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Introduction

When money is borrowed, the lender generally gives the borrower money, in exchange for which the borrower agrees to pay back the initial amount of cash (principal) plus interest. The repayment takes place over a specified time period (term). In a buy-sell context, the buyer would borrow money from a third party and then use that money to purchase the shares from the seller.

Generally, loans may be available from several sources:

Conventional Borrowing Sources

Characteristics

Commercial Bank

  • May require personal guarantee by borrower for business loan
  • May require collateral security
  • Term depends on type of loan
  • May have information reporting requirements based on loan size

Savings & Loan

  • May be willing to make longer term loan than bank
  • May require collateral security
  • Term depends on type of loan
  • May have information reporting requirements based on loan size

Credit Union

  • Generally loan only to members, which often means just keeping a savings account with the credit union
  • May have information reporting requirements based on loan size

Commercial Finance Company

  • Often require loan to be secured by working capital assets
  • May have rigorous information reporting requirements

Small Business Association (SBA)

  • Direct loan to small business is rare
  • SBA may guarantee bank loan
  • Specific requirements must be met

Individual Party

  • May be hard to find an individual with funds to loan

When Can It Be Used?

Buyer Can Obtain Credit (At the Time the Money Needs to Be Borrowed)

Whether a buyer can obtain a loan will depend on who the lender is and what factors it examines in determining its willingness to extend credit. If the business itself is the buyer, it might be possible to pledge business assets to secure a loan. If the buyer is an individual, personal assets might have to be used for collateral to secure a loan.

Strengths

You (Or Your Estate) Get All the Money At Once

Caution: See Tradeoffs With borrowings used for buy-sell payment funding, you (or your estate) would receive the sale price in one payment. This provides convenience.

Conceptually Simple Method

The use of borrowings for funding is a simple concept. When the time comes to make the purchase, the buyer visits the lender, gets the loan funding, and hands you or the executor of your estate a check. Of course, in reality, the borrowing process can be difficult, depending upon the size of the loan as well as other factors.

Tradeoffs

Possibility You or Your Estate Might Not Get the Cash When the Time for the Sale Arrives

As the seller under a buy-sell agreement funded with borrowings, there is some risk that you may not get paid. Any number of events could happen between the time the buy-sell agreement is drafted and the time the business interest is sold. This risk might be the result of:

Change in Financial Condition--Buyer May Be Creditworthy Today, May Not Be Tomorrow

Although the buyer may be in a favorable position to borrow funds at the time the buy-sell agreement is drafted, there is no guarantee that financial conditions will remain the same. While the buyer can control some factors, other external events can affect borrowing capability.

For example, an individual or company is generally not able to control prevailing interest rates and availability of funds in the market. Economic conditions could cause a decline in the value of business assets so that they can no longer support a large loan. Personal circumstances can change greatly, and the resulting financial impact could make getting a personal loan to buy the business interest difficult or impossible.

Changing Interest Rate Environment Could Make Borrowing Too Costly

In a low-interest-rate environment, borrowing to fund the buy-sell agreement may be a wise move. Unfortunately, there is no guarantee that today's low rates will be available tomorrow.

If Business Is the Buyer, May Lack Cash Flow To Service Debt

Even if a business is relatively debt free, it may not generate enough cash flow to make the principal and interest payments on the amount of debt that is needed to buy the interest.

Death of Key Person Could Make Business Loan Difficult

Lenders may be reluctant to loan funds to the business at a time when an important asset (you) is gone. If your business is the buyer under your buy-sell agreement, and the funding plan relies on borrowings, the sale of your interest could be delayed.

Request Guide TRG

How to Do It

Things to Do Now

Think About How Much Risk You Are Willing To Accept

If you are very confident that your buyer will be able to secure a loan and pay you or your estate when it is time to sell your business interest, then borrowing to fund the purchase may be appropriate for your buy-sell agreement. However, if you would like more certainty that payment for the sale will be both available and accessible, you may want to look at alternative funding methods such as installment payments, stock redemption, sale-leaseback, appreciated property bailout, or life insurance.

Things to Do Later

You and Your Buy-Sell Participants Should Review the Agreement on a Regular Basis, Especially If Terms Specify an Annual Valuation of the Business

If it appears that the value of the business is increasing to levels that might make the amount of the loan too large, you might consider adopting funding methods to be used in conjunction with or in place of borrowings.

Review Your Buyer's Finances--(Is A Loan Still Possible?)

As part of the funding arrangement, you should routinely verify that the buyer is still in a position to get a loan. If the time comes when a loan is not possible, other funding can be arranged. This type of finance review can avoid an unpleasant surprise later.

Tax Considerations

Income Tax

Income Tax Impact on Seller's Estate

The buyer's use of borrowings as opposed to another funding method won't affect the income tax of the seller (or estate). However, the specific buy-sell agreement transaction may result in income tax consequences. Refer to the specific buy-sell agreement discussions for more information. It should be noted that the funding method used may have an impact on capital gains tax treatment. If the seller receives a lump-sum cash payment, the sale is subject to capital gains tax in the year of the sale. Use of a private annuity or installment sale may allow the capital gain to be spread over the payment period.

Tax Effect on the Buyer: Interest on Borrowings May Be Deductible

  • Individual as borrower: Generally, interest on personal loans is not deductible on your income tax return, but if it can be shown the loan proceeds were used for business purposes, the interest may also be deductible. Home equity interest may be deductible.

Tip: Document the use of the proceeds of a personal loan used for the purchase of a co-owner's interest in the business. If the Internal Revenue Service (IRS) questions your interest deduction, you will be able to back yourself up.

  • Business as borrower: If the business is a C corporation, the interest might be deductible if the borrowing can be shown to be for a valid business purpose.
  • S corporation as borrower: If the business is an S corporation, the deductibility is tested at the individual shareholder level. If a shareholder is an active participant in the business the interest is deductible. If the shareholder is a passive investor, the interest deduction is limited to the amount of the shareholder's investment income. In any event, a shareholder may not deduct their share of S corporation losses and deductions in excess of their adjusted basis in the S corporation's stock.

Gift and Estate Tax

Amount Estate Receives From Sale of Business Interest Sets Estate Tax Value

When your estate sells your business interest under a buy-sell agreement, the amount received from the sale usually sets the value of the business interest that is included in the gross value of your estate. It doesn't matter what funding method was used to facilitate the transaction.

Caution: If the price received is determined to be less than the fair market value (FMV), the estate will be required to include the FMV determined by the IRS in the gross value of the estate. This means it is possible that the estate could be required to pay tax on value it did not (and never will) receive.

Questions & Answers

Is There Any Risk To Using Buy-Sell Funding Methods Other Than Insurance?

The biggest risk is that you (or your estate) won't receive your money when you are ready to sell your business interest. Your buyer may have neglected to set aside the cash or was unable to get a loan. Or maybe your buyer did set aside the cash at one point and then needed it for some other purpose. If the business entity itself is your buyer, it may not have been able to set aside cash due to internal cash flow constraints or the possible imposition of the accumulated earnings tax.

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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