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Why Are "Identifiable Earnings" Important for Business Ownership Transitions?

What are identifiable earnings? They are earnings that are, well, identifiable on the income statement of a business. You can look at revenues and expenses and see a bottom line with earnings. This is a level of earnings that has absorbed all appropriate compensation for owners and others. These identifiable earnings are capitalizable and create business value. The concept is pretty simple.

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Business 1. An owner is interested in transferring ownership to his son. However, last year, on some millions of revenue, the business showed a small net loss. The father knows the business is profitable, because he owns the building the business occupies, and the rental payment is substantially above market. Working with his accountant, the business owner has taken significant additional steps to insure that the company pays minimal taxes. This company is probably reasonably profitable at some level, but dad is having a pretty hard time convincing son that he can afford to pay some millions for the business. Its earnings are not identifiable.

Business 2. This is a larger business in a state with an income tax on dividends or distributions from businesses. To avoid paying this income tax, the business has paid out almost all earnings in the form of bonuses to it's owners and other employees. This policy creates a problem. There is no real "bottom line" that separates the returns to labor, i.e., compensation, and the returns to capital, i.e., identifiable earnings. This might seem like a simple problem to correct, but it is not. Future owners need the certainty of distributable, identifiable earnings. Absent a history of a clear separation between returns to labor and returns to capital, it is difficult to transition ownership, because future owners are skeptical of the real level of earnings. They are not identifiable.

So we have two companies whose owners are driven by a desire to minimize taxes. Unwittingly, their tax minimization strategies are value-hiding strategies in disguise. Both companies can recover and their underlying values can be revealed, but it won't happen overnight. It will take time for the future owners of these businesses to have faith that the earnings they are buying are, indeed, identifiable earnings.

You might think that we could simply normalize the earnings in Business 1 and Business 2 and have identifiable earnings right away. We could. However, the son in Business 1 has to believe that the earnings are real and that will take some time while dad and his accountant unravel things, some of which will likely have adverse tax consequences. The future owners in Business 2 also have to believe that the normalized earnings are real. Belief follows action and often with a long lag time.

Are the earnings in your business identifiable? Are you clear regarding what portion of the revenue stream compensates you and your fellow owners for their labor and what portion is a return on your investments in your business? I've often said, there are worse things in life than paying taxes. If you pay taxes on your company's earnings, no one will question them. They are identifiable earnings and the only kind of earnings that buyers will pay for are identifiable earnings.

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Posted in Cleaning Services Post Date 07/29/2018


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