Paying more income tax might make some clients wealthier.

• Author: Rutter, Grover

Every business owner wants to know how to make the most money while paying the least amount of income tax; however, some business owners, but not all, will find that sometimes paying more income tax might increase the value of their businesses.

To reduce their taxes some business owners engage in such practices as "skimming," underreporting income, overstating deductions, or other practices that illegally reduce taxes. Many taxpayers want to pay their fair and legal share of taxes; however, not all business owners feel the same about income taxes.

CPAs cannot condone these illegal practices, but they may find an alternative to discharging clients who find ingenious, but illegal, ways to reduce their tax bills. The alternative is to demonstrate to these clients that they might be cheating themselves more than they are cheating Uncle Sam.

Cases in point

A couple of examples illustrate my point.

Small mom and pop "Main Street" businesses generally can sell for 2 to 3 times the seller's discretionary earnings (SDE). Larger "Main Street" businesses can sell for 2.5 to 5 times the SDE.

Many business brokers define SDE as earnings before interest, taxes, depreciation and amortization (expenses), plus owner salary and benefits. Here is one example of SDE in which the owner has not reported $25,000 of annual income.

Business pretax profit (under reported by $25,000) $37,000 Add: Owner salary already deducted 36,000 Owner "benefits" paid for and deducted 15,000 Interest expense deducted 5,000 Depreciation deducted 15,000 Total SDE $108,000 Let's assume that businesses with similar attributes and in the same industry as this business have been selling for 2.5 times the SDE. That means that a potential buyer may expect an estimated price for the business (operating equipment and goodwill) to be approximately $270,000 (2.5 x $108,000 = $270,000).

However, the business owner knows that the business makes more than what has been reported. Therefore, the seller believes the business is worth more than $270,000 based on the following calculation of SDE:

Business pretax profit (considers all income) $62,000 Add: Owner salary already deducted 36,000 Owner "benefits" paid for and deducted 15,000 Interest expense deducted 5,000 Depreciation deducted 15,000 Total SDE $108,000 The indicated value then would be $332,500 ($133,000 x 2.5 = $332,500).

What then is the difference in indicated value of the company?

Here is the answer:

Value having reported all revenues...