In business valuations—particularly for SBA 7(a) loan purposes—calculating free cash flow must be based on verifiable, legally reported financial data. A frequent misconception among small business owners is that a valuation should consider unreported (i.e., “off-the-books”) cash receipts. However, incorporating unreported cash into a business valuation is improper, unethical, and legally indefensible. Not only would doing so imply the underlying tax returns are fraudulent, but the seller has already benefited economically by evading taxes on the unreported income. This white paper explains the risks and rationale for excluding unreported cash from free cash flow in formal valuations, supported by references to the Internal Revenue Code (IRC) and professional standards.

The Importance of Verifiable Financials

A core principle of business valuation is reliance on verifiable financial information. Business appraisers—and SBA lenders—require documentation that is consistent, credible, and reconcilable to filed tax returns or audited financial statements.

The Internal Revenue Code requires that all income, regardless of source, be reported for tax purposes:

IRC § 61(a) defines gross income broadly as “all income from whatever source derived,” including cash transactions. [26 U.S.C. § 61(a)]

Failure to report income—whether cash, barter, or otherwise—is a violation of U.S. tax law. Valuation professionals cannot legally or ethically rely on unreported or illegal income streams to determine free cash flow or business value.

In SBA loan valuations, tax return verification is mandatory under SOP 50 10 8, reinforcing that reported earnings form the baseline for underwriting and valuation.

Unreported Cash = Tax Fraud

Including unreported cash in a valuation inherently assumes that the business underreports its income to the IRS. This raises serious legal and ethical concerns:

• Under IRC § 7201, the willful attempt to evade or defeat tax is a felony punishable by fines up to $100,000 ($500,000 for corporations) and imprisonment up to 7 years.

[26 U.S.C. § 7201]

• Under IRC § 7206(1), knowingly submitting false returns, statements, or documents is a felony punishable by fines up to $100,000 ($500,000 for corporations) and imprisonment up to 3 years.

[26 U.S.C. § 7206(1)]

By acknowledging or relying upon unreported cash in a valuation, the appraiser would be knowingly or negligently complicit in recognizing fraudulent financial information. This violates professional standards (e.g., USPAP, AICPA SSVS1) and exposes the appraiser to legal liability, including potential civil penalties or loss of professional certification.

Thus, appraisers are ethically and legally bound to ignore unreported cash in any valuation for legitimate purposes, including SBA lending.

The Seller Has Already Been Compensated

Some sellers argue that “the business is worth more” because of the unreported cash. This argument is fundamentally flawed.

When a seller fails to report cash receipts, they already receive a substantial economic benefit: they avoid paying income tax on that revenue. For example, if a seller hides $10,000 in cash and avoids a 30% tax rate, they retain an additional $3,000 personally. This “tax shield” is real, immediate, and personal to the seller—but it does not enhance the ongoing, legal, reported cash flow of the business itself.

In valuation, we are concerned with future transferable free cash flow—what a hypothetical buyer could expect to legally earn and report going forward. Unreported cash cannot be assumed to continue post-sale without implicating the buyer in future tax fraud.

Moreover, the tax-evaded income does not create enterprise value; it simply reduces the seller’s personal tax burden. The economic benefit already received by the seller must not be double-counted by inflating the selling price.

Addressing the Seller’s Perspective

Sellers may believe unreported cash justifies a higher valuation because they assume a buyer will continue underreporting income. This assumption is flawed for several reasons:

• Legal Risk: A buyer who continues underreporting cash risks IRS audits, penalties, and criminal prosecution under IRC § 7201 and § 7206(1).
• Financing Constraints: Lenders, especially SBA lenders, rely on verified financials. Unreported cash cannot be used to justify loan amounts or valuations.
• Market Reality: Ethical buyers will not pay a premium for illegal income streams that cannot be verified or legally sustained.

Thus, unreported cash does not increase the transferable value of the business and cannot be included in a legitimate valuation.

The Inherent Difficulty of Verifying Alleged Unreported Cash

Another major reason unreported cash cannot be considered in a valuation is the practical impossibility of verification.

Because unreported cash transactions, by their nature, are intentionally hidden from formal financial records, there is no objective, auditable evidence to corroborate the seller’s claims. Typical issues include:

• No accounting trail: The alleged cash receipts do not appear on income statements, bank deposits, sales ledgers, or tax returns.
• Self-serving estimates: Sellers often present unverifiable verbal claims or “handwritten notes” as supposed evidence, which cannot be independently validated.
• Inconsistent or exaggerated numbers: Even among internal staff or owners, recollections of unreported cash are often inconsistent, inaccurate, or inflated.
• Regulatory noncompliance: Attempting to authenticate illegal or non-compliant financial activity exposes both appraisers and lenders to significant regulatory scrutiny.

The SBA requires the use of reliable and verifiable data. Using unsubstantiated figures—especially figures arising from alleged criminal activity—violates both SBA SOP and common sense valuation principles.

If an appraiser were to “credit” a business with alleged unreported cash, it would amount to baseless speculation rather than an independent, supportable valuation conclusion. Professional valuation requires evidence, not conjecture.

Thus, the inability to verify alleged unreported cash further reinforces the mandate to exclude it from any legitimate calculation of free cash flow or business value.

Professional Standards Prohibit Considering Unreported Cash

Business valuation standards across the profession strictly require reliance on documented, lawful, and supportable financial information:

• Uniform Standards of Professional Appraisal Practice (USPAP): Ethics Rule, Record Keeping Rule, Standards Rule 1-4 (data collection), and Standards Rule 2-2 (reporting requirements).
• AICPA Statement on Standards for Valuation Services No. 1 (SSVS1): Requires the use of “sufficient relevant and reliable data.”
• SBA SOP 50 10 8: Requires tax return verification and reconciliation with the valuation.

None of these professional frameworks permit “crediting” unreported income in the determination of value.

Conclusion

Unreported cash cannot and must not be considered in calculating free cash flow in a business valuation. Doing so:

• Relies on fraudulent financial data
• Exposes the appraiser and lender to regulatory and legal risks, including fines, imprisonment, or loss of certification
• Ignores that the seller has already been compensated through avoided taxes
• Cannot be verified by objective, auditable evidence
• Violates IRS regulations and professional valuation standards

Proper valuation practices ensure that only verifiable, legally reported income informs the calculation of free cash flow and enterprise value.

Buyers, lenders, and appraisers should be extremely cautious when sellers claim that “off-the-books” cash justifies a higher purchase price—it does not.