One owner received $18,000 disability income for nine months ($2,000 a month) and was taxed on the full amount of the benefits. Reason: He paid his disability premium ($1,200 a year) through his business. Since the disability premium was recorded as a deductible expense of the corporation (not as W-2 or 1099 income to the owner), the benefits from the disability income were fully taxable to the owner.

The lesson: Disability premiums are relatively low compared to the potential benefits they can provide. That's why it's usually best to pay disability premiums personally with your after-tax dollars so any future benefit payments to you and your family are received tax-free.

The Cautions: Cancellation, Nonrenewals, Health Problems, and Big Increases in Premiums

Buying term life insurance is a wise move for many individuals. The premium is lower than whole life, variable, and universal policies and it can fill big gaps in one’s overall insurance protection. However, it is not permanent insurance, so you have to be very careful on how long you keep term insurance before converting the policy to permanent insurance. You also must periodically review existing term policies so you don’t overlook certain options which expire over time, e.g., your right to convert the term insurance to whole life or other permanent insurance.

Questions to ask: How long is the term insurance convertible to permanent insurance: 5, 10, or 20 years? Is the life insurance effective to death or only to a certain age, e.g., age 65? Are the premiums guaranteed against annual increases? Is convertibility to permanent insurance contingent on a medical exam? Be careful; some term insurance policies do not guarantee the premium rate when the policy is converted to permanent insurance. To obtain the guaranteed rate, a medical examination may be required. If the exam reveals health problems, the premium on the permanent policy could be substantially above the premium specified in your term insurance policy.

What to do: Call your insurance agent and get answers to the questions posed above. Also consider converting your current term insurance coverage to permanent insurance. Reasons: You don’t want the insurance coverage nonrenewable or cancelled by the insurer when you need it most. You also don’t want substantially higher premiums later on if you decide to convert the term insurance to permanent insurance. As a general rule, if you know you will be converting a term policy to permanent insurance, do it as soon as possible. That way, part of the premium goes to the build-up in the policy’s cash value.

Relevant Resource:
Resource Report #30: Your Insurance: Get the Most from Your Life Insurance Dollars and Protect What You Have

The goal: To adjust the company’s profits upward so you can apply the price-earning’s and operating profit (EBIT) multiples to the higher profits for the highest value and selling price. Even if you're not in the market to value or sell the business today, the concepts and examples illustrated in this advisory are crucial in understanding how you will set a value and selling price in the future. They work in reverse also, to help you determine the best purchase price for a business you’re interested in buying.

Adjusting the income statement is especially critical for closely held businesses because the owners typically keep reported profits as low as possible to minimize taxes. Some of the techniques used to lower taxable income and profits include increasing salaries, declaring bonuses, setting aside more retirement money, and writing off inventory.

Based on our investment banking experience over the last 30 years, a company’s adjusted profits, on average, will be about 80% above its reported profits. So don't penalize yourself today or limit the value of the business just because you made salary, tax, and cash flow decisions which lowered the profits in the past. In most cases, the impact of those decisions can be explained and illustrated to a potential buyer by showing them the adjustments you made to reflect the company's true profitability.

Income Statement Adjustments

Adjustments to a company’s earnings should add back to earnings: (a) excess compensation paid to the company's owners/officers and family members above reasonable amounts, (b) extraordinary tax writeoffs of bad debts, unusable inventory and equipment, etc., (c) unreasonably high fringe benefits, (d) special year-end bonuses, (e) investments in affiliated businesses, and (f) any nonrecurring expenses incurred in one year which benefit the company over future years, e.g., preparing and printing sales brochures, new product development costs, establishing a new sales office, etc.

Example of add-backs: If the company's reported pretax income is $100,000 ($65,000 after taxes) and these adjustments total $60,000, its adjusted pretax income is $160,000. To this figure, apply a  tax rate (say, 35% overall) to obtain the company's adjusted net income of $104,000 (65% times $160,000). Thus, the company's reported aftertax income was adjusted from $65,000 to $104,000. Now, to determine the value of the business, let's apply a simple 10 price-earning's multiple (p/e) to both numbers:

Reported Net Income: $65,000 times 10 p/e equals $650,000

Adjusted Net Income: $104,000 times 10 p/e equals $1,040,000

Added Company Value equals $390,000

The added value of $390,000 represents a 60% increase above the value based on the company's unadjusted income statement. That shows you the importance of adjusting the financial statements before starting the valuation process and/or setting a price tag for selling the business. Note: If the company is a sole proprietorship, partnership, S corporation, or limited liability company, you must adjust the income statements as if it were a regular (C) corporation with applicable corporate, not personal, tax rates.

Relevant Resource:
Reference Manual: How to Value Any Business with 16 Case Studies and 27 Valuation Methods