Key Insight
Net income is what the business reports to the IRS. It's designed to minimize tax liability, not to tell a buyer what the business actually earns. Always start with net income — but rarely stop there.
Why Net Income Understates True Earnings
Small business owners optimize for tax minimization, which means:
- Owner compensation is maximized (legitimate tax strategy; legitimate add-back)
- Personal expenses are run through the business (legal with proper documentation; add-back with receipts)
- Large deductions are taken in profitable years (bonus depreciation, Section 179)
- Timing of income and expenses is managed to reduce taxable income in high years
All of these legal tax strategies reduce net income below the true economic earnings of the business. The normalization process — adding back legitimate non-recurring and owner-specific items — converts net income into SDE or EBITDA.
Net Income on Tax Returns vs. Financial Statements
Tax return net income and P&L net income often differ due to:
- Depreciation methods (MACRS on tax returns vs. straight-line on financial statements)
- Timing of income and expense recognition
- Bonus depreciation and other elections available only for tax purposes
Buyers should request both tax returns and independently prepared financial statements — and reconcile them. Significant discrepancies warrant explanation.
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