Add backs are expenses that are often found in the profit and loss statements of privately and closely held companies. These expenses could be personal expenses that can legally be deducted per IRS Tax Code, but don’t really affect the profitability or operations of a company. They could also be for business expenses that are one-time expenses such as litigation or product development. The rule I like to use, is any expense not required to operate the business, and that will not be conveyed to the new owner, is a discretionary expense.

Many first time buyers of a business don’t understand what is a true add back and what isn’t. This can cause them to either make a bad purchase, or miss out on a great deal. A CPA’s job when representing a client, is to make sure the client can expense as many legal expenses as possible, and reduce tax liability. There is a clear difference in Tax Accounting and Cash Flow Accounting.

Let’s explore the difference.

One example is often auto expenses. A legitimate addback for auto expenses may be a company car ( perhaps a Lexus or Mercedes ) that’s driven by the owner. The owner may conduct business and drive the vehicle to meetings, but the expense is not required to convey to as new owner of the business. We would remove this expense from the P & L. The owner had a choice to expense the Mercedes, and tax code allows this to a point.

On the flip side of the equation. If a business has a delivery truck that is required to make deliveries to customers, we would not allow this expense to be added back to the P & L. The truck is a required expense to operate the business.

Another example we see frequently are one-time expenses as large purchases, but it was more advantageous for a tax purpose to expense these rather than capitalize them and place them on the balance sheet for depreciation. For example, a business may have purchased a $35,000 commercial freezer. The freezer is needed to operate, but it should have been placed on the balance sheet rather than expensed. Many times a buyer will ask that these not be included for the purpose of the recast financial model. If they are added back to the P & L, we always then add the asset back to the Balance sheet as well. If it’s removed from one side, it must be placed back on the other. The reason for this is you must pay for the value of the asset in the transaction. Otherwise you’d be getting this asset for free. It’s to the buyers advantage to make sure to value all of the assets for tax allocation.

This is not a complete list, but it’s what we see most frequently. There are many other considerations regarding add backs, such as eligibility to finance a business and treatment for tax purposes on both sides of a transaction.