The Risks of Underreporting Income for Business Owners

One of the most critical questions for prospective buyers, investors, and lenders is understanding a business’s true income. The party most invested in uncovering it, though, is the IRS.

Determining a business’s real income should be straightforward from the financial records, but many business owners often engage in practices to reduce their tax liability. IRS audit data shows that income from sources with little or no third-party reporting, like sole proprietorships, goes unreported at a far higher rate than income that is: as much as 54% of sole proprietorship income never makes it onto a return, compared to roughly 1% of wage income that is subject to withholding.

Business owners, even those not yet considering a sale, should start preparing by presenting their company as a profitable, legitimate enterprise. A buyer will scrutinize not just the numbers but the history behind them, so any gap between the books and the tax returns is a red flag. A fresh narrative about the business’s potential will not convince a buyer, who is looking for tangible evidence of consistent, legitimate profitability. They will look at the historical earnings of the business.

How to position your numbers before you sell

Think long-term. Instead of chasing short-term tax savings, prioritize showing long-term profitability. Buyers are looking for businesses that demonstrate consistent, strong earnings performance over time. The more stable and profitable your business appears, the easier it is to justify your asking price.

Review and adjust past records. If your business has grown but that growth is not reflected in your tax returns or financial reports, this is the time to fix it. Go through the past few years of records and adjust them to present a clearer, more accurate picture of the business’s financial health.

Reconstruct historical financials if you need to. This means carefully revisiting past transactions, correcting under-reported income, and ensuring your financial history aligns with the real growth of the business. It takes real effort, but accurate records that reflect legitimate success build trust with buyers and lenders in a way nothing else can.

Itemize your tax-deductible expenses and benefits. Salaries, fringe benefits, and other perks allowed by the IRS provide ongoing value to the business and should be clearly listed in your records. Buyers appreciate seeing a business efficiently managing its finances while taking full advantage of available deductions, and this documentation directly supports your adjusted earnings figure at sale.

Addressing these areas improves your appeal to buyers, lenders, and investors alike. Most importantly, truthful financial reporting keeps the IRS focused on someone else’s business. If you want an estimate of what your business could command in a sale, try the free valuation calculator.

Mark Herrmann is the founder of Trustmark Mergers & Acquisitions in Charlotte, North Carolina. This article is general information, not legal, tax, or financial advice.