Tax evasion is totally out of control but creates investment opportunity

Recently, I've been looking to buy an existing small business in order to deploy some of my idle financial resources that have been sitting on the side due to inflated real estate asset prices. I've got investors lined up ready to invest in a business with me. All I need to do is find a business with an acceptable business model and decent financials.

I've had serious conversations with 3 or 4 businesses the last 2 months. In each case, I've been informed by the owners that they have been cheating on their taxes. I'm told that the tax returns don't reflect the financial strength of the business *wink wink*, and that all I need to do is to see their sales figures or spend a few days at the business to observe foot traffic.

As a result of this tax evasion, it's literally impossible for me to deploy traditional debt capital (e.g. SBA financing) into my acquisition strategy because existing documentation would not justify the asset price, hence traditional lenders would not lend. The IRS estimates that there is a tax gap of more than $120 billion a year from small businesses, which is outrageous. However, the result is that many otherwise successful businesses are listed for 30-45% cash on cash returns because they are so difficult to finance, which leads to some interesting potential outsized returns when the seller is willing to finance half the deal.

Anyone here have any experience dealing in these smallish businesses ($2 million or less of sales)? Any feedback or tales or horror or suggestions or warnings?

 

I definitely blame the government for creating perverse incentives with the tax system, but I'm also a strong advocate of the rule of law. I've been tempted to cheat on my taxes every single year. My bonus this year was paid to me literally in an envelope with a cashier's check inside, and I'm still going to report it on my taxes even though everything in me wants not to.

I've always credited the U.S., as a society, for being a nation where people (besides illegal aliens and ghetto rats) voluntarily submit to the law. Foreigners, for example, always seem amazed when they see how Americans obey traffic laws (more or less) and how drunk driving is frowned upon here and how public corruption (while it occurs) is literally unacceptable culturally (outside of the ghetto). So it's kind of disappointing to think that a disproportionate number of businesses are actually committing felonies with their financial reporting.

On the other hand, my sample size of 3 (4?) was an Indian, Hispanic, and Chinese guy. Maybe it's the new immigrants who have retained their cultures' dirty habits.

 
DCDepository:

On the other hand, my sample size of 3 (4?) was an Indian, Hispanic, and Chinese guy. Maybe it's the new immigrants who have retained their cultures' dirty habits.

you live in an alternate reality if you think thqat corruption is a cultural habit, it's penetrates every community, including North America.

 
down on the upside:
DCDepository:

On the other hand, my sample size of 3 (4?) was an Indian, Hispanic, and Chinese guy. Maybe it's the new immigrants who have retained their cultures' dirty habits.

you live in an alternate reality if you think thqat corruption is a cultural habit, it's penetrates every community, including North America.

It absolutely IS a cultural habit. You're in an alternate reality if you think otherwise. My best friend is from Bolivia. He marvels to this day that when drivers get pulled over in the U.S. they can't just whip out a $20 bill and be on their way. His uncle is equivalent to a what a U.S. Senator would be in America because of his uncle's close ties to the government. Russian billionaires, for example, largely got that way because of their connections to the government in the 1990's. In Greece, DUI is illegal, but it's essentially unenforced. Of course the U.S. has some corruption, but it's the fact that corruption and law-breaking are not culturally acceptable that separates the U.S. (North America at large and Western Europe) from many other countries and regions.

I'm sorry, but to think that there isn't a cultural difference in rule of law and corruption between North America and Eastern Europe, China, or Central and South America or Africa is asinine. Utterly asinine.

 

You seem like a nice, smart enough guy, but when you say things like this, it makes you seem in-experienced, vacuous, and stupid. You live in the N. VA/DC area, of course many of the small businesses will be hispanic/indian/chinese owned, as many of the white people in the area are more corporate. Go 10 miles South or West (or, god forbid, even more) of the beltway and you will see all the same small business habits you described being done by all people, whites included.

