How to Calculate SDE From a Real Tax Return

Why SDE Is the Most Important Number in a Sale

SDE is probably the most important number in a small business sale. It determines your business's valuation, it determines how much buyers are willing to pay and it determines how much banks are willing to lend against your business. In this video, I'm going to take you through a real-life example of how you can calculate SDE for your business using just its tax returns and some information that you as a business owner would know off the top of your head. I'll also include a link to the worksheet that we're going to use throughout this video so that you can either follow along at home or use it on your own time to calculate SDE for yourself.

The link to that will be in the description below.

A Quick Recap: What SDE Measures

As a quick recap, SDE is a number that answers a very simple question that sits at the heart of every business sale. And that question is, how much cash could a new owner draw from the business if they were to run it at arm's length? Now if you want a quick refresher on what exactly SDE is, you can go back and take a look at one of my older videos. It's an 8-minute long video which explains exactly what SDE represents and what it means for your business. So make sure you go ahead and check that out if you haven't done so already. I'll leave a link to that in the description too. I'm Ed, I'm a business broker and the founder of Sundance Financial.

We help small business owners sell their companies all over the US. With that being said, let's get into it. Now if you've seen my previous video, you'll know that SDE can be calculated using a relatively simple formula.

The SDE Formula

SDE is equal to your earnings before interest, tax, depreciation and amortization, also commonly known as EBITDA, plus your owner's salary for one owner operator of the business, plus any personal expenses that you run through the business which a new owner would not have to pay. And then finally, plus or minus any market rate adjustments for sweetheart deals and family and friend rates. Hopefully by the end of this video, all of this will become very clear to you because we're going to use a real tax return to walk you through this formula and what it looks like to apply it in practice.

The Tax Return and the Free Worksheet

So the first thing I'm going to do is pull up my tax return. For the purpose of this video, I'm going to use a real tax return that I've received in the past. As you can see, it's a little bit on the older side from 2021, but this particular business is a residential steel contractor, which reported about $1.5 million in sales and about $300,000 in ordinary business income for 2021. This tax return is redacted for obvious reasons, but hopefully it still serves as a good example of how you can do this exercise with your own tax return at home. Now that I have my tax return open, what I'm going to do is pull up this worksheet.

Again, you'll have access to this worksheet, so feel free to download it, use it and put any questions you have down in the comments below. This worksheet has several tabs. As you can see, there's the Start Here tab, which really just talks you through the worksheet and the steps in this process. There's the SDE Calculator tab, which is where we're going to spend most of our time in this video. There's the Check My Work tab, which is what you can use to check whether or not you've filled in this worksheet correctly. And finally, there's the Example tab, which really just presents a filled in example of what this might look like.

Now I'm going to go ahead and go over to the SDE Calculator tab.

The Five Steps

So what you'll see in this sheet is that there are several rows that we need to fill in. And I'll walk you guys through that in detail, but there are essentially five steps that we need to go through. You'll notice that these five steps correspond to the formula I mentioned earlier, which is EBITDA plus an owner's salary, plus personal and discretionary expenses, and then plus or minus any market rate adjustments to get us to arm's length. That's the overall structure of what we're going to be doing today. Essentially our goal in this particular sheet is to fill in all the cells that are shaded in yellow.

Let's start here at the top with the business name. I'm just going to call this Residential Steel Contracting Co. The tax year is 2021.

Why Your Business Structure Matters

Now this next part is really important. What you'll notice if we go back to the tax return is that this business is an S corporation. Now the reason that's so important is because different types of businesses will file different tax forms. For example, you can see here that as an S corporation, this business files a form 1120-S. Now if instead this were a C corporation, it might be filing a form 1120, or if it was a sole prop or single member LLC, it might be filing a Schedule C or form 1040. So one of the first things that we should do as part of this exercise is go to the sheet and select the right option from the dropdown menu.

As I said before, this business is an S corporation. So I'm going to go ahead and click this option. Now what that does is that updates this column, which says where to find it on your return with the specific lines that you'll need to look for on your tax form as you go through this exercise. As you can see, if I change this from a 1120-S for an S corporation to say a Schedule C for a sole proprietorship or single member LLC, some of these lines will update. And these lines are really just to help you navigate your tax form as you go through this exercise.

