Say your business generates $400,000 per year in profits, is worth $2 million and your tax basis in your S corporation stock is $400,000. You have a key employee (KE) who wants to buy the business. You have managed your finances prudently over the years and you don’t need top dollar from the sale. KE has helped you build the business and is highly capable of running the company but doesn’t have much cash. You would like to give KE a chance to own and run the business so you ask your CPA how this might work. CPA says no problem—we’ll sell the stock to your key employee for an installment note.
The CPA structures the note as follows: $2,000,000 principal, 4.0% interest, 10 year term, annual payments of $243,000. If we allow 35% for federal and state taxes, the $400,000 cash flow will generate about $260,000 after taxes, giving the company an annual cushion of about $17,000 ($260,000 – $243,000). And here is the best part: The $2,000,000 in principal payments that you receive over 10 years will be taxed as capital gains, after deducting your $400,000 basis pro rata as you receive payment. If we assume a 25% federal and state combined capital gains rate, your total taxes will be $400,000 on the $2,000,000 [($2,000,000 – $400,000) x 25%] and your after tax proceeds are $1,600,000. What could be wrong with that? Plenty.
First of all, 10 years is an eternity when it comes to getting paid out from a closely-held business. At a minimum, consider a balloon payment after 4 or 5 years. If the business is doing well, the note can be refinanced using Small Business Administration guaranteed financing. If the business is not doing well, then you have problems that must be addressed in any event.
