Tax burden... am I doing this right?

October 17, 2020

by a searcher from Full Sail University in Milwaukee, WI, USA

Trying to answer a sellers counter to my LOI, and want to make sure I'm really solid on how the taxes would work since margins are getting thin. Does this read correctly? Labeled across the top for help interpreting.

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Reply by a searcher
from Harvard University

I don't think depreciation and amortization are ever reflected in SDE--SDE is a pre-tax cash flow number, and D&A have nothing to do with cash flow. And to highlight Ron Buck's point, generally you're going to have far more D&A deductions than the seller. Seller will have depreciated or expensed equipment as it was purchased over the years, and if they started the business they have no goodwill to amortize. You will get to expense the entire value of capital equipment in year 1 under section 179 (depending on the business, a potentially massive tax savings) and then get to expense the amortization of goodwill over 15 years. But to the extent that the business requires capital equipment, you will have to replace portions of that every year, which will further reduce your cash flow (but also your tax burden). Also note that the allocation of the purchase price between hard assets and goodwill is an important part of the purchase agreement--both parties must agree and file forms with the IRS. You will want a bigger portion allocated to hard assets (which you can immediately depreciate); seller will want a larger portion allocated to goodwill. This can sometimes upend a deal if no one has thought about it in the initial agreement.

Reply by a searcher
from Harvard University in Plano, TX, USA

Once you've factored in D&A to get your EBIT, called "Equity earnings" in your sheet, you are correct that interest will reduce taxable earnings. After you pay interest and tax, you get net earnings. To calculate your free cashflow (I think this is what you were aiming for in your final column), you will then need to deduct the principal portion of the payments on the 2 loans (SBA + seller note) as well as capex and any change in net working capital from year to year.

In the first 3 years, since the seller note is interest only, that means the principal portion is $0. For the SBA loan, you will need to split out the interest and principal portions. You can use the IPMT and PPMT formulas in Excel.

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