Step 1: Revenue and Profit From the Return

So the first row we're going to look at and the first cell that we're trying to fill in here is total revenue or sales for the year. If I go back to this dropdown and switch it back from the Schedule C to the 1120-S like we talked about, what I can see here is what I'm meant to do is go to my tax form and find line 1c for this number. So let's go ahead and do that. I'm going to go over to my tax form. I'm going to find line 1c. And what I can see here is that the business reported about $1.5 million in sales for the year. So what I'm going to do is I'm going to take that number, the $1.5 million, and just copy and paste it into this yellow cell over here.

There you go. You can also see in column E that there are some notes that I've left about these particular lines. For revenue in particular, this is only really used to sanity check your SDE at the end. It's not really used in the formula that we talked about earlier, but it's still a useful number so I'm going to leave it in here. Now if we go to the very right, we can see that there's a yellow cell here that we want to fill in where we would just input the explanation of this number or where it came from. This becomes a little bit more important for some of the later adjustments that we make, but for now I'm going to keep it simple and just say tax return 2021.

Great. So moving on, the next row that we're going to want to fill in here is the profit row. Again here, if we look at this column, what we can see is that we'll find this on line 22 of the tax return filed under ordinary business income or loss. One quick note on this before we move ahead. You'll notice here that this form is a 2021 tax return. And so if we go to line 22, it's actually not what we're looking for. What we would use in this particular instance is line 21, which corresponds to ordinary business income or loss. Now the reason for this discrepancy is that these forms are updated from time to time.

And so if I pull up the latest form 1120-S from the IRS, what you'll see is that line 22 does in fact correspond to ordinary business income or loss. So if you're using a new tax return, these lines should add up. In any case, I'm going to go back to the original tax return, pull up this $300,000 figure that is entered into ordinary business income or loss, and then just input that into our sheet under this row. Similarly, I'm just going to go over to this right hand side column over here and input tax return 2021, just as a mental note so we remember where it came from.

Step 2: Getting to EBITDA

So moving on to step two here, there's a similar story with interest, depreciation and amortization. If I go to our tax form and I look at lines 13 and 14, what you'll find is there's very little interest and very little depreciation in this business, about $104 and $1 respectively. But every business is a little bit different. And so your tax form might look a little different from what we're seeing here. One more thing worth pointing out is on amortization. None of the four forms that we're looking at in this exercise actually gives amortization its own line. If your business has any and most small businesses won't, it'll be bundled in with the other deductions which we'll look at in a little bit.

In this case, there isn't any amortization. And so line 14 here is all we really need. Now I'm going to go ahead here and input these two values back to our spreadsheet. So I'm just going to copy $104 into here and I'm going to input $1 here. And similarly on the right hand side of this, I'm just going to put down tax return 2021. Now the next three rows that we're going to fill in won't necessarily come from your tax return, but it will rely on some informational knowledge that you as a business owner would have about the business. And what we're really trying to do with these three rows is remove or quote unquote normalize certain expenses that are once off and non-recurring in nature.

The reason that's important is because for example, you might have one year where for one reason or another you need to pay a bunch of legal fees to settle a pending lawsuit. Or one of your warehouses might have just happened to burn to the ground and you needed to spend a bunch of money to relocate. Because these expenses aren't really part of the ongoing business, they were once off in nature, they generally shouldn't be factored into the earnings of the business going forward, which is what buyers really care about. One note that I do want to make here that's really important is that repairs in and of themselves aren't necessarily once off in nature.

If you have a piece of equipment that needs repairing every couple of years, that shouldn't be added back here because that's what I would consider an ongoing business expense. What we're talking about in these next three rows are truly once off unexpected or extraordinary items that are very, very unlikely to reoccur.

One-Off and Non-Recurring Expenses

Having said all that, just looking at this tax return and making some judgment calls here, I'm going to assume that all three of these rows are zero. Now again, this might be different for your business, but that relies on information that only you would have as the business owner. And so you would have the best sense of what you should and shouldn't put into these cells here. What I'm going to do is just put zero in all three of these and then go over to the right and just put not applicable for all of them. Okay, let's move on here to the next row, which is where we're going to add back the owner's salary.

