The Impact of Tax Savings on Business Valuation

The Fourth quarter is the time of year business owners begin to identify strategies to pay as little tax as possible. What many don’t know is that saving taxes can negatively impact the value of their business when they are ready to sell.

Certainly no one likes to pay more taxes than they need to. While at the same time, as a business owner you want to sell your company for the highest dollar amount possible!

How tax savings impact business valuation.

As a business owner it feels good to make decisions that reduce the amount of taxes you need to pay. This typically happens by lowering income, as income or earnings are what you pay taxes on. Earnings are a company’s after-tax net income, also known as the bottom line. However, income and earnings are also the basis of business valuation.

So, when a business owner makes decisions that reduces their earnings in order to pay less taxes, they also decrease the market value of their business, because their earnings are reduced. The greater your earnings, the greater the market value of your business. Buyers are seeking businesses that have predictable revenue, cash-flow and profit. The more earnings a business has the more a buyer will pay for the business. If saving taxes is reducing earnings it will almost always result in a buyer paying you less money when you decide to sell. Let’s look at this closer:

Three common tax-saving tactics: 

1. Shifting revenues to the next year: Business owners can reduce their taxes by decreasing their earnings in the current year. For example, a business owner may choose to wait to send out December invoices until the first of January, effectively shifting this year's income to the next year. While this strategy lowers the taxable income for the current year, it's important to consider that it could have an impact on the business's valuation, simply because the business is showing less income and earnings.

2. Prepaying next year’s expenses in the current year: By increasing the amount of deductions in the current year earnings are reduced, resulting in a lower tax bill. As an example, a business owner may decide to pre-pay bills due in January of the next year in December of the current year, thereby increasing the current year’s expenses. As in the example of shifting revenues to the next year this strategy also lowers the business’s earnings, affecting the business valuation. 

3. Purchasing assets to increase expenses: Buying assets that qualify for tax deductions to reduce taxes is a common strategy, and a smart one IF your business actually needs the assets being purchased. However, buying assets solely to reduce taxes can negatively impact the market value of your business. Spending money on unnecessary assets reduces earnings, and cash flow, and may interfere with the ability to invest in potential business opportunities.

At least three years before you sell, you need to make informed decisions about your income tax strategies. Buyers and their lenders like to see at least three years of business financials to evaluate what they are willing to pay for a company, which means your earnings need to be as high as possible to maximize the market value of your business.

Your tax strategy should not be done on an annual basis. It needs to be a long-term strategy tied to the value of your business.

Sit down with a professional tax advisor to explore smart strategies to mitigate what you pay in taxes without adversely impacting the market value of your business. Work with an advisor in advance to understand the tax percentage you will pay when you sell your business. The amount of taxes you pay upon the sale of your business is influenced by your business legal structure; depending on if you are a sole proprietorship, partnership, limited liability corporation, etc. There may be several advantages to changing your business’s legal structure prior to selling.