Discussions > Discussion Details

Buying A Small Business: Why Is It Important To Look At Its Tax Filings?

Comments & Replies: 3 Views: 8032 Posted By: Business Broker

Business tax filings are very important factor in determining the credibility of business financials. Just seeing those financials, you can't determine whether those values are overstated or not. Some business owners provide made up financials to buyers - so, that's where tax fillings come in.

Topics: Buying A Business Tags: buying a business

Contributor: Business Broker - SF Bay Area

Business tax filings are very important factor in determining the credibility of business financials. For instance, Profit/Loss statement of business indicates its revenues/sales, expenses and net income annually and monthly. Some of the business sellers provides the made up financials in which they overstate the value of their gross sales or revenues in order to increase their value of business. Just seeing those financials, you can't determine whether those values are overstated or not. So, that's where tax fillings comes in. Let me explain through following examples:

You go to buy a restaurant business in San Mateo and ask for its financials. The owner provides you P/L statements for the year 2016 and 2017, which indicates that their gross sales for both the years are $400,000 and $700,000 respectively. Now, as a buyer you see that within one year, business has $300,000 increase in their gross sales, which is a pretty big jump. So, either that business has done exceptionally well in 2017 to increase their sales, or these values are overstated. So, this is the first call to you as a business buyer, that you need to verify the credibility of these business financials. So, here you need to ask them for their tax fillings. While seeing these tax fillings, the questions is how to verify the credibility of such business financials?

Match the Numbers (Gross Sale Value and Sales Tax)

Taking into account above scenario, You need to ask for taxes filed by the business with both State and IRS.

First look at Gross Sales value in the Sales Tax filings with the California State and IRS tax fillings. You see that it matches with P/L statement of 2017. Now, on the filing look at the sales tax value: it is mentioned: $29,600. Now remember that you are buying business in San Mateo where the Sales Tax rate (collectively including both of tax rate of State of California and San Mateo) = 9.25%, so (9.25% of $700,000) is $64,750. So, here now you instantly notice that the value of sales tax mentioned in the tax filings is not in accordance to value of Gross sales ($700,000) as mentioned in P/L statement. Hence, numbers don't match!

So, through this method you find ambiguity in the tax fillings. Financials should accurately match with tax filings from penny to penny.

Inquire from the Seller/Brokers about it:

You ask from the restaurant's owner or his Broker about this ambiguity.They respond that that $320,000 of Gross Sales were made from hot food, for which the sales tax is $29,600 (9.25% of $320,000), whereas the remaining sales were from cold food (cold food is non-taxable for restaurants). Though, it seems a valid point, but the problem is that taxable income and non-taxable income should be specified separately on tax filings. If those taxable and non-taxable incomes are mentioned on tax filings, and sales tax value is in accordance with gross sales value, it establishes the somewhat credibility of business financials, which is not the case in above scenario. So, in either case, what should you do next?

Ask for Invoices for Cold Food Sales:

Then you should ask from the owner about the invoices for sale of cold food. If the owner is able to provide those invoices, and the collective values of those invoices matches with the cold food value which owner claims it to be, then it could be credible. However, if owner is not able to provide you such invoices or those invoices collective value don't match with non taxable income (cold food, then it's more proabable that you are being given made up documents and you should not buy that business.

Look for K-1 schedule in IRS Tax filings:

In the tax filings, you should also check out K-1 schedule, first of all look out that whether the Final K-1 is marked or Amended K-1. If both of the options are not marked, then its a red flag. However, if either of Final or Amended K-1 is marked, you should look for the values of K-1 that owner is taking. After this, you should ask for bank statements from business owner and look for any red flag that may contradict such K-1.

For example, If an owner is taking $85,000 as K-1, but his bank statements do not support those, then its a red flag. For example, the non-sufficient fund charges are showed in bank statement of business accounts. It is a big red flag. Because if a business is making that much money annually, then why bank is charging its account for non- sufficient fund transactions.

So, you need to be very thorough in analyzing the tax filings of a business if you are considering of buying one.

Contributor: Joe Ranieri, Business Broker: LA, Orange Counties

I have worked with buyers and worked with sellers who have been asked by buyers to provide tax returns directly from the IRS with seller's approval. During the due diligence period, some buyers have been suspicious that the seller's tax returns may be fraudulent or tampered with and so they request them to be verified by an independent third party, and while some seller's are compliant, others have refused, and I've witnessed that this has been an issue that has killed deals.

Contributor: Timothy Cunha JD: Business Broker, SF Bay Area

Sometimes sellers will provide income tax and sales tax records to all prospective buyers; sometimes they want to restrict that "granularity" to a buyer under contract during due diligence. Either way can work just fine, but no buyer should consider buying a business without examining a few years of tax returns before making the deal final. And, to be confident that these are the real filed returns, a buyer can request a Form 4506-T, signed by the seller, to obtain true copies directly from the IRS.

While it is prudent for a buyer to know what should be examined on the tax returns, it is always advisable to invest in a few hours with a CPA to provide an objective third-party perspective and to properly correlate the returns with the P&L statements, with bank statements, and with the seller's calculated discretionary earnings ("SDE"). There can be legitimate reasons for discrepancies amongst these documents, but a professional is the one who should sort that out.

