Published May 07, 2011

The Importance of Tax Return Due Diligence

By Scott Dickes

A business owner recently asked me, "Why do you need to meet with my accountant and review the tax returns?"  It's a good question.  Why review both the financial statements and the tax returns?  Isn't this a duplication of effort?

The answer is that the reconciliation between the two is a material aspect of due diligence.  Tax returns are often more reliable than internal financial statements.  They are prepared with an eye towards being audited by the IRS instead of just for internal use.  The exercise sometime brings to light useful information.

I'll give you a recent example.  During negotiations, the owner of a business said his salary was $100,000 and that he wanted to continue that going forward as an employee of Newco.  This made sense to us and we agreed.  We entered into a letter of intent based upon the company's income statements which we assumed included the $100,000 salary.  But what we learned after reviewing the tax returns was that the owner's $100,000 salary was in fact a distribution and as a result the $100,000 cost was not included in the income statements.  So our understanding of the cash flow of this business was overstated by $100,000.  Said another way, the $100,000 salary lowers EBITDA by $100,000.  Using a 5X multiple, this equates to $500,000 of enterprise value.  Not a small number.  The owner wasn't intentionally trying to mislead us, but without digging in and comparing the income statements to the tax returns this may have slipped through.