Aside from that, great thread.

 
youngunner:

You seem like a nice, smart enough guy, but when you say things like this, it makes you seem in-experienced, vacuous, and stupid. You live in the N. VA/DC area, of course many of the small businesses will be hispanic/indian/chinese owned, as many of the white people in the area are more corporate. Go 10 miles South or West (or, god forbid, even more) of the beltway and you will see all the same small business habits you described being done by all people, whites included.

Aside from that, great thread.

Right. I'm sure multi-generational U.S. citizens are as likely to cheat on their taxes as new immigrants. Right. I'm the one who sounds inexperienced, vacuous, and stupid.

 

Why do you have to eat it? Have they even shown you the unofficial numbers and if so how can you verify them? Their selling price should reflect their official numbers otherwise you're being taken for a fool IMNSHO.

There's a big difference, in this case legal, between arranging your business and incomes to get the lowest rate possible and flat out reporting false numbers.

 

I think the implication was that they were underreporting their income on their taxes. I talked to a guy today and he said he doesn't report any of the cash sales.

My point is, I'm not really ready to buy a business that tells me one thing on the P&L and another thing on the tax returns (in a manner that can't be reconciled), but if there are people willing to take the (calculated) risk then there could be some outsized returns to be had. I think if people are willing to roll their sleeves up and get dirty, they might be able to verify that the cash flow, in principle, is approximately what's being sold. In that case, they may have access to mis-priced assets due to poor financial reporting.

 

Just purchase at a slight premium to the valuation represented by the tax filings. If their tax filings are truly conservative, then the final purchase price should still represent a discount.

The higher lending costs can be recouped via good cash flow. Buy cheap, fix the tax stuff, and sell at a higher price.

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Yeah, that was another strategy I was thinking of. Once there are several years of operating history that are properly reported, then the business becomes marketable to a wider audience at a better price.

Dingdong, pretty much any business that makes sense where the lion's share of the work can be hired out but where I (as GP) might spend about 10-20 hours of work a week managing at a high level. Any ideas? I've been looking at laundromats, but their finances are a total mess. Same thing with dry cleaners and liquor stores. Spoke with a Verizon Store owner today, but same issue--guy is cheating his ass off on taxes, so it's a 100% cash purchase.

 
DCDepository:
I've had serious conversations with 3 or 4 businesses the last 2 months. In each case, I've been informed by the owners that they have been cheating on their taxes. I'm told that the tax returns don't reflect the financial strength of the business wink wink, and that all I need to do is to see their sales figures or spend a few days at the business to observe foot traffic.

Not saying that these guys are pulling your leg - but if I was selling a small business, looking to maximise price and happy to be a little loose with the selling story, I'd say this whether or not I was paying full taxes. More so if I was selling assets than equity (selling equity means new owner inherits the risk of tax audits).

I'd be hoping you revise upward your expected cash flows to account for unbooked sales, hence increase the purchase price.

Per @dingdong08's suggestion, ask them to show you the non-tax books and reconcile to bank statements, inventory purchases or something else. Otherwise, you could just be paying for sales that never existed.

Those who can, do. Those who can't, post threads about how to do it on WSO.
 
SSits:
DCDepository:

I've had serious conversations with 3 or 4 businesses the last 2 months. In each case, I've been informed by the owners that they have been cheating on their taxes. I'm told that the tax returns don't reflect the financial strength of the business *wink wink*, and that all I need to do is to see their sales figures or spend a few days at the business to observe foot traffic.

Not saying that these guys are pulling your leg - but if I was selling a small business, looking to maximise price and happy to be a little loose with the selling story, I'd say this whether or not I was paying full taxes. More so if I was selling assets than equity (selling equity means new owner inherits the risk of tax audits).

I'd be hoping you revise upward your expected cash flows to account for unbooked sales, hence increase the purchase price.

Per @Dingdong08's suggestion, ask them to show you the non-tax books and reconcile to bank statements, inventory purchases or something else. Otherwise, you could just be paying for sales that never existed.

Good reminder to make sure a contract is an asset purchase.

