Nobody likes to pay taxes. We get that and we don’t like to pay taxes either, but many business owners have been known to blur the lines of “business” and “personal” expenses to save money on taxes. No one talks about it, or likes to admit it, but it happens a lot. We see it all the time and we’re not here to judge or lecture you on the matter. Having said that, if you are a business owner planning to exit in the next three to five years, it is important to know how your personal expenses, if run through the business, can impact the value of your business. Often business owners don’t realize they are being penny wise and pound foolish.
In past articles, we’ve talked about the importance of business valuations (the process of learning what your company is truly worth). During the valuation process, financials are recasted to remove or adjust items that are unrelated to the operation of the business. These are commonly known as add backs – expenses that will not be included in a prospective buyer’s future.
In an owner-operated, “main street” business, certain add backs are expected and can easily be added back such as:
Other types of expenses that are not truly operational expenses and are personal in nature are not so easily added back and can directly diminish the value of a company. Here are some examples:
The general idea behind running these personal expenses through is to reduce taxable income. However, it is important to understand that these expenses will also reduce the value of the business. A bank will generally not allow add-backs for these personal expenses even if a buyer agrees, so financing becomes a real challenge. Simply put, you might save $0.20 – $0.30 on the dollar today by putting through these personal expenses, but you may be giving up 2 – 3X on your earnings when it comes to your sale price.
Recently a seller came to us to value their business for the purpose of sale. The business was solid and performing well; however, they were running some personal expenses through their business that we couldn’t add back because a lender would not approve them if a buyer needed to get a loan to purchase the business. Ultimately the personal items they were expensing that couldn’t be added back ended up reducing the net income of the business by about $90,000. Say the seller is in a 20% tax bracket, that’s about $18,000 in taxes he may not have paid that year. The kicker is this particular business had a 2.5 multiple on their earnings, so it cost the seller approximately $225,000 in value! Saving a little money now ended up costing him a lot more money in the end.
If there is any chance you might sell your business in the next five years, clean up your financials now and stop running personal expenses through the business. If you are unsure of what would or would not qualify as an add back, reach out to us. Our team at Murphy Business of Cape can help you establish an accurate value for your business. This will foster trust between you and your prospective buyer (as well as their bank) from the beginning so it should sell quickly and you can walk away with what you deserve.