San Francisco Bay Area :: Business Sales, Valuations, and Advisory Services for Privately Held Companies

Under-Reporting Comes Under Fire

What is the true income of an independent business? This is a question of interest to many parties--including prospective buyers, investors, and lenders--but nobody is more determined to know the answer than the Internal Revenue Service.

What makes the "truth" about a company's income so elusive? Isn't this what financial record-keeping is all about? Yes and no. Business owners have been known to go from minor figure-fudging to major-league cheating, in an effort to lower the amount of income necessary to report to the IRS in any given fiscal year. In fact, the IRS estimates that two out of three business owners regularly under-report income.

"Unreported income" is the official phrase for this practice; however, in the trade, the word often heard is "skim." It sounds light, healthy, and maybe good for you. But is it? Consider an item from a newspaper in a typical Main Street town, bearing the headline "Business Owners Sentenced":

Two Myrtle Beach business owners were sentenced in federal court in Florence [S.C.] for not declaring money received from poker machines in their bar on their income tax returns, according to a statement by the US Department of Justice.

Roy Gipson of Charlotte and Ann Willis of Myrtle Beach, former operators of Players, a sports bar in the Galleria Shopping Center, were indicted by the federal grand jury in September. They pleaded guilty in October to filing false income tax returns.

(Sun-News, Myrtle Beach, SC)

This is a depressing story, resulting in the sentencing of one of the defendents to three years' probation, three months in a halfway house, several months of home detention, and a $5,000 fine payable within six months. The second defendent was sentenced to three years' probation, two month home detention, and 400 hours of community service. All this for a little poker-machine skimming? How was anyone to know? How did anyone find out?

It's the story behind the story that should really catch the attention of business owners. And especially of potential business sellers, because the unreported income in this case was discovered by IRS agents who went undercover, in "disguise" as typical business buyers.

The undercover agents, acting as any savvy prospective buyer would, wanted a close look at the true worth of the business in order to make an informed "offer." The sellers were happy to comply, and readily admitted that they were not declaring on their tax forms money received from poker machines that had generated more than $120,000 over a two-year period. Truth, in this instance, did not set its tellers free. Business owners are often tempted to have it both ways--under-report to the government, and then, to sellers, reveal that the news is much better than it looks. The Myrtle Beach bar owners are not the only ones who have been tempted to slant the worth of a business in two different directions at the same time. This practice, although illegal, is not uncommon. And when "everybody does it" becomes the perception, even the most reputable, otherwise law-abiding citizens can get caught in their own trap.

As one Delaware restaurant owner of 20-years' excellent standing in his community says, "I made more than a decent income which I disclosed on my tax return. However, over and above my regular salary, I also skimmed a geat deal of unreported and untaxed cash for myself and some of my employees. I always thought that most people do it and if I got caught, I could just pay the IRS the taxes due plus some interest and penalties." Instead, when it came time for the restaurateur to sell his business, he disclosed its true worth to prospective buyers who turned out to be--yet again--undercover IRS agents. The restaurateur says, "Without my knowledge, they tape-recoreded everything I said. You have no idea what it is like to hear your own voice on a tape recording. I never knew the IRS conducted undercover operations." He adds, "I thought that very few people go to jail for committing tax crimes and those that went to jail were mostly organized crime figures and drug dealers. I now find that sixty percent of all the people committing tax crimes go to jail. They generally serve between one and three years. I am now waiting to be sentenced, but whether or not I go to jail, by the time I'm done paying the taxes, interest and penalites, for every one dollar I skimmed, I will have to pay the IRS three dollars." (This business owner is presently serving a six-year prison sentence.)

Even if a business owner who skims escapes being caught by such a sting operation, he or she will still face a dilemma when it comes time to sell. Whether or not business owners have made the immediate decision to sell, they should prepare for the future by building the image of a successful business. The picture they have painted for the IRS is not likely to be admired by buyers, who will want to pay only for what is reflected on the books, including what is revealed by the tax return. The seller may think it's possible to set a fresh scene for the buyer--one based on the theme of potential; however, buyers will be far more impressed by proof of a good track record.

Here are some suggestions to sellers for unveiling hidden profits and putting them where they will do the most good--in front of prospective buyers:

• Think Ahead. Remember that the future is now, and set your mind on long-term instead of short-term benefits. Show maximum profits for each quarter.
• Take a Step Back. If necessary, look back on the previous months' financial records and work toward showing the truest--and hopefully, the best--profit situation.
• Delve Into the Past. Go even further back and reconstruct records (without showing "skim") that reveal the legitimate profit situation over a meaningful period of time.
• List Tax-Deductibles. Make a separate list of salaries, and of fringes and perquisites that are tax-deductible and that provide a current benefit to the business.

And don't forget--it won't be only the buyer who will be impressed by true profits. Loan underwriters and potential investors will be more apt to show favor. And the IRS will send its agents-in-disguise to somebody else's door.

Copyright 2007 Business Brokerage Press