Add-Backs and Seller's Discretionary Earnings (SDE) for a Sale

What are add-backs and seller's discretionary earnings (SDE), and who defines them?

An add-back is a cost in your books that a buyer would not carry after the sale, put back into profit. Seller's discretionary earnings (SDE) is the total: profit, plus one owner's pay and benefits, interest, depreciation, and the personal and one-time costs a buyer would not inherit.

SDE is a market term that business brokers and buyers use to compare owner-run businesses. It is not a tax-return figure, and the SBA lender manual does not define it. Treat it as common practice, not a rule: the buyer or lender decides which add-backs it accepts.

The lender's test is stricter than the label. For an SBA 7(a) loan to buy a business, the manual has the lender justify each adjustment to the business's cash flow in writing, and an adjustment without that support is ineligible. Banks outside the SBA programs set their own tests; the manual shows what one large program asks.

Buyers and lenders accept an add-back they can trace: one row per item with the year, amount, account and a document, starting from the profit on the filed return. That restated profit and loss statement (P&L) is the recast.

What makes a case not simple: a broker, buyer or lender is asking for SDE or a recast P&L, and your books show any of these: personal costs deducted on filed returns, family members on payroll, cash sales that never reached the bank or a return, an S corporation owner paid a low wage, or books that are behind or do not match the bank. Each is a judgment call worth settling with a CPA before a schedule goes to a buyer.

What to gather: three years of filed returns and P&Ls, a P&L for the latest 12 months, bank and card statements for the same months, payroll records, and a list of personal items by year.

Which costs can I add back?

Add back a cost only if it reduced your profit and a buyer would not have it after the sale. The SBA manual's list of additions and subtractions to cash flow names seller discretionary expenses and ownership compensation, and also non-recurring income and unfunded capital expenditures, which come off (SBA manual).

For a sole proprietor, a personal cost booked to the owner's draw never reduced profit, so there is nothing to add back. The IRS describes a drawing account as where a sole proprietor records business income withdrawn for personal and family expenses (Publication 334). Other entities book an owner's personal cost as a draw, a distribution, wages or a loan, and that choice decides whether the return deducted it: see personal expenses paid from the business account for partnerships and LLCs, an S corporation and a C corporation. A vehicle used for both business and personal purposes must be divided (Publication 334), so add back only the personal share; see mixed-use expenses. Pay, one-time items and unreported cash each have their own section below.

Which add-backs will a buyer or lender refuse?

A buyer or lender refuses an add-back it cannot trace to a record, or one the business will still need after the sale. The SBA manual has the lender explain why each adjustment is prudent, necessary and supported by the business's ongoing operations, and it makes an unsupported adjustment ineligible (SBA manual).

Common refusals:

• No proof. A figure with no statement, invoice or payroll record behind it.
• A "one-time" cost that repeats. Legal fees, repairs or software that show up in most years are operating costs.
• A cost the business still needs. A relative who staffs the counter, a vehicle used on jobs, or a subscription the buyer must keep.
• Owner pay with no replacement. Someone must do the owner's job, and the buyer pays for it.
• Income no record shows. Cash sales missing from both the deposits and the returns.
• Numbers that differ from the filed return with no explanation.

An SBA lender tests the adjusted earnings against a coverage ratio. For an SBA 7(a) loan to buy a business, the manual sets minimum debt service coverage of 1.25:1 (lower when an existing business buys another): earnings before interest, taxes, depreciation and amortization (EBITDA), as reported or adjusted, divided by the loan payments after the sale.

How does a buyer or lender test an add-back?

They compare your schedule with the filed return, the IRS's copy of it, and the bank. Four checks:

Outside the SBA Express programs, an SBA lender must obtain return transcripts and reconcile any differences with the business's financial data, and for a change of ownership it must validate what the seller reported (SBA manual). The IRS gives a lender tax records only with the taxpayer's consent (IRS Income Verification Express Service), so the seller has to authorize the request. You can see the same record first: request a record of account transcript (the return plus later changes) with Form 4506-T and compare it with your P&L.

For larger purchases an SBA lender also requires an independent quality of earnings review that rebuilds cash from the bank statements. See getting books ready for a quality of earnings review, what the report costs, and, from the buyer's side, checking a seller's books.

I ran personal expenses through the business: what does an add-back say about my past returns?

An add-back for a personal cost says that cost sat in your expenses. Section 262 allows no deduction for personal, living or family expenses unless another provision expressly allows one, and section 162 allows only ordinary and necessary business expenses (section 262; section 162). If a personal cost was deducted as a business expense, a filed return deducted something section 262 does not allow, unless the business paid it to you and reported it as wages.

If the cost went to a draw or distribution instead of an expense, the business return did not deduct it, so there is nothing to add back. For a corporation or partnership, check the owner's side too: a C corporation's distribution is a dividend to the extent of its earnings and profits (section 301; section 316), and one above basis from an S corporation or partnership is taxable gain (section 1368; section 731). If it was deducted, three things follow:

• The reader of your schedule also reads your returns. A lender compares the two, so it sees which years carried the costs.
• The IRS generally has 3 years from the date a return was filed to assess more tax. There is no time limit if no return was filed or a return was fraudulent (section 6501).
• An accuracy-related penalty of 20% can apply to the part of the underpayment caused by negligence, disregard of the rules or a substantial understatement (IRS). Added tax on a qualified amended return, filed before the IRS first contacts you about that return, is left out of the penalty unless it comes from a fraudulent position (26 CFR 1.6664-2(c)).

Fixing a filed return is a decision, not a line on the schedule. Whether to amend, and for which years, turns on the amounts, the years still open and whether the costs were deducted at all. See personal expenses paid from the business account and amending a return for business expense mistakes, and a CPA can settle it before the schedule goes out.

