Your Next Decision: Wealth or Income?

The new year is here, and so is another opportunity to create wealth. Surprised?  I’m talking about the decision you will have to make by March 15 about how much profit to show on your corporate tax returns.  

Why is this important?  Because if you choose the traditional route of showing the least profit (and thus paying the least taxes) you are electing short term income over long term wealth.

Small Savings or Huge Wealth

“Wealth” for a business owner means the value of their business.  And the value of a business is driven by the documented profits.  (And in this case, “documented” means on the tax returns.)  If you were to list your business for sale, the first thing a buyer would ask to see is the tax return — and the documented profit that you have declared.

So you have a choice: Can you increase the future sale price of your company (and your wealth when you exit) by showing more profit on your tax return? We’ll get to the “how” in a minute.  For now, let’s consider the impact of showing more profit this year.  What are the costs and benefits?

Do the Math

To make this decision, be sure you understand the math. Tax savings are easy to see and calculate.  Your CPA can show you your “marginal tax rate”, which is likely to be between 21% and 37%. (For simplicity, we’ll use a marginal tax rate of 30%.) So for each $1 you decrease your taxable profits, you’ll pay $0.30 less tax.

Simple, right? Tax savings is a fraction of profits.

But wealth is created as a multiple of profits.

That’s right. When you sell your business, it is likely that you will receive 3 to 5 times the profit (EBITDA, actually) that your business generates.  Some companies sell for up to 10 times profits!

So let’s do the math. For each $0.30 you save this year, you’ll lose $3 to $5 (or more) when you sell your company.

That makes the decision easier, doesn’t it?

To me, tax strategy is not about paying less tax; it is about accumulating and keeping the most wealth.  So if you are claiming your country club membership, your new BMW230i and your kids allowance as “company expenses”, stop.  Even though expensing your $600/month car payment will save you $2000 in taxes this year, it will cost you $36,000 or more when you sell. That’s enough to buy a brand new car. ($600 x 12 months = $7,200 annual difference in profit… x5 multiple at sale is $36,000 more when you sell!)

When to Worry

If you are planning to sell your company sometime in the next 3 years, this is a real issue.  But if you’re the kind of person that wants to run your business forever and die at their desk, well you can safely disregard most of this.  Or can you?

What if that “die at your desk” moment happens next year… or next week?  Your estate (and therefore your family, spouse, heirs) will be better off by receiving the true value that you have created in your business.

There are plenty of entrepreneurs who will elect to save the taxes this year — and that may be the right move for them — but if a sale or exit is in your near future, consider the alternative.

How to Boost Profits

There are discretionary costs in every business. The dangerous ones are those that are clearly personal in nature, or simply outside the scope of the business. Family travel disguised as a business trip is usually the biggest problem. If you claim it as an expense on your taxes, and later tell a seller that it was not a business expense, you’re not likely to be believed. Sellers are not interested in hearing about your trip to Bermuda, much less the extravagant meals, cars, phones, or insurance that you enjoy as a business owner.  Once those expenses are recorded in the tax record, they are assumed to be normal and necessary expenses for your business.

So expensing that $10,000 vacation to Curacao saved you $3,000 in taxes last year, but just cost you $30,000 in long term wealth.

The next biggest bucket of discretionary expenses is unnecessary payroll. Are you employing your family in the business and paying them more than market rate for the job they are doing?  I’ve met entrepreneurs who put their spouses on the payroll despite the fact that the spouse never lifts a finger. It might be good for tax purposes today, but it is going to reflect poorly on your sale price tomorrow.

What Not to Claim

Because businesses are generally sold on a multiple of EBITDA (*Earnings Before Interest, Taxes, Depreciation and Amortization), there are plenty of items that you should deduct as expenses, even on your taxes.  As the name EBITDA implies, Interest, Depreciation and Amortization are not things that a buyer will worry much about, but which are deductible for tax purposes.

During a sale process, interest, depreciation and amortization become “add-backs”.  The buyer adds them back to your stated net profit. So go ahead and claim these items in order to reduce your taxes now…. They will not have any impact on your long term wealth.

Can You Get Away with It

If you think you can have it both ways and get away with it, you may be right. There are stories of business owners who manage to convince a buyer that all those business trips are indeed unnecessary family travel, but those are the exceptions not the rule. 

During a sale negotiation, there are enough thorny issues to deal with — do you really want to add “discretionary expense add backs” to the pile?  And even if you convince the buyer, you’ve also got to convince the buyer’s banker (and maybe the SBA who will back the bank). Those audiences tend to be much less flexible.  I have yet to meet a banker who will engage in a conversation about vacations, cars, phones, or country-club memberships.

Come Down in the Middle

I like to paint this issue as black and white. But of course, it is not. The profit you show and the tax you pay are, to some extent up to you and your CPA.  Playing it safe is my preference: you never know when a chance to sell will come along (or when the IRS might decide to audit you).  

Your preference may be to play it loose and fast.  That’s fine, as long as you understand that you may be trading 30 cents now for $3 later.

Dedicated to your (wealth building) profits,

David