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

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.

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.

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.