Step 3: Adding Back the Owner's Salary

If you look over at column D, what you'll see is that we can find this on line seven of the tax return, which says compensation of officers. One important note that I've included in the next column over is that this value should represent the salary for one owner operator only. For many small businesses, there is only one owner, and so this isn't that relevant. But there are some situations where there are multiple owners of the business and all their compensation is included in line seven. In that scenario, what we're going to want to do is add back the compensation of the primary owner operator.

Just keep that one in mind. In this case, however, there's only one owner operator and they pay themselves about $150,000 if I look at line seven of this tax form, which is nice and simple. So I'm just going to go ahead and input $150,000 here. And as always put tax return 2021 here, again, just to keep things very simple. Now that we've done all that, what we're going to do is move on to step four, which is where we add back personal and discretionary expenses that are run through the business.

Step 4: Personal and Discretionary Expenses

As small business owners, you would all know that there are many situations where you're running things through the business that aren't necessarily 100% business related. That might include things like your personal vehicles, your own health insurance, travel and entertainment, et cetera. Essentially, if a new buyer came into the business, these would represent expenses that they may not necessarily need to incur. And so for the purpose of calculating SDE, these items don't necessarily need to be included. Now what I've done is put some of the most common examples over here, which is, as I mentioned, vehicle usage, phone usage, personal travel, meals, as well as things like health insurance that's of a personal nature and donations and sponsorships that are discretionary and unrelated to the business.

Where Add-Backs Hide on Your Return

Now for these items, typically what you'll want to do is go to the statement that's attached to line 20 of your tax form. Line 20 is just a row that aggregates all the other expenses. And so you really want to dig one level deeper in order to review each line in detail. Now you can see here that because, again, this is a 2021 tax return, we actually want line 19 in this case, but if you're using a newer tax return, it should be line 20. So if I look over at this row, I can see that there should be a statement two attached to this tax return. And that's where you'll go. If I scroll all the way down to the statement two here, this is what it looks like.

You can see here that there are automobile and truck expenses of about $27,800. You've got insurance expenses of about $66,700. And then you've got meals, entertainment, and all that other kind of stuff. This is also where any amortization would show up if the business has any. But again, this business doesn't. So as we did earlier, what we're going to do here is make a few assumptions about the business. Again, in practice, this would rely on things that you would know as a business owner, but no one else might. But let's suppose, for example, that roughly half of this $27,800 charge for automobile and truck expenses was actually of a personal nature.

So maybe only about 50% of the mileage on those vehicles related to the business. What I'm going to do here is I'm going to take that figure, the $27,800, I'm just going to paste it into this cell, and then I'm going to divide it by two because we only want to add back the portion of the expense that is personal in nature. Now over here on the right hand side, I'm just going to make note of that assumption that we made. So 50% of vehicle expenses are personal. Great. Now moving on to the next line, which is the phone bills, personal travel, meals, and club dues. Again, we're only going to add back the items that are not strictly related to the business.

If I go back to the tax return, what I can see here is that there's a telephone bill of about $3,872 as well as meal expenses of about $769. Now let's assume all the meals were actually business related, which could be things like you taking clients out to dinner, et cetera, which a new owner might also have to do. So we're not going to add back any of that $769. But let's suppose that about half again of the phone bill is of a personal nature. That's things like your home internet, personal mobile, et cetera, things that you might have run through the business, even though it's not strictly related to the business.

As we did before, what I'm going to do is I'm going to take this $3,872. I'm going to paste it into this cell, and then I'm just going to divide it by two. On the right hand side, as we did earlier, I'm going to note that 50% of telephone usage is personal and that'll complete that row. Now moving on to the next row, here's where you would add back some of the stuff that's not so easy to categorize. Often it's things like personal insurance, but it could be groceries, it could be any of those other things. In this particular example, we noticed that there was insurance expense of about $66,700 for the business.

And what we're going to do is assume about $10,000 of that relates to the business owner's personal health insurance. Again, that was just being run through the business, but wasn't strictly of a business nature. What I'm going to go ahead and do is I'm just going to input $10,000 here into this cell. And on the right hand side, I'm just going to say $10k of personal insurance. Now finally, on the charitable donations and sponsorships here, if we take a look at column D, because it's an S corporation, this should be zero. And that's what it says in here. In that case, we're just going to put zero here and enter not applicable in this cell.

Great.

