I spend a fair amount of time talking with clients and prospects in the construction industry throughout our Ohio footprint. I enjoy this quite a bit, whether it’s talking about the industry in general or their business specifically. Of course, this time of year, one of the central themes is always taxes – be they federal, state, or local and I continue to run across some owners whose sole goal seems to be to pay as little in taxes as possible.
Now don’t get me wrong, I’m not advocating that we should ignore tax implications or not focus on utilizing proper tax structures and incentives – it is part of our business, after all! I’m all for making smart decisions in your business – but financial and capital allocation decisions should ideally be driven by the return generated (inclusive of taxes), not solely for the purpose of avoiding taxes.
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Here’s the thing: while spending money simply to avoid taxes can be sub-optimal, there’s a more important reason that this can prove to be problematic; it significantly reduces the value of your business.
Here are a few ways in which this becomes apparent:
- Reduced access to capital – For most financing providers, cash flow is king. Artificially reduced financial statement earnings or significant book/tax differences create a reduced ability to access capital for expansion or an owner liquidity event (i.e. ESOP, management buyout) – be it through a line of credit, equipment & real estate debt, or term debt based on enterprise value.
- Reduced valuation of business – Many events or transactions require an independent third party Valuation or Quality of Earnings report. Again, “managed” or reduced earnings will negatively impact the results of these third party findings in a material fashion.
- Reduced bonding capacity – Surety capacity is often a function of working capital and/or net worth. Investing in excess equipment or artificially reducing earnings to reduce tax liability will negatively impact both of those balance sheet measures. Furthermore, most bonding agents and underwriters I know don’t enjoy having to advocate for why an otherwise strong performing contractor shows artificially modest financial statement earnings.
At the end of the day, “managed” financial statement earnings or an overly aggressive use of tax deductions (which creates significant book/tax differences) often create more harm than good. Yes, you’ve accomplished the goal of reducing your tax liability, but this has been done at the expense of de-valuing your business in some fashion. More than once, I’ve seen this come home to roost when the construction contractor wants access to capital or is planning for some transfer of ownership. While a case can be made that ‘discretionary items’ should be added back to accurately reflect the true performance of the business, these ‘add-backs’ are rarely given full credence by third party evaluators.
What’s the best practice? If you’ve read or heard me in the past, this will sound familiar: have a joint discussion with your CPA, finance provider, surety, etc. to outline your goals and discuss the best path for creating the value in your business that you desire in the long run.
If your providers aren’t thinking holistically like this on your behalf, give me a call at 614.314.5937 to discuss.