How Buyers Read Your Tax Returns
Buyers and their lenders start with your tax returns and compare them to everything else. Here is what they look for, line by line, and what to tell your CPA.
Words by
Matan Michael
The first thing a serious buyer asks for, after the nondisclosure agreement is signed, is your business tax returns for the last three years. The second request is usually the monthly statements, and the third is the bank statements. Nobody asks for these in that order because they distrust you. They ask because the three sets of numbers are made by different people for different reasons, and when they line up, the buyer relaxes. When they do not, the buyer slows down. It helps to know how the returns look from the other side of the table before you hand them over.
The first hour with your return
A buyer, or more often the buyer's accountant, does not read a return from the top. They go to a handful of places. Gross receipts, to see the size of the business and whether it moved. Cost of goods sold, to see what is left after direct costs. Officer compensation or the owner's draws, to see what you take out. Depreciation and interest, which are costs on paper that do not reduce cash the same way a payroll does. And the line near the bottom called other deductions, which tends to be the most interesting page in the file.
If the business is a sole proprietorship, the story is on Schedule C. If it is an S corporation or a partnership, the story is spread between the return itself and the K-1 that shows how profit was passed to the owners. Different forms, same question: what did this business produce, and how much of what is on the page will a new owner be able to count on.
An experienced reader can usually tell within an hour whether the return was prepared by someone who understood the business or by someone who worked from a shoebox in March. Both kinds of return are legal. One is much easier to defend.
Why the return shows less than the business earns
Your return is built to produce the lowest tax bill the rules allow. That is what a good accountant does for you, and nobody should apologize for it. The result is that taxable income is almost always lower than what the business put in your pocket, and a buyer who understands that will go looking for the difference.
The gap has a few usual sources. Your own pay, which might be below or above what a manager would cost. Perks that run through the company, such as a vehicle, a phone plan, travel, a family member on payroll. Depreciation that was taken quickly on equipment that is still working fine. Interest on debt the buyer will not inherit. A one-time legal bill, a lawsuit settled, a flood. Each of those moves the number the buyer cares about, which is the cash a new owner could expect, and we describe how that number gets built in our post on seller's discretionary earnings.
The work for you is to make each adjustment visible and provable. A list on a page that says the vehicle is personal use is a claim. The same list with the lease agreement, the mileage log and the line in the return where it appears is evidence. We cover how buyers treat each kind of adjustment in add-backs and what counts.
The lines that draw questions
Some entries make a reader stop and ask. Officer pay that is very low, or zero, in a business with a full-time owner. A large other deductions figure with no breakdown. Rent paid to a company you also own, at a rate nobody has checked against the market. Loans from the owner that grew over several years and were never repaid. Loans to the owner that look like salary. Cost of goods sold that swings from one year to the next with no change in sales.
Cash is its own topic. If some of what the business collects never reaches the books, the return understates revenue, and the owner often tells a buyer about it in conversation. A buyer cannot pay for money that was never reported, and a lender cannot lend against it. We would rather you hear that plainly now. Whatever the history was, the cash that is not on the return is not part of the price, and a buyer who suspects it may stop looking at your business altogether.
Payments to workers deserve a look as well. If you have people paid as contractors on a 1099 who work set hours at your location, a buyer's attorney may see employees, and the cost of fixing that lands on the buyer. The same attention goes to W-2 payroll, where the totals should match what the payroll service reports and what the quarterly filings show.
Filing history gets read too. A return filed late three years running, or an unpaid balance with a payment plan, tells a buyer something about how the books are kept. Payroll taxes and sales taxes get the closest look, because a buyer can inherit the paperwork trail even when the business is purchased without its liabilities. If you owe anything, find out the exact amount now and either pay it or have the payoff figure ready, so it can be settled from the proceeds at closing without a scramble.
Three years, side by side
Buyers read the returns as a set. One year tells them what happened. Three years tell them where the business is going.
A steady climb is easy to read. A dip in one year draws a question, and the question has a good answer only if you have one ready: a major customer left, you remodeled and closed for a month, a key person was out. A spike draws the same question from the other direction. If one year included a large one-time job or a government program payment, the buyer will want that taken out when they work out what the business normally earns.
The newest year matters most, and it is often the one that does not have a return yet. If you sell in the middle of the year, the buyer will work from the last filed return plus the year to date statements. That means your accountant should finish this year's return on time, without leaving it on extension for months, and your monthly statements should already tie to what the return will say.
Where the return meets the bank and the statements
A buyer will compare total deposits in the bank to the revenue on the return and on the statements. Small differences are normal and can be explained with timing, sales tax collected, owner deposits and refunds. Large ones need a schedule that shows the work. A lender will often ask you to sign a form that lets it request the return directly from the tax authority, which removes any chance that the copy you handed over differs from what was filed.
We have walked through the lender side in SBA loans in business acquisitions, and the loan is sized from what the returns show. If the return supports a smaller number than your story does, the loan is smaller, and a buyer who needs that loan to close will lower the price. Some buyers hire an outside accountant to rebuild the numbers from the ground up before they commit. That is a quality of earnings report, and it goes much faster when your returns, books and bank all agree to start with.
The balance sheet pages of the return are easy to skip, and buyers do not skip them. They show what the business owns and owes at year end, including inventory, receivables, loans and equity. If the numbers there never changed from one year to the next, or show a loan nobody remembers taking, a reader concludes that nobody has looked at the file in a while. Ask your CPA to walk you through each balance and say what it represents. You will probably find one or two that need cleaning up, and a year is plenty of time to do it.
What to do with this, starting now
Call your CPA and ask for the last three returns, the workpapers behind them, and a short meeting about what a buyer will ask. Bring the question as a buyer would ask it: what does the return say, what does the business earn, and why do those differ. Have the CPA produce a one page bridge from taxable income to the figure you intend to present, with a backup folder behind each line.
Fix what can be fixed going forward. Pay yourself a stated salary if you do not. Put personal expenses on a personal card from here on. Stop paying family members for work they do not do, if that is the case, and write job descriptions for those who do the work. Record all revenue.
Do not amend old returns to make the business look larger. That creates a paper trail that a buyer's attorney will read as a problem, and it can create a tax bill of its own. Your accountant and your attorney can tell you what, if anything, is worth correcting before you list, and rules vary by state.
If you are not sure how your last three years would look to someone reading them cold, Business Advisors of America will go through them with you before anything goes to a buyer. The conversation is usually short, and it tends to turn up the same three or four items every time.
