Funding The Transfer

The funding aspect of the succession plan involves quantifying the owner’s needs, identifying alternate sources of funds, and determining which are economically feasible, both to the seller and buyer. Both tax and nontax considerations affect the analysis.

One of the biggest obstacles to transferring ownership in a business is the ownership successor’s lack of funds. This can especially be a problem when the successor is the owner’s child whose available cash and credit are limited. Although the owner can finance a portion of the sale, many owners try to minimize the amount they finance.

The various payments that can be used to fund an ownership transfer have unique tax and economic consequences to the owner, the ownership successor, and the business. These must be considered when evaluating business payments as a funding source.

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Nonqualified Deferred Compensation Plans

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A nonqualified deferred compensation plan is a tax-efficient way to facilitate a future sale of the business. As the liability for the owner’s deferred compensation increases, the value of the business decreases, reducing both the gift tax value and the selling price.

Establishing the deferred compensation plan results in less sales or redemption proceeds to the owner at the transfer. However, the owner will receive the balance under the deferred compensation arrangement in future years. Deferring owner compensation usually defers the related tax liability. However, it also puts the seller at risk of nonpayment if the business fails.

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Compensation for Past Services

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The key to this technique is whether the bonus is reasonable. A business can deduct compensation payments for previously under-compensated years. Thus, the business must be able to demonstrate that compensation paid in prior years was less than the value of the services performed. Often, the reason for paying less than fair value was that the company was underfunded at the time or all cash was being reinvested in the business.

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Consulting and Employment Agreements

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Consulting and employment agreements can supplement the owner’s income after retirement if the owner wants to stay active in the business and the company can benefit from his or her services. A consulting or employment arrangement should be supported with an official contract, signed by both parties, and should provide for specific duties to be performed by the former owner. Consulting fees or employment wages paid to a retired owner are deductible as compensation expense by the company and ordinary income to the recipient.

The amount paid for services by the retired owner must be reasonable in relation to the work performed. Otherwise, the IRS may classify payments to the former owner as dividends or additional sales proceeds. The reasonableness test is one of facts and circumstances, however, the compensation paid to the former owner should be supportable by what would be paid for similar services in an arm’s length transaction.

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Lease and Purchase Options

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Operating equipment or real estate held outside the business entity may offer planning opportunities if the retiring owner can lease these assets back to the business. Leasing arrangements can provide an additional source of income to the former owner. In addition, purchase options can be paid by the company to the retired owner to “lock in” a current price for the assets or simply to lock in the option to buy the property in the future. When the option is exercised in the future, the asset is sold to the business, generating additional income to the former owner.

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Covenants Not to Compete

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If the owner is selling his business to an unrelated party, or a commercial lender is involved in financing the succession, a noncompete covenant may be required of the retiring owner. A noncompete covenant which meets the IRS tests for reasonableness is a method of compensating the retiring owner for assurances that he will not compete with the business in the future.

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USING SELLER FINANCING

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Seller financing is common when a business is sold. Banks will normally finance only a percentage of the hard assets and none of the goodwill. Thus, sellers often must fill in the financing gap left by the bank. Seller financing can also help the seller negotiate a higher selling price, especially if he or she is willing to charge a lower interest rate on the note than would be charged by a bank. Seller financing has the advantage of being fast and convenient, since there is no approval process, and inexpensive, since there are no loan fees.

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Ensuring Repayment

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Obviously, the seller is concerned about the tax consequences of seller financing. However, the seller’s primary concern is usually the risk of default associated with the buyer’s purchase obligation. Simply put, the seller wants to get paid. The seller’s concerns about the buyer’s ability to pay are well-founded if business cash flows are the buyer’s main source of funds for debt repayment. This concern may be heightened if the seller has no continuing role in the business operations. Since the seller’s future financial security may depend on the buyer’s ability to successfully run the business, the business owner must be careful to objectively evaluate the buyer’s ability.

Obtaining and carefully evaluating the buyer’s business plan detailing how the debt will be repaid is a very important means for evaluating the buyer’s ability to repay the debt. Of course, the seller should take all other common business precautions, such as obtaining a lien on assets, personal guarantees from the buyers, life insurance on the remaining owners, and a pledge of the company’s stock or partnership or LLC interest as collateral on the installment note. If an ownership interest is accepted as collateral, the seller should be aware that an interest in a business unable to make installment payments may not be worth much. The seller should also restrict the borrower’s ability to strip cash out of the business by setting compensation caps and limiting the buyer’s ability to borrow additional funds. However, if a commercial lender is also financing part of the acquisition price, the seller will probably not receive the same level of security as the commercial lender.

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Setting the Terms of the Debt

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Typically, the seller receives a down payment and the buyer’s note for the balance of his portion of the financing. The note usually obligates the buyer to make regular interest and principal payments for a specified term. At the end of the term, the buyer may make a balloon payment for the remaining note balance.

Choosing an interest rate may affect the amount of ordinary income (vs. capital gain) that that seller will realize. Generally, a higher purchase price can be negotiated if the interest rate is lowered. This tends to decrease the seller’s ordinary income and increase his or her gain on the sale of the business. Conversely, the buyer’s tax situation is often improved if a lower purchase price is exchanged for a higher interest rate, since the interest expense is deductible currently, while the purchase price is capitalized.

Another negotiable point is the amount of the down payment. Obviously, the greater the down payment, the less risk the seller assumes in the form of a note receivable. However, the down payment may be limited to the buyer’s available cash.

In a sale to a family member, the purchase price and interest rate may not be negotiated strictly based on the buyer’s and seller’s opposing interests. Instead, the seller may determine the amount of income required for retirement (taking into account the down payment and any other assets owned). If the seller is financially able, he or she may help the buyer by charging a lower rate of interest than would be required from an unrelated party. However, the interest rate must at least equal the AFR to avoid re-characterizing some of the principal payments as interest income to the seller.

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Addressing the Buyer’s Concerns

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Potential At-risk Limitation Seller financing can raise an issue under the at-risk rules that apply to individuals and certain closely held corporations. The buyer is not considered at-risk for debt if the lender is related to any person (other than the purchaser) who has an interest in the business. This could present problems if the seller owns less than 100% of the business and is related to one of the other owners. The effect of the at-risk rules may be to limit the deductibility of losses which the buyer incurs in the course of operating the business.

Nontax Issues In a family sale, the seller may be more willing to provide guidance to help a purchaser operate the business. This may be a source of conflict if the seller stays involved in the business (both professionally and emotionally) more than the new owner would like. This may be especially uncomfortable for the buyer if the seller is a parent who treats the buyer as a young child needing instruction. On the other hand, the seller may need the income from the note receivable for retirement and therefore have a valid reason to remain involved.

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