Cash sales that were never reported are a different problem. Gross income means all income from whatever source derived (section 61), so income a return left off is a tax question, not a bookkeeping adjustment; see amending for income left off past returns. A lender has no record to support revenue that the deposits and returns do not show.

How do I treat my own pay, and pay to family members, in the recast?

How your pay shows in the books depends on your business type. SDE counts one owner's pay, so the recast adds it back wherever the books deducted it.

Then subtract the full cost of replacing you: pay, employer payroll taxes and benefits. If the work takes a manager, the buyer's earnings are SDE less that cost. If a second owner or a spouse also works there and the buyer must fill that role, subtract a market wage for it too (market practice, not a rule). An SBA lender also checks that the buyer's own pay is enough to cover their obligations and living expenses (SBA manual).

An S corporation must pay a shareholder-employee reasonable compensation for services before non-wage distributions, and the IRS can reclassify other payments to the owner as wages (IRS). If you took a small wage and large distributions, a buyer is likely to price a market wage, and past payroll tax may be a question. See S corporation owner salary.

Pay to family members is deductible only as a reasonable allowance for services actually rendered (section 162). The regulation tests reasonable pay by what like enterprises ordinarily pay for like services in like circumstances.

How do I show one-time income and one-time expenses?

Show each one-time item on its own line, in the year it happened: add back a one-time expense and subtract one-time income. The SBA manual lists non-recurring income among its cash flow adjustments and has a quality of earnings review document non-recurring revenue or expenses (SBA manual).

• One-time expenses: a lawsuit settlement, storm damage, a move.
• One-time income: an insurance payout, a government grant or tax-credit refund, a gain on selling equipment, a large job that will not repeat.

Check the other years. A similar item in most years is an operating cost, not a one-time one. A schedule that removes one-time costs but keeps one-time income overstates earnings, and a lender that checks both sides will see it. Add a line saying what happened and attach the document.

How do I document each add-back?

Give each add-back one row:

• Year: the year the cost was booked.
• Amount: the exact amount, and the total for the year.
• Account: the account in the books where it sits, so the buyer can find it.
• What it was: one line; for a mixed cost, the personal share and how it was figured (miles, hours).
• Proof: a statement line, invoice, payroll record or log.

The IRS lists the documents that support entries in your books: sales slips, paid bills, invoices, receipts, deposit slips and canceled checks, kept by year and type (Publication 583). For an add-back, the proof shows the cost was personal or one-time, not only that it was paid. Start each year from the profit line on the filed return so every line ties to what the IRS has: Schedule C net profit, ordinary business income on Form 1065 or 1120-S, or taxable income before the net operating loss and special deductions on Form 1120. On Forms 1065 and 1120-S the section 179 deduction (a first-year write-off of equipment cost) passes through to the owners on Schedule K, outside that line, so add back only the depreciation the line deducted (Form 1065 and Form 1120-S instructions). SDE is figured before income taxes, so add back any the books deducted.

My books are messy: how many years do I recast, and do I fix the books first?

A common recast covers three years plus the latest 12 months; a younger business recasts every year it has. The SBA manual has a lender analyze the acquired business's three most recent year-end statements and its latest interim statement against the same period a year earlier, and its cash proof covers the trailing 12 months (SBA manual).

Fix the books first where you can, then use the schedule for what the books cannot change. This order is common practice, not a rule:

1. Reconcile every bank and card account for the period. A recast on books that do not match the bank has nothing to stand on; see catching up on overdue books.
2. Leave filed years matching the filed return and show personal and one-time items on the schedule. Changing a filed year is part of the amending decision above.
3. In a year not yet filed, book personal costs as what they are before the return goes in (an owner's draw, or for a corporation wages, a distribution or a loan), so the latest 12 months need fewer add-backs.
4. Build the schedule, starting each year from the return's profit.
5. If the books are cash-basis and the buyer wants accrual, see switching from cash to accrual accounting.

Example

These examples are illustrative and use US dollars.

A plumbing company with a Schedule C profit

A sole proprietor's Schedule C shows a profit of $120,000. The recast:

No owner pay is added back, because a sole proprietor's profit already includes it. Here the $11,400 of vehicle and phone costs was deducted on filed returns, so listing it tells the buyer those returns deducted personal costs. The seller should talk to a CPA before sharing the schedule.

An S corporation whose owner is replaced

An S corporation shows $140,000 of profit after $60,000 of owner pay (wages plus the employer's payroll tax on them). Adding back that pay gives SDE of $200,000. A buyer who must hire a manager at $90,000 all in, with payroll tax and benefits, restates earnings to $110,000 (140,000 + 60,000 - 90,000). The owner's pay is replaced, not simply added back.

Cash sales that were never deposited

An owner wants to add back $20,000 of cash sales that were never deposited or reported. The deposits and the returns do not show it, so a lender has no record to support it. It is income, not a cost, and it raises a tax question that belongs with a CPA before any listing.

Different for you?

• A broker, buyer or lender has asked for SDE or a recast P&L, and personal costs, family pay or cash sales run through the books: which items are real add-backs, what to do about returns already filed, and how to present the numbers before an offer are judgment calls that depend on your returns and records. See bookkeeping help for the recast and the books behind it.
• Cash sales or money "off the books": see cash business sales records and amending for income left off past returns.
• Your S or C corporation paid your personal bills: see S corporation paying personal expenses or C corporation paying owner expenses.
• Family members were paid in cash or without payroll: see paying family on payroll in an S corporation.
• Your books are months or years behind, or will not match the bank or your filed returns: start with catching up on overdue books and getting books ready for a quality of earnings review, and see bookkeeping help.
• You want the tax on the sale and how the price is split: see selling your business.
• You are the buyer: see checking a seller's books before you buy.