Your Tax Return Is Not What Your Company Earns

It is lower, usually by a lot, and it is lower on purpose.

That is not a criticism. A private company is run to serve its owner, and a company run to serve its owner reports less profit than the same company run to serve a buyer. The question is how you demonstrate the difference to somebody who has every reason to doubt it.

The exercise is called recasting, and it is the single most consequential piece of preparation you will do, because value is set off earnings and the recast is what establishes the earnings.

What a recast is claiming

Each adjustment is called an add-back, and every one of them makes the same argument in a different costume: this is a cost the company really incurred that the next owner will not.

Three kinds. Costs that burdened the past and will not burden the future, like the money a distributor spent two years ago to win the rights to a product line that is profitable now. Costs a buyer running the business for profit simply would not incur, like the plane nobody needs or the product line that loses money every year because a family member runs it. And expenses that serve the owner rather than the business, from compensation above market down to the club membership.

All of them are real, all of them were properly deducted, and all of them stop or shrink when somebody else owns the company.

Why skipping it is the largest number in the transaction

A buyer reading unadjusted statements projects forward from figures that include costs the business will not incur again, and arrives at a lower number than the business will actually produce.

Then they apply a multiple to it.

That gap, multiplied, is frequently the largest single number in the entire deal, and it is lost silently. Nobody tells you what you would have been offered. An owner with no recast is priced on their tax return, which understates earnings in almost every owner-run company.

The rule that governs the biggest category

Add back the excess, not the whole number.

A buyer will employ somebody to do your job and will give that person benefits, so compensation, health, life, and retirement are add-backs only to the extent they sit above what the market would pay. If you take four hundred thousand dollars and the role costs one hundred and eighty, the add-back is two hundred and twenty. If your health and retirement are in line with what any employer provides, there is nothing to add back at all.

An owner who adds back their entire salary is telling a buyer they expect the company to run with nobody in the chair.

You do not get paid for what you cannot document

An add-back a buyer cannot verify is an add-back a buyer removes, and they remove it without much argument, because they do not have to argue. They simply do not include it.

For each one you want the general ledger detail behind it, a one-line explanation of why a new owner would not incur it, and documentation proportionate to the size of the number. A four-thousand-dollar phone bill needs a line. A four-hundred-thousand-dollar compensation adjustment needs a market comparison you can hand somebody.

Which creates an uncomfortable overlap, because the category owners most want to add back is frequently the category with the least documentation. If genuinely personal spending has been run through the company and deducted, that is a matter for your tax advisor rather than a presentation problem, and the fix takes effect slowly: a buyer prices the last three years, not the current one.

Conservative beats aggressive, and it is not close

An aggressive schedule full of marginal adjustments invites scrutiny of all of them, including the solid ones.

A schedule where every item is obviously correct gets accepted quickly and makes the few larger items easier to defend. Owners consistently over-claim here and lose more to the resulting suspicion than they would have gained from the marginal items.

Every item claimed that does not survive makes a buyer look harder at the items that would have.

Build it while it is happening

A recast built while a buyer waits reads like one.

What survives is what was written down at the time, with the support attached, by someone with no number to hit. The timing is worse than it looks: diligence requests land by the hundred while you are still running the business, so an owner building the recast then is doing the hardest analysis of the sale under the worst conditions of it.

What a weak recast costs

Two different failures, and they cost differently.

No recast, and you are priced on your tax return. Silent, permanent, and unmeasurable afterward.

An aggressive or undocumented recast, and the add-backs get struck one at a time during the buyer’s investigation. The price falls in stages, each successful strike makes the next request easier to make, and by the end the owner is a long way from the number they opened with, having spent their credibility getting there.

The recast is the one document in this process where accuracy and self-interest point in exactly the same direction. Everything a buyer cannot verify, they discount. Everything you can prove, you get paid for.

More on this: The Expenses You Can Add Back, and the Ones You Only Think You Can; The Multiple Gets the Headline. The Add-Backs Get the Money..

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This is what we do. Prism Edge builds the recast before a buyer sees a number, with the support attached to each line as it is built and the marginal items left out on purpose, so the schedule that reaches the buyer’s accountants is one that holds rather than one that gets negotiated down. The work is cheapest years before anybody else’s clock is running.

The full chapter on proving what you actually earn is in The Business Sale, free to download here.