Let’s face it, a great number of business owners in cash businesses do not claim all or a substantial portion of their cash revenues to the IRS. Being a business broker from the Philadelphia region, I have observed this scenario from owners first hand. These owners do this for one reason; they want to spend significantly less money in taxes. A lot of owners feel as if they shell out enough in taxes and try to keep what they can. Others feel that all business owners do it and that they would not be able to survive otherwise. Whatever the explanation, the fact of the matter is that it is illegal.
The number one reason that business owners ought to avoid hiding their cash is the simple fact that they can be fined hundreds of thousands of dollars and face up to five years in prison. Title 26 USC 7201, “Attempt to evade or defeat tax,” states “Any person who willfully attempts to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof: Shall be imprisoned not more than five years, or fined not more than $250,000 for individuals ($500,000 for corporations) or both, together with cost of prosecution. The hard truth, however, is that there is no certainty in prosecution and most owners are willing to roll the dice and hope not to be audited. Truth be told, the IRS has extremely limited resources and the resources they do have are allocated to going after larger businesses where the return on prosecution is considerably greater. The lack of certainty of prosecution coupled with the immediate benefits of saving money creates an environment in which tax evasion amounts to pandemic proportions.
Business owners seeking to sell their business that have a history of hiding money encounter an uncomfortable quandary. Most owners want to capitalize on the true revenues of the business and expect to see a business valuation that incorporates the hidden income. These owners want the business broker to market the business based on the precise revenues. That is where things get a little precarious, as these owners strive to persuade possible buyers of the precise revenues. Sellers try to produce a second set of books or gross sales receipts to prove accurate revenues. The Seller is practically airing out their dirty laundry and nothing stops a disgruntled prospective buyer from reporting them to the IRS when a transaction falls apart. This is simply not a risk worth taking.
Sellers that hide their cash who are looking to sell their business will lose money in the end. Most buyers will not take into consideration revenues not identified on the tax returns in their offers and rightfully so. Most Sellers do not keep records of the hidden cash as they do not want a paper trail of their unlawful activities. Most businesses are valued as some multiple of cash flow or owner’s discretionary earnings. Here is a mathematical explanation as to why sellers who hide their cash will lose in the end. For this illustration we will use a business with a cash flow on the books of $250,000 and where the owner has skimmed off $100,000 hard cash. This means that cash flow number is reduced from $350,000 to $250,000. The owner saves on taxes at their tax rate. Let’s say the owner’s tax rate is 35%. The owner for that year basically saves $35,000 in taxes by skimming the $100,000 off the top. If an owner does that for three years straight they save $105,000. That may seem to be like a fantastic savings, but most business valuations take into consideration the last three years of financials. If we assign a multiple of 3 to the cash flow for a valuation, the Selling Price based on financials would be 3 x $250,000 = $750,000. Had the owner not skimmed money off the top the valuation would be 3 x $350,000 = $1,050,000. That is a $300,000 difference. The owner saved $105,000 only to lose $300,000 in the business valuation. That is a $195,000 loss! The loss is reduced somewhat by the taxes on the sale. If the $300,000 is taxed at the current long term capital gains rate of 15%, then the result is $300,000 x 15% = $45,000 for a total net result of $300,000 – $45,000 = $255,000. The owner still loses $150,000. $255,000 – $105,000 (skimmed money) = $150,000! Even if the $300,000 is taxed at the owner’s tax rate of 35% they still lose money. $300,000 x 35% = $105,000 for a total net result of $300,000 – $105,000 = $195,000. The owner still loses $90,000. $195,000 – $105,000 (skimmed money) = $90,000. Keep in mind that we set a multiple of 3 in this case. The loss to an owner will lessen and get closer to a wash as the multiple gets closer to a 1 multiple. Most decent businesses with a decent cash flow will sell higher than a 1 multiple and likely will be closer to 3 than 1.
In conclusion, business owners seeking to sell their business within three years ought to stop hiding their money. The risk associated with fines, penalties and jail, coupled with the simple fact that an owner will likely lose money or at least break even with the business valuation, is incentive enough to clean up the books and report all revenues, including the cash.