Is Reducing Stock for Tax Reasons Always a Smart Idea?
Is Reducing Stock for Tax Reasons Always a Smart Idea??
Not If You’re Thinking of Selling!
With End-of-Financial-Year just around the corner,?conventional accounting advice is most likely directing business owners to reduce their tax exposure.?There is nothing wrong with that unless you are thinking of exiting or selling your business in the short term.?If you are, there is one tax-reduction practice that can dramatically reduce your selling price. And, unlike other below-the-line, one-off and discretionary expenses, this is one that neither your business broker nor your accountant can "add-back".
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What is it?
STOCK.
Not every business has stock (inventory) of course, but many do, and ending the financial year with high stock levels strikes fear into the hearts of many business owners.
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Why?
Because effectively, they will "pay tax" on every dollar of stock. The higher the closing stock level?in the trading account, the higher the gross profit, and potentially the higher the taxable profit.
But when it comes to putting your business up for sale, the asking price is most often determined by a Multiple of Net Profit. Let's say the multiple is 2.5. This means for every extra $1 of net profit, you can add $2.50 to your asking price.
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Compare this to your Potential Tax Savings
If your business' profit is taxed at 25% (30% if you are not classed as a "Small Business"), then for every extra dollar of taxable profit you make, it will cost you 25 cents. On the other hand, if you are selling your business in the short term (1-3 years), every extra dollar of taxable profit you make might earn you $2.50!
Reducing stock levels just to minimise tax exposure is not always wise if you are planning to sell, as it directly impacts your Net Profit.
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You might be thinking about running stock levels down in order to make it “easier” to find a buyer for your business. This might be reasonable if:
- You can dispose of old, damaged, or poor-performing stock – a big bugbear in the due diligence phase of selling and a source of disputes when under contract.
- You can do so without compromising your Gross Margin. If selling off stock means you have to take a dive on your margin, then you might compromise the overall value of your business, no matter what the revenue. Remember: buyers buy profit, not revenue.
Some business owners are tempted to under-report or short-report stock in order to reduce their tax exposure. This is against the law, but believe it or not, we do see this much more frequently than you would think. This practice will reduce the market value based on a multiple of Net Profit.
Let’s look at the example in the tables below:
Scenario A?(LOWERED STOCK)
Sales ? 500,000 ? ??
Less: Cost of Sales ? 180,000 ?
(Opening Stock 40,000 + Purchases 160,000 - Closing Stock 20,000)?
= Gross Profit ? 320,000 ?
Scenario B (NORMAL STOCK)
Sales ? 500,000 ? ??
Less: Cost of Sales ? 140,000 ?
(Opening Stock 40,000 + Purchases 160,000 - Closing Stock 60,000)?
= Gross Profit ? 360,000 ?
As you can see, there is a difference in Gross Profit of $40,000. If you put this into a sample Profit and Loss (see below) and calculate a Market Value based on a multiple of 3x Net Profit, the difference can be significant.
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Scenario A (LOWERED STOCK)
Gross Profit ??320,000
Less: Expenses ?160,000
= Net Profit ?160,000
Appraisal Value (@ 3x) = $ 480,000
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Scenario A (LOWERED STOCK)
Gross Profit ??360,000
Less: Expenses ?160,000
= Net Profit ?200,000
Appraisal Value (@ 3x) = $ 600,000
So, while reducing stock and saving tax may be tempting?if you are serious about fetching the best price for your business, it will always pay you more to maintain your profit.
Alternative Methods to Help Reduce Tax Exposure
So how can you end the year with a high stock level, still reduce tax but maximise profit to be able to set a premium price on your sale?
Your first step should be to discuss this with your accountant, but from a business broker's point of view, there are many actions you can take that will not affect the calculated market value. These could be (but are not limited to*):
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Pre-payment of rent for the following tax year. This is easily added back, and any pre-paid rent still in credit will be charged to the new owner as a disbursement at settlement.
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Some capital expense that enjoys a 100 % write-off in the current year. Standard practice for minimising tax, yet in many instances a broker can add this back if it is not a true reflection on the operating costs of the business e.g.:
- Discretionary expenses: Donations; gifts; justifiable owner's expenses reimbursed by the business - this is where a discussion with your account can pay dividends.
- One-off expenses. In particular those that will improve the salability of your business, e.g. New logo; repainting; landscaping. Any one-off expense not related to the ongoing operational costs of running the business can be justifiably added-back.
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Of course, these types of actions potentially involve spending some money, whereas running down your stock does not. Just keep in mind that neither we, nor your accountant, can go back into your balance sheet and "add-back" your stock.
If you are considering selling, we recommend talking to both your accountant and an experienced broker to determine where your current multiple sits for your business and in your industry.
Once you know that, the rest is a simple matter of maths!
PS. If you are curious as to what your business might be worth, ask me for an in-depth appraisal.?You’ll receive a written comprehensive report, benchmarked against similar businesses sold by LINK, utlising LINK’s unique industry-leading appraisal tool, our extensive database and specialist brokers.
And yes, it’s free, with NO obligation. Just ask.
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*LINK does not provide accounting advice. These are suggestions only, and we recommend you discuss your specific situation with your accountant. If you do not currently have one, we are happy to provide a list of accountants we deal with on a regular basis (we have no financial relationship with these providers, preferring to offer you your own free choice).
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