Ask the owner of an owner-run business what tax the business pays, and the answer is often about the owner. The business is a pass-through, its profit is taxed on the owner's return, and the owner pays whatever the accountant says at the end of the year. What tax the business's operating profit bears on its own, as distinct from what the owner pays on it, has never needed an answer. Nor has the question of whether the business has started owing tax in places it has never filed: the states it now sells into, the state where a remote employee lives, the state where its stock sits in someone else's warehouse.
A buyer who models cash needs both answers. It values the business's operating profit after the business's own taxes, and it needs to know there is no tax bill it has not been shown. Tax Position establishes the tax the operating profit bears at the level of the entity, reconciled to the returns and free of unquantified exposure, so the buyer can compute after-tax cash flow from the business's own figures. Without that, the buyer uses a penal assumption of its own.
Where Tax Position sits
Two drivers take the business's cash to operating profit after its own taxes. This essay covers the first.
Cash conversion
- Tax PositionThis essayEstablishes the tax the business's operating profit bears, reconciled and free of unquantified exposure
- Entity StructureDraws the boundary of what is being valued: which entity holds what, and what is inside the sale
NOPAT
Cash taxes, reconciled
The starting point is three years of income taxes paid at the level of the entity, or on the entity's income where it passes through to the owner, reconciled to the filed returns and to the tax lines in the statements, with every difference scheduled.
Most of this is assembly. The bank records of every tax payment, the filed returns and the statements' tax lines for the three years are brought into one place, and every difference between them is listed with its amount and source. Some are timing differences or estimated payments, some are penalties, and some are taxes the owner paid personally on income the entity earned. That last kind confuses buyers more than any other, because the tax on a pass-through's profit appears nowhere in the business's own books. Once the tax can be traced from the profit to the return to the bank, the buyer has nothing left to doubt about what was paid, and the discount it would otherwise take for uncertainty falls away.
A rate the business can state
The memo then states the rate at which NOPAT is computed at the level of the entity. Where the entity pays tax itself, that is its effective cash rate. For a pass-through it is a notional corporate rate, with the basis for the rate written down, and NOPAT is shown for each of the last three years.
The notional rate can look like an invented number, so it is worth explaining. A pass-through pays no income tax itself, which leaves its operating profit untaxed at the level of the entity. A buyer still has to compare it with businesses that do pay tax, and has to allow for the chance that the business will pay tax after the sale, since many acquirers are taxpaying companies. So the operating profit is taxed at the rate that would apply if the entity were a taxpayer, built from the federal and state rates with the outside tax adviser, and the way it was built is written down. NOPAT is then computed in every monthly package as operating profit less tax at the stated rate over the trailing twelve months. A figure that has been reported every month for years carries more weight than one produced when a sale comes up.
What this changes is the size of the deduction. The tax line in the buyer's model becomes the business's documented figure, where it would otherwise have been the highest rate the buyer could justify.
Nowhere the business has not filed
The third piece is a study of where the business owes tax. It covers income and sales tax in every state where the business has sales, employees, contractors or property. The aim is a business registered and filing wherever it is required to be, with any past exposure settled or quantified and reserved, and no tax audit open without a reserve.
The tax adviser does the study. It tests sales by destination state, payroll and contractors by the state where they work, and property by location, against each state's thresholds. Those thresholds have changed in recent years, and in many states a business can now owe sales tax on its sales into the state without having anyone or anything there.
Can this create a filing obligation elsewhere?
Illustrative, and general rather than tax advice: the tests differ by state and by tax, and a tax adviser's nexus study is the only reliable answer. Guess, then select each to see why it matters.
Select each item to see the verdict.
Many states now tax sellers by their sales into the state, whether or not the seller has anyone there.
A worker in a state can create obligations for payroll tax there, and often for income tax as well.
Property in a state is a common basis for a filing obligation, even if the business has no staff there.
