One day I had a meeting with a deli owner in Manhattan. Their real (not tax-disclosed) numbers per annum follow (numbers are approx.):
Gross revenue: $2.55 mil
Total Expenses: $2.3 mil
Net Income: $250,000
Based on its type and location, the business is valued at 2.5 times SDE (seller's discretionary earnings); and so valued at
$250,000 * 2.5 = $625,000.
Unfortunately for the owners, they were recently audited by the state for underpaid sales tax and imputed with a tax payback of $550,000; thus leaving the owners with $75,000 in net proceeds ($625,000 - $550,000 = $75,000) if the business were to sell at market value. To make matters worse, the owners wanted $850,000 gross (3.4 * SDE) as to net $300,000, and thus were requesting above-market price for their business. Accordingly, no VCs or investors entertained their unreasonable offer.
I asked the owners a few personal questions to ascertain their personal finances. Combined they had over one million in personal assets, and thus were unable to file a Chapter 7 bankruptcy to extinguish the sales tax in three years. The owners were genuinely saddled with this tax debt.
As most entrepreneurs know, it is almost impossible to ascertain the genuine financials of a cash business, as most revenue is undisclosed. I sent an employee to the deli who sat by the register to check the numbers they were alleging for three weeks. I then made the owners an offer:
Guru: You do understand that no investor will buy this company from you at 3.5 times earnings. Further, your $550,000 sales tax liability will accrue interest at 9% per annum plus penalties. In the next two years, you will owe the state $653k plus penalties leaving you close to $700k. My offer to you is $750,000, and will be my only and final offer.
The owners stated they would get back to me. Two days later, they came back to the office, and agreed. But I was not yet finished:
Guru: You do understand my $750,000 offer is above-market. We are all reasonable people. Accordingly, I do have one caveat. My offer is conditioned upon reaching a tax settlement of less than $150,000 on the $550,000 you owe within 120 days. And so if the $150,000 tax settlement is reached, the sales price of the business will be $200,000 net proceeds to you plus the amount of the tax settlement, totaling $350,000.
Owners: But that is ridiculous! If it were possible to settle this tax, don't you think we would have done it ourselves?
Guru: I’m not negotiating this caveat. It’s final. You will be saddled with $700,000 in sales tax debt in two-years time otherwise, which you don’t have. You can't file for bankruptcy protection. You will not sell this business otherwise. If you want to think about it, and get back to me, that’s fine. But that’s my offer.
The owners took a week to chew on it. And returned:
Owners: We accept your offer, but on one caveat in return: If you were to settle the tax, we split the tax savings 50/50 which we will adjust toward the sales proceeds.
Guru: As I had stated, that is my best and final offer. Not interested otherwise.
They tried. Lol. They then accepted my offer.
I prepared a contract of sale conditioned upon the sales tax being settled, and held the sales proceeds in escrow. I then called the state tax dept:
Guru: Yes, I just purchased XYZ Deli, Inc., and I noticed you have an alleged sales tax imputation of $550,000. I am not paying it, but I do wish to settle with you. Can we arrange a meeting to discuss this further.
A meeting was scheduled two weeks later at my office. When the two tax agents arrived, at first I talked “shop.” I offered them coffee and donuts. I befriended them. I make a few jokes. Lightened up the room. And then the negotiation:
Guru: Guys, thanks for coming. Could you please tell me how you arrived at this tax imputation of $550,000?
Tax Agent 1: Well we audited the owner and calculated his average daily taxable gross revenue at $7,100, annualized at $2,527,600, off a sales tax rate of 8.875% equals $225,000. The owner only paid $41,000 per year, leaving him at a $184,000 annual deficit. We go back retroactively for three years, so we have imputed a total $550,000.
Guru: Now that’s a lot of money! (I state with a smile).
Tax Agents: Yes (they chuckle).
Guru: Could you tell me exactly how you ascertained this average daily taxable gross revenue of $7,100?
Tax Agent 2: We sent an auditor there for one day and verified his intake and gross receipts.
Guru: Hmm, one day. <Pause> Let me see if I understand this correctly. <Pause> You sent an auditor there
for one day, and based off his taxable sales for
that one day, you imputed tax retroactively for
1,095 days?(Stated very slowly).
Tax Agent 2: Well, yes.
I pull out a sheet of paper.
Guru: Gentlemen. Here is a list of seven construction sites in a four-block vicinity of this deli. It's quite the coincidence that XYZ deli's revenues have increased over 500% in the past eight months as the majority of its customers now are construction workers, and the gross receipts you audited were indicative of this increase. Accordingly, you cannot retroactively tax a business three years back for revenues not generated, nor is there statutory or case law demonstrating you can.
The tax agents looked surprised.
Guru: My offer to settle this matter is 10%, $55,000, which is a generous offer, because as demonstrated XYZ, Inc. paid the tax dept $41,000 a year for the past three years, which is exactly 8.875% of the taxable revenue it generated.
Tax Agent 2: OK, but what about the last two quarters that XYZ, Inc. underpaid the sales tax.
I was thinking at this point, “Wow, that was easy!”
We ended up settling at $75,000, a 13.6% settlement.
My total cost was the $75,000 tax settlement, $200,000 net proceeds to owners plus several thousand in administrative costs totaling $278,000.
I held the business for four months profiting another $62,000 in net income, and sold the business at a discounted price of $550,000, lien-free, totaling $612,000 gross minus the $278,000 investment--a $334,000 profit.
Take-Home Lessons:
1. Don’t create such rigid rules within your business stratagem that you miss opportunities disguised as distressed dogs.
2. Keep a great percentage of your assets liquid (index-funds, conservative stocks) to take advantage of business plays when they are made available.
3. If you are already consulting with businesses daily, assiduously study their infrastructure and financials to see if any opportunities arise where you—or--you and they may capitalize by out-of-the-box thinking.
4.
Diligently study and understand the federal, state, and local laws relating to bankruptcy, taxes, regulations, and licensing to be fully equipped when opportunities do arise.