These guys are listing their businesses at "full cash flow" and when I request financials they say that the tax returns don't reflect reality as they underreport income. So they're basically offering to sell their businesses at gigantic mark-ups from their legally reported income. They aren't listing the business and then putting on the hard sell by saying that there is actually more money to be made--they are saying that they are cheating on their taxes so that I need to take their word that the business is stronger than their financials report.

My struggle is that I'm dealing with obviously unethical sellers, so I have little confidence that they aren't manipulating point-of-sale data or their own P&L inputs. By cheating on their taxes it poisons the well of trust surrounding their numbers.

I wonder if it's illegal extortion to audit their books during due diligence and then threaten to report them to the IRS if they don't lower their price…The IRS does have a nice reward for turning in tax cheats. Could be a fun and lucrative hobby.

 

They want you to pay a mark-up to reflect the "full value" of their businesses. This is what I was talking about, they should be the ones taking the hit on the deal (getting a price lower than the "true value") for under-reporting, as in it shouldn't cost you any more than their official numbers dictate irrespective of whether or not their actual numbers are substantially higher, otherwise you can't finance the deal or verify the value of what you're buying. They can't have their cake and eat it too.

 

I'm not surprised, though do you also find significant issues with how they run personal expenses through the business or pull cash out without reporting it?

I have to say that when I watch the profit, the show on CNBC, I always think about how great it would be to go in and build a business up. Then I see the horror stories on there, and here, about how operations go and it seems like more trouble than it is worth much of the time. Obviously since that is a TV show who knows how much of it is reality and how much is set up to make for good television. I'm not sure.

 

Figure out what the average profit margin for that type of business is and figure out what sales on a "typical" week are. For example, from talking to a couple Subway owners and doing some online research, the average Subway location has a 20-25% profit margin on sales. Seeing a location for sale with a 65% profit margin leads me to believe something is not right.

 
Best Response

I own a small retail business and have looked into plenty others for sale. It's very hard to trust the books and records of these businesses. Performance is often misstated unintentionally because the owners don't know shit about bookkeeping or accounting. When they're ready to sell they clean up the books in their favor (often on the advice of a small business broker).

Sales is usually the only number you can rely on (you should still verify as best possible). You can look at POS. Also check merchant account for credit card volume, then apply industry ratios to estimate cash sales (my biz is ~60% credit, ~40% cash), but our average transaction is under $10 (if avg trx is higher, the probably less cash sales). Sales and COGS are going to be the biggest things you want to find out. Check industry numbers, and ask for purchase orders/invoices to verify COGS. Also be aware if there are other elements that go into COGS. What you want to get is the gross profit number, then see how that compares to labor and overhead costs. Labor is often the most misstated cost. Many owners work 60-80 hours per week and that is not reflected in labor costs (and they'll tell you that the business is absentee-run, lol). Also, they may have relatives working there whose labor is not in the books.

Solely relying on industry margins (other than COGS) is not a good idea either. Margins are all a function of sales. Most small businesses have significant fixed (or relatively-fixed) costs and overheard. Low sales = shit margins, higher sales = okay margins. If you have a subway that does avg subway sales,~$450k, you will not even be close to 20-25% margin, think 5-10% max. And that's with the owner working their 40-60+ hours per week. Now, if you have a subway that does $600k, you're in a much better situation. With 33% higher sales, your fixed costs (rent, insurance, labor*, utilities, etc) as % are reduced drastically, freeing up margin at the bottom. *Labor is what I call a "relatively-fixed" cost. It goes down like crazy with higher sales. You get way more utility out of your employees. I'd be wary about buying any retail business with less than $500k in sales because the margins are usually shit.