One additional point: sometimes there can be an apparent huge jump in income from year to the next. This may not, in fact, be growth, but rather a case of the seller "getting religion" and deciding to report (and pay taxes on) cash income in order to substantiate the value they are asking for the business. The prudent, diligent buyer should drill down on this and get the real story--especially in retail or service business with direct consumer customers who could be paying in cash.

Helpful Resources To Assist In Selling And Buying California Businesses

Elizabeth McGovern: Escrow Services - San Francisco Bay Area

McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.

Diane Boudreau-Tschetter: Escrow & Bulk Sale Services - CA

California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.

Steve Zimmerman: Restaurant Broker Specialist, California

Steve founded Restaurant Realty in 1996. He has personally sold/leased over 1000 restaurants, bars & clubs, & completed over 3000 valuations. The author of "Restaurant Dealmaker- An Insider's Trade Secrets For Buying a Restaurant, Bar or Club" available on Amazon. Reach Steve direct at 415-945-9701.

Matt Weiler, Business Broker: Gas Station Specialist

Business Broker Specializing in primarily gas stations. Geographic area of focus: San Francisco Bay Area to Sacramento and as far South as Monterey, California. To sell or buy a small or large gas station phone Matt (gas station business broker specialist) direct at 408-623-0920.

William F. Ziprick, Attorney: Legal Services For Buyers And Sellers

Through creative problem solving, attention to detail, accessibility, & understanding that unnecessary delay is often a deal killer, I work closely with my clients and other professionals to consistently achieve a high rate of closings. Office: 909-255-8353, Cell: 509-951-7230.

Shalonda Chappel: Escrow & Bulk Sale Services - Southern California

Escrow services to brokers/agents, sellers, & buyers. Established 43 years. Extraordinary service. Experienced with handling difficult transactions. One stop for all your escrow needs: Bulk sales, lien searches, UCC searches, liquor license transfers, publishing & recording services. 951-808-3972.

Peter Siegel MBA, BizBen Founder, ProBuy, ProSell, ProIntermediary Programs

Founder Of BizBen.com (since 1994). I am the Lead Advisor for the ProSell, ProBuy, & ProIntermediary Programs. I consult daily with buyers, sellers, and brokers daily about buying and selling California small to mid-sized businesses. Call 925-785-3118.

Harry Sidhu, CBB, Broker: SF Bay Area, Central Valley, SAC Region

Assisting both sellers and buyers of businesses - dealing mainly with Liquor Stores, Grocery Markets, Gas Stations, Smoke Shops, Restaurant Related, Retail Related, Service Related. Serving SF Bay Area, North Bay, Sacramento area. Call Harry Sidhu, CBB for assistance at 510-366-6130.

Related Articles, Events, Blog Posts, Discussions, Videos, Interviews

Business Purchase Financing Expert Peter Siegel - Tips On Proving Cash Flow

What are the actual "provable" adjusted net earnings (cash flow) of a small to mid-sized business being purchased? Buyers need to look carefully at all financial info for the "real" adjusted net income/cash flow. Peter Siegel, MBA (BizBen ProBuy & ProSell Lead Facilitator) at 925-785-3118 explains.

Thinking About Selling A Small Business? Know These 8 Factors That Matter

The likelihood of selling a business is often determined by external factors in the marketplace. Here are eight influences on how easy, or difficult it might be when selling a small California business. Peter Siegel at 925-785-3118 (BizBen ProSell Program) explains these factors for owner/sellers.

Getting An SBA Loan To Buy A Small Business: Dispelling Some Major Myths

When seeking SBA loan financing many potential business buyers have wrong information about the process of securing the best financing to buy a business. Peter Siegel, MBA (at 925-785-3118) a business purchase financing expert delves into the myths and facts regarding SBA loan financing.

Buying A Business: Why Is It Important To Look At Its Tax Filings?

Business Purchase Financing: SBA Loans & Non SBA Financing Solution Services

I provide niche business purchase financial advisory and loan placement services with SBA and Non-SBA Financing, Retirement Fund Rollover Solutions, Combo Financing Packages, etc. To get more information about getting Pre-Qualified & more info on the ProBuy/ProSell Programs: 925-785-3118 Direct.

6 Simple Things To Increase Business Value Before Offering It For Sale

How do you value a small business before putting it on the market? Tim Cunha, JD offers 6 items all business owners should consider. Other advisors and business brokers also weigh in on this very important topic especially when over 70% of small businesses never end up selling (due to pricing).

BizBen Podcast & Webinar: Business Purchase Financing And SBA Loan Options

Ever wonder what is involved in obtaining business purchase financing to buy a business or franchise? Peter Siegel, MBA who has over 25 years advising on all types of financing for business buyers in this BizBen Podcast & Webinar - SBA loans, Non-SBA Financing, Alternative Financing Sources.

Purchase A Small Business With Limited Or No Cash: Financing Tips For Buyers

Purchasing a business with no money down can be difficult, but not impossible. Financing a business purchase or down payment can often be accomplished with these strategies offered from Peter Siegel, MBA (Business Purchase Financing Expert, ProBuy & ProSell Program Advisor with BizBen) in this post.