Income
Approach:
We are going to begin with the Pretax Net Income line from your most
recent federal income tax return (Schedule C-Line 31, Form
1120-Line 28, Form 1120s-Line 21. On your worksheet, enter your
pretax income. On the next line enter your Officer
Compensation (Form 1120 & 1120s only); on the next line enter
your Depreciation expense; the next line add your Interest Expense.
Enter these addbacks for each of the past 3 years. If you have Excel on your computer and you want to use an Excel template that's already set up for this, Download it here. Your worksheet should be starting to look something look like the
example below: |
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| Pretax
Net Income: |
$37,000.00 |
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| Addback
- Officer's Compensation: |
$60,000.00 |
|
| Addback
- Depreciation Expense: |
$8,750.00 |
|
| Addback
- Interest Expense: |
$1,875.00 |
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| Total
so far: |
$107,625.00 |
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| Now we will look for the less obvious types of addbacks. Go through the expenses shown on the front page of your tax return, as well as the detail page which shows your company's Other Deductions. As you go through each line item, try to identify any personal related amounts that might be included in these expenses. You may want to try to calculate actual dollars or just do some percentage estimating here.
Examples of personal related addbacks which we see regularly are things like: Only about half of the amount of Auto Expense charged to the business is actually business related (the rest may include the operating costs for other vehicles driven by family members); or, only about a third of the amount of Travel & Entertainment is actually business related; or, much of the amount shown for Office Supplies is actually spent on items for your personal use; or, Inventory converted to personal use; or, Telephone & Utility expenses (from your home) are charged to the business; Insurance coverage (life, health, auto) for your entire family that is paid by the business, etc.
For purposes of illustration, we will create some of these types of addbacks here for a hypothetical business and include them with the addbacks which are shown above:
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| Pretax
Net Income: |
$37,000.00 |
|
| Addback
- Officer's Compensation: |
$60,000.00 |
|
| Addback
- Depreciation Expense: |
$8,750.00 |
|
| Addback
- Interest Expense: |
$1,875.00 |
|
| Addback - 40% of Travel Entertainment: |
$6,000.00 |
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| Addback - Personal Insurance: |
$3,000.00 |
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| Addback - Personal Auto Expense: |
$4,000.00 |
|
Addback
- Salary for family members
(not active in the business): |
$10,000.00 |
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________ |
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| Total Discretionary Earnings: |
$130,625.00 |
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| Discretionary Earnings of $130,625 are quite a bit different from the the Pretax Net Income of $37,000 that we started out with. Now we are seeing the cash flow available to the Owner of the business. In technical terms, we have calculated the pretax, debt-free earnings of the business that are available to the Owner. This exercise illustrates a few of the various types of expenses that are routinely run through businesses by Owners.
There is one important point that needs to be stressed at this point; all of your personal addbacks should be provable. A prudent business buyer is not likely to accept all of your adjustments on faith. If your run a lot of personal expenses through your business, keep records of these expenses. If you are under-reporting your business revenues and taking cash straight out of the business, you are only diminishing the the earnings that would be used in a valuation; not to mention the fact that the IRS would probably like to discuss this with you. |
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