What are add-backs when selling a business?
Small businesses play a critical role in the US economic landscape. All the businesses on the Dow 30 started as small businesses. They then reached a critical mass, which led them to become public companies and grow into what they are today. Depending on the statistics used, small businesses account for approximately 98% of all companies in the US economy.
One of the benefits of being the owner of a privately held business is that you get to take tax deductions that wage and salary earners are unable to claim. This is all part of the risk and reward scenario that comes from owning and operating a small business.
When it comes to selling the business, these tax deductions can hinder the sale as they reduce the actual cash flow of the business. This impact on the cash flow then affects the business valuation and, therefore, the amount the Buyer is willing to pay. To navigate this scenario, it’s essential to understand how to handle these legitimate tax deductions, also known as add-backs.
Do they apply when buying a business?
An add-back is a legal expense that appears in a business’s financial statements, typically in the Income Statement or Profit and Loss Statement. These expenses are then included in the business’s tax return. What’s important is that the expense has no actual economic value in the business’s performance. For example, most business owners opt to purchase health insurance for themselves and, if applicable, their spouse and children.
If the spouse and children do not work in the business, then it would be legitimate to accept this expense as an add-back.
In the example above, there are two critical things. The spouse and children must not be currently working in the business, and they must not work in the business once the Buyer takes over.
Other add-backs the business owner may choose to run as an expense through the business include personal expenses, auto costs (such as gas, repairs, maintenance, or insurance for non-working family members), cell phones, and vacations claimed as business trips. Another acceptable add-back is the payroll tax paid against the salary earned by the business owner.
Legitimate add-backs play a crucial role in appraising and negotiating a business. They can be contentious, but the best approach is to prepare a report that clearly outlines the add-backs the Seller claims as reasonable, allowing the Buyer or lender to have an open and honest discussion.
Add backs and Best Practices.
The best approach when claiming add-backs is only to claim them if they are sizable and there are not too many of them. What is sizeable? That depends on each business, but I would suggest anything greater than $1,000 is a good starting point. I would not recommend trying to justify every add-back, as a Buyer will feel too uncomfortable; in the end, they don’t want to spend too much time and energy worrying about every dollar and cent.
Are you thinking about selling your business in California? Would you like to know the value of your business?
For more information, please visit my website, Business Valuation.
For more immediate help, you are welcome to send an email to Andrew Rogerson or give me a call at (Toll-Free): (844) 414-9700
Further reading
5 Lessons Learned from Selling a California Business in California