to avoid tax saving opportunities. However, owners like you need to be smart about tax savings strategies, and consider the impact of tax motivated decisions on business value. Make certain your business’s tax decisions are smart overall business decisions. Here are some ways.
Use compensation for strategic purposes, not tax purposes
It is common practice for many business owners to pay bonuses to key employees at end of year, to reduce taxes. This is often justified by labeling bonus recipients as “strong performers.” That may be a true statement, however, tax saving should not be the motivating factor for paying bonuses. Bonuses should be used as incentives for employees to achieve specific goals. Bonuses should be tied to behaviors that result in increasing the business’ growth, profitability, operational efficiency, financial performance and value.
Choose a business savvy tax advisor
Ensure your tax advisor considers the non-tax consequences of tax advice they provide. If your tax advisor is not also a competent business advisor, the tax savings advice could actually do more harm than good.
- Understand the difference between tax deductions and financial statement expenses
Seek tax deductions that will reduce taxes but will not reduce the profit on the books. One example is the “pass-through deduction” for business entities such as S Corporation and LLCs. Under section 199A of the tax code, qualifying businesses will pay tax on 80% of their business income while 20% of the profit is tax-free. The pass-through deduction reduces income tax taxes but it is not an expense on the books, thereby reducing taxes while sustaining the profit on the financial statements.
Understand effective use of tax depreciation
Accountants can get lazy and take the depreciation expense from the tax return and use the same amount on the company’s books, so they do not have to do another set of depreciation calculations. Tax preparers may make tax return elections to expense equipment purchases all in year-one. That is great for reducing taxes, however it is terrible for the business’s financial statements.
The depreciation on the books does not have to be the same amount of depreciation on the tax return. The accountant may take far smaller amounts of depreciation expense on the books each year and show higher profits. While sophisticated investors may ignore depreciation expense and focus primarily on cash flow, the point remains: show the best financial results possible, and focus on building value first and foremost.
Buyers do not like hidden liabilities
Aggressive tax positions in Ronnie’s example above represent a potential hidden tax liability in the event of a tax audit. This may result in not only additional taxes, but also penalties and interest. When a buyer finds hidden tax liabilities, it makes the buyer wonder what other liabilities may be hidden under the rugs of the business.
Remember risks within a business drive down business value. Buyers always seek to discover the risks in a business before making a final offer: the more risks they find, the lower purchase price.
The most astute business owners focus their attention first and foremost on building enterprise value. You should make savvy tax decisions that will not likely drive down business value. Your tax advisor should be a thoughtful business advisor who gives you tax advice without failing to see the non-tax impact of any tax advice. An effective tax strategy, therefore, is one that will reduce taxes without being detrimental to business value.
Rich Gunn leads BPM’s Value Acceleration Service Team, which helps with succession planning, transition business exit strategies and exit planning for business owners. Rich is a Certified Exit Planning Advisor and a member of the Exit Planning Institute.
The Business Owners’ Special Series (B.O.S.S.):
The Business Owners’ Special Series (B.O.S.S.) is a library of information for business owners who are proactively seeking guidance from experts on how to implement value acceleration in their business. Be sure to keep reading, if you desire to develop your business to its maximum potential value and gain an understanding of how and why beginning the process sooner results in building greater value.