Step 5: Arm's-Length Adjustments

And with that, there's only one more step that we need to go through here. And this is where we would adjust for quote unquote arm's length adjustments. If you recall from my last video, SDE should really show how the business would perform if it were run on an arm's length basis at standard market terms. That means no sweetheart deals, no family deals, nothing of that sort or nature. And so anywhere where a business is getting something cheaper or more expensively than what a stranger would otherwise get, we would need to make an adjustment here. It's important to note that these adjustments can run in both directions.

What you'll see here is that positive values indicate where the business is paying less than what it otherwise would. And negative values indicate where the business is paying more. Let's say as an example that for this particular steel contracting business, the owner's spouse helps a lot on administrative tasks for the business, but doesn't actually draw any salary for it. What that means is that a new owner stepping into the business is very likely going to have to hire someone to replace the work that the spouse currently does. Now let's assume for a moment that the market value of that replacement, in other words, the amount that it would cost a new owner to replace that person is about $60,000 because the business is currently paying less than what a new owner would have, here you would enter a positive value of $60,000. In the note column, you would enter adjustment for replacement of spouse, $60,000. Again, just to reinforce this point, there are lots of situations where you might actually pay a spouse or family member for work that they're not actually doing. That might be for tax or personal reasons or whatever it may be, but in that situation, you would instead enter a negative value in that cell because a new owner would not have to pay those same expenses. Now moving on to the next row, what we have here is rent adjusted to the market rate. This row is really just meant to reflect the fact that there are many situations where the business is not paying rent that's exactly equal to the market rate.

For example, you might be renting from a property you own yourself and therefore the business might pay above market rent for whatever reason. Similarly, you might be renting from an old friend of yours who's willing to give the business a bit of a discount. A new owner coming in wouldn't necessarily have access to this kind of discount, nor would they pay above what market rate really is. And so this row is meant to adjust for that. Going back to the tax return, if we look at line 11, what we can see here is that the rent is about $53,752. Now let's say that this business is actually renting property that's owned by the business owner and the business owner is charging the business above market rent to solve for his or her own personal tax situation.

Let's say that the market rent for this same facility in the same location is actually closer to $40,000. What we would have in this case is an overpayment of $13,752. In that case, what I would enter into this cell here is negative $13,752. This is a negative number because the business is paying more currently than it would otherwise under new ownership. In the notes column, I'm just going to enter something like market rent of $40,000 and that completes that row.

Missing Recurring Costs

Now, finally, just to finish up this sheet, what we're going to look at is any sort of business related recurring expense that is currently missing from the return. What I'll say is that this is relatively uncommon, but if for example, for whatever reason you pay the business's insurance from your personal account and that expense doesn't appear anywhere on the business's tax return, that's where you would input these values. For simplicity's sake, I'm just going to say here that it's zero and input N/A into this column.

The Result: $300K of Profit Becomes About $430K of SDE

Now that we've entered that in, we've gone ahead and finished the sheet. What you can see is that we started with sales of about $1.5 million, ordinary business income reported of about $300,000 and after all the adjustments we've made, SDE of about $430,000. Now this is important because if you had valued your business based on only the operating profit reported on your tax return, you would be leaving a lot of money on the table. That's why I always encourage business owners to really understand what SDE is and to try to figure out how it applies in their situation. Now the final thing we're going to do here is really just move to the Check My Work tab and make sure that these are all green and saying okay.

Checking Your Work

This tab essentially just flags if you've accidentally missed a cell or input something that doesn't look quite right. But given that we're seeing all green here, it looks like we're good to go.

Final Thoughts

So that's it. That's how I would go about calculating SDE if I were a small business owner. Now there's a bit more nuance and complexity to this, which a good business broker will apply for you and walk you through. But I think this worksheet is a really good starting point which will get you about 80% of the way there, again just using a simple tax return and information that you would know as a business owner. If you found this video helpful, you can do me a favor and hit subscribe. I'm building out the channel to give small business owners the straight, practical talk on valuing, preparing and listing their business for sale.

You can also check out my video explaining what SDE actually is by clicking on the link in the description below. On top of that, I've included a link to a four-part series on how to value your business that walks you through the methods that buyers and their lenders will actually use in practice. If you want to talk through your specific situation or you're seriously thinking about selling your business, I offer a free no-obligation consultation. Just book in via the link in the description below. Again, I'm Ed from Sundance Financial and I'll see you in the next one.