One brief visit rarely creates an obligation by itself, though regular visits or work done on site can.
People doing the business's work in a state can create a presence there, whether or not they are employees.
Whatever the study finds is then dealt with. The business registers where it should. Where past exposure exists, it pursues voluntary disclosure agreements in the states where they limit how many years back the state can look and how much it can charge in penalties. Anything that cannot be settled is quantified, with interest and penalties, and reserved. At each annual filing the sales and payroll data are tested again and any new state is added, which keeps the study from going out of date. A buyer reading it can see that no tax bill has been left out.
Why coming forward is cheaper
A business that discovers it has owed tax in a state for several years can wait and hope the state does not notice, or it can come forward. Waiting gets more expensive every year, because a state that finds the business can usually reach back over every year the obligation went unfiled and add penalties and interest to each.
Many states offer a voluntary disclosure agreement instead. A business that comes forward before the state contacts it can often limit how many years the state looks back, and have penalties reduced or waived. The terms differ from state to state, and they are open only to a business that comes forward first. That is the reason to commission the study before anyone else asks the question.
Coming forward, or being found
Illustrative and simplified, with interest left out: the terms vary by state. A business that discovers it owed tax in a state for years can wait to be found, and owe every year with penalties, or come forward under a voluntary disclosure agreement, which in many states limits how far back the state looks and reduces or waives the penalties.
In the illustration, $20,000 a year owed for six years, found by the state with a 25 percent penalty, costs $150,000 before interest. The same obligation settled under a disclosure agreement that looks back three years costs $60,000. The business can then show a buyer an exposure that is already settled, where the buyer's lawyers would otherwise have found an open one.
An audit already under way works the same way. An open audit without a reserve is a finding at the checkpoint, because a buyer cannot price an outcome nobody has estimated. Reserving the likely outcome, with the adviser's estimate and its basis, turns the open question into a known deduction.
What it does to value
The framework separates what this driver does to the business from what it does to the buyer's model. The gap between a penal rate a buyer might assume and the reconciled rate the business documents changes the buyer's NOPAT and therefore the price, but the business pays the same tax either way. The framework records that as a price effect and does not rank the driver on it.
Value, here, is cash. It comes from the penalties and interest avoided by registering and filing where the business should have been, and from exposure settled through voluntary disclosure for less than it was reserved at. It also comes from the valuation's downside case, a tax assessment after the sale, being cut to the quantified exposure, which moves probability from the downside toward the base case. Because only the avoided penalties and the settled exposure count as value, and most of the driver's effect is on price, it ranks seventh on the bridge.
What has to be in place first
The memo starts from the reconciliation of returns to statements already built under Books, and adds cash, rate and exposure to it, so three years of filed returns reconciled to the statements come first. An outside tax adviser has to be engaged and budgeted, because questions about where the business owes tax and what rate the entity bears are beyond what a bookkeeper or a compiling accountant should be answering. And the invoicing and payroll systems have to produce sales by destination and payroll by work location, or the study of where the business owes tax is a guess.
Knowing that it works
Progress shows in three places. The first is the years of cash taxes reconciled, out of three, with the unexplained difference in dollars. The second is the count of states tested, registered and filing, set against the states the study identifies. The third is the quantified exposure outstanding, settled or reserved, which should fall until none of it is unreserved.
The owner can be tested too. Asked without the adviser present, the owner should be able to state the business's tax rate and the reason for it in one sentence. Asked to list from memory every state the business files in, the owner's list can be checked against the study, and each state the owner leaves out shows where the owner's picture of the business is behind the record.
Why it slips, and what holds it
The risk is tax exposure building in new states as the business grows into them. Two habits guard against it. A nexus review is part of every year's tax engagement, which catches a new state in the year the business crosses its threshold. And tax payments and notices go to the finance seat and the adviser as well as to the owner, so a notice from a state the business did not know it owed is answered within its deadline by someone whose job that is.