As far as taxes, make sure when you buy the biz that you're not liable for any previous unpaid taxes should the IRS decide to go after the biz. The biggest concern: DO NOT UNDERESTIMATE YOUR INVOLVEMENT IN THE BUSINESS. I had a big surprise going from investment banking to managing minimum wage workers. Holy shit. WTF. You quickly learn why they make minimum wage. Managing these employees is the hardest part of the job. I could write a hilarious article about dealing with my employees (maybe I will when I have time). Shit breaks or goes wrong regularly, so someone has to make the decisions (half the time, I just have to tell my employees to unplug it and plug it back in, lol). For example, when the POS freezes or the internet goes down, who's solving that problem? The roof's leaking, Melissa didn't show up for her shift and nobody can cover last-minute, the door fell off the hinges, employees are fighting with each other, homeless guy is harassing the two girl employees who are working, customer complains, etc. The list goes on and on. If you're planning on being mostly absentee in day-to-day operations, you'll need more than just a regular manager, so you need to factor that cost into your analysis. The operations do get easier with experience, but that doesn't mean you'll get profitable. The other big concern: MAKE SURE YOU HAVE ENOUGH CAPITAL. You may be profitable, but with big loan payments, you may be cash flow negative. If you start running into capital issues, it's a downward spiral. I see this often. You start cutting corners, operations go down in quality, you have to spend more time at the biz, etc. If you're new to the industry or new to buying businesses, be very conservative and raise extra capital. If, in one year, it turns out to be too much, then pay some debt off early or return some capital to investors. It may hurt your ROI, but it's worth it. If capital gets tight, you're in a bad position.

 

You are going to find this kind of thing in every business, not just the small ones. The bigger ones are just more sophisticated about it. When I was in PE, even when we bought $800mm top line revenue businesses their taxes were rarely "in line" if they were founder owned. They wouldn't do something as stupid as not reporting income (that is a quick way to get sent to jail), but they would run everything and the kitchen sink through the business (child support, daycare, cars, golf memberships, housing, etc.), they would set up "shareholder loans" to get cash out of the business tax free, and things of that nature. Oh, and none actually paid their sales and use tax according to the letter of the law. Every time we audited that it came back as an "area that would need to be addressed."

That aside, to echo what others have said, dealing with small businesses is fairly difficult from an investment perspective. You basically need to go and count the cash in the register and match it against their books to be satisfied things are as represented. And don't forget, you're going to need someone to run the place, which will be difficult and could completely decimate your profit. If the business is making $200K / year as an owner operated business, adding a manager or "CEO" is going to take the profit down to a negligible amount. Just something to consider.

 
IlliniProgrammer:

If they can cheat the IRS, they can cheat you as well. Honestly a smart businessman would mark the business up X% to full value, then apply a fraudster discount of 1.5X.

Yep, you hit the issue on the head.

 

OP I'm not calling you stupid but having grown up in a family of small business owners, I can tell you first hand every small business that can lie to the IRS, does, every chance they get. Anything you look at with a cash business, they're under reporting, it's a fact, if there is no cash end i.e. construction or any kind of contracting etc. they still most likely do. They will most of the time run perfectly legit businesses through and through, right up until they get to what they tell the IRS, then they lie their ass off. I'd second the response from one of the previous posters who said to ask for the internal non-tax quickbooks, that is a real thing. Also just make sure your attorneys write up the contracts well so that you can reneg on the deal within a reasonable amount of time if you ended up buying something that was misrepresented, there's your ace in the hole, there is about a 99% chance you will have far better lawyers than them. The information is all asymmetrical in favor of them, but you're the one with the gold, so you make the rules.

Also you could wear a wire to the next meetings where they tell you that the tax forms are way off, then either rape them on the price or turn them in to the IRS and collect your reward. Now that I think about it you could make an entire side business doing that, just hire people to pose as prospective buyers and get the info that way and collect the rewards, there's your business!

Just a thought.

 

I underwrote commercial real estate and small and medium sized commercial/business loans for a top lender for over a year and ran a mortgage banking office for over 2 years as well. I've audited many small and medium sized business and real estate LLC and partnership financial statements and I can state unequivocally that the vast, vast majority of the businesses and LLCs and LPs I saw legitimately reported their income to the IRS. By no means do I believe that all or the vast majority of business owners cheat on their taxes like you state. With respect, I reject your statement. You can call me stupid or insinuate it or think it. I don't care. But thanks for the preface anyway.

 
kj5159:

OP I'm not calling you stupid but having grown up in a family of small business owners, I can tell you first hand every small business that can lie to the IRS, does, every chance they get. Anything you look at with a cash business, they're under reporting, it's a fact, if there is no cash end i.e. construction or any kind of contracting etc. they still most likely do.

