The Tax Return Test: How to Outsmart Sellers with Shady Cash Claims

So, you're about to buy a business, and the seller is sweet-talking you about all the unreported cash they've been pocketing over the years. “Hey,” they say, “the business is actually making way more than the tax returns show!” Tempting, right? Wrong. Before you fall into that trap, let’s have a little chat about why those tax returns are your new best friend.

The Myth of the P&L: It's Like Believing in Unicorns

Profit and Loss Statements (P&Ls) are like that one friend who always tells you they’re going to the gym but somehow never lose a pound. Sure, they look nice on paper, but are they telling you the whole truth? Probably not.

- Easily Manipulated: Sellers can twist P&Ls like a balloon animal to make the business look like it’s booming. Don’t be fooled by those pretty numbers.

- Lack of Consistency: P&Ls are like snowflakes—no two are alike. Try comparing them can be challenging.

- Non-GAAP Practices: Many small businesses don’t follow the rules. They do their own thing, which might involve some creative accounting that doesn’t exactly scream “reliable.”

Tax Returns: The Unmasking of the Real Business

Now, let’s talk about tax returns. If a seller tries to tell you the tax returns don’t reflect the business’s “real” income, it’s time to raise an eyebrow—maybe even both.

- Accuracy and Verification: Unlike P&Ls, tax returns are the real deal.

- Standardized Format: Every tax return follows the same structure, so comparing them is as much easier.

- Debt Service Calculation: If you’re planning on getting a loan to buy this business, the bank will look at the tax returns, not the P&L. They trust the tax returns because they show what the business really earns—according to the government, anyway.

The 'Oh So Honest' Seller: A Buyer’s Cautionary Tale

Imagine this: You're sitting across from the seller, and they’re bragging about how they’ve been skimming off the top for years, stashing away all that unreported cash. They think they’re clever, but guess what? The IRS doesn’t know about that money, and as far as you’re concerned, neither should you.

So, you smile politely and say, “Well, it seems like you’ve already gotten your benefit by shortchanging Uncle Sam. I’m here to buy a business, not a pipe dream, so I’ll stick to what’s on the tax returns, thanks.” Watch the color drain from their face as they realize their little scheme isn’t going to fly.

Why Banks Only Dance to the Tune of Tax Returns

Banks aren’t in the business of taking risks—they leave that to people who buy lottery tickets. When it comes to financing, they use the tax returns to figure out if the business can actually pay back the loan. The calculation they use is called the Debt Service Coverage Ratio (DSCR), and it’s all about real, reported income.

- DSCR: This little number tells the bank whether the business is making enough money to cover its debts. The higher, the better. And guess what? They calculate this using—you guessed it—tax returns.

How to Avoid Getting Played

- Review Multiple Years of Tax Returns: Look at the last few years (3-5 years) to spot trends and make sure the business hasn’t just had a one-time lucky break.

- Cross-Check with P&Ls: Sure, P&Ls can give you some extra details, but always double-check them against the tax returns and bank statements. If they don’t match up, it’s a big red flag.

- Bring in the Pros: Hire a CPA or financial advisor to comb through those tax returns with you. They’ll know exactly what to look for—and what to watch out for.

Conclusion: When in Doubt, Trust the IRS (But Maybe Not the Seller)

At the end of the day, tax returns are your best defense against buying into a fantasy. The seller might have pulled one over on the IRS, but don’t let them pull one over on you. Stick to the tax returns, and you’ll be much more likely to make a solid investment. Remember, you’re not just buying a business; you’re buying its history—and the tax returns are the most reliable record of that history.

So, the next time a seller starts spinning tales about unreported cash, just smile and say, “That might’ve worked for the IRS, but it’s not going to work for me.”

Besides, if a seller can lie, for years, to the IRS, are they really someone you can trust? Unreported cash is not only illegal but it’s a pretty good indication of the character of the seller so beware!