Business tax returns are the most authoritative financial document in any acquisition because they represent what the seller certified to the IRS as accurate. Learning to read and analyze business tax returns is one of the most valuable skills any Illinois business buyer can develop.
What Entity Returns Tell You
S-corporation returns (Form 1120S) show business revenue, expense categories, and officer compensation on Schedule K. Partnership returns (Form 1065) show similar information plus partner distributions. C-corporation returns (Form 1120) show corporate taxable income after officer salaries. Schedule C filers (sole proprietors) show all income and expense on their personal return. In each case, look at the revenue trend across three years, the consistency of major expense categories as a percentage of revenue, and the reported net income that forms the base for SDE calculation.
Key Line Items to Analyze
Focus on: gross revenue or sales (Line 1 of most business returns), cost of goods sold or cost of services, officer or owner compensation (Schedule E of 1120S, Line 17 of 1120), depreciation and amortization, interest expense, and net ordinary business income. Expenses that are unusually high or unusually low relative to revenue deserve explanation. Year-over-year changes of more than 15–20% in any major category warrant investigation.
Personal tax returns cross-validate business returns for pass-through entities. A sole proprietor's Schedule C net income should flow through to their Form 1040. An S-corp shareholder's K-1 income should appear on their personal return. Discrepancies between business returns and personal returns are red flags that require explanation before you proceed.