This is not true. The easiest way to justify and rationalize what you're doing is to convince yourself that everyone else is doing it.

 
reformed:
kj5159:

OP I'm not calling you stupid but having grown up in a family of small business owners, I can tell you first hand every small business that can lie to the IRS, does, every chance they get. Anything you look at with a cash business, they're under reporting, it's a fact, if there is no cash end i.e. construction or any kind of contracting etc. they still most likely do.

This is not true.
The easiest way to justify and rationalize what you're doing is to convince yourself that everyone else is doing it.

About the methodology of rationalizing, you're 100% correct. I have many friends, clients, and associates who get around paying big amounts of their taxes one way or another, some if it legal, some of it grey area, some of it illegal. It's a fact, not my opinion.Tons of people do this. Do some homework, ask people who don't work in finance.

DCDepository:

I underwrote commercial real estate and small and medium sized commercial/business loans for a top lender for over a year and ran a mortgage banking office for over 2 years as well. I've audited many small and medium sized business and real estate LLC and partnership financial statements and I can state unequivocally that the vast, vast majority of the businesses and LLCs and LPs I saw legitimately reported their income to the IRS. By no means do I believe that all or the vast majority of business owners cheat on their taxes like you state. With respect, I reject your statement. You can call me stupid or insinuate it or think it. I don't care. But thanks for the preface anyway.

You misunderstood, one of the earlier posts said you were stupid, I was saying I disagree with that. And what someone will show to a banker vs. private money (not PE or any kind of fund) when looking for financing is night and day different, again same thing as above where this is very common. I'm not saying EVERYONE in the world does this, but your chances at throwing a dart and hitting one who does rather than doesn't is at least 50/50.

 

This is an interesting thread. Recently (2 years ago) I was part of a deal to buy a ~$1.8m small business, and I had the opportunity to get an inside look at the process from beginning (pre-acquisition due diligence) to now. I've also had the opportunity to talk to many other small business owners.

Here's what I've learned so far (similar to what has been said before):

  • Being an absentee owner or working ~20 hours is very hard (for most businesses), even with a good manager. YOU MUST SLEEP WITH YOUR EYES OPEN. TRUST NO ONE. Most people don't realize the level responsibility you have as an owner. The manager can take away some of the day to day supervision, but at the end of the day if ANYTHING happens to the business, YOU are responsible. And let me tell you SHIT WILL HAPPEN. Be ready to come in on a Saturday morning at 6 am. because your industrial freezer stopped working and now you have to wait 3 hours for the repair man to come fix it (and figure out what to do with all the spoiled/damaged inventory) or convince your manager to do it (good luck).

  • Almost all small businesses (I'd say 80%, across the board) engage in some sort of gray-area or tax avoidance behavior, whether this be paying some employees under the table, not reporting cash income, or deliberately delaying contractor or vendor payments for extended periods of time, etc. This is not to say that you cannot be successful or run a business without doing these things, but it is warning that this is how the game is played. Whether you like it or not, your (small business) competition is most likely engaging in these activities and that puts you at a disadvantage. It is also difficult to uncover this type of behavior with regular financial due diligence (i.e. audit for a bank loan) People get very creative.

  • Employee management is a bitch, especially low wage employees. Some shit I've seen: Employees randomly quitting (sometimes in the middle of the day) without any notice, employees showing up late to work or not showing up at all (without notice). Seemingly outstanding and personable employees turning around and stealing cash/inventory. Employees taking extended breaks/lunch or at times not doing any work at all... Also, my favorite, employees suddenly strangling other employees in a fit of rage, etc. etc.

  • You will need more cash/capital than you think. Shit will break, buyers won't pay, economy will tank, etc. etc. So many unforeseen costs. (Also, You must be aggressive in collecting and staying on top of accounts receivables) If you don't ask, people will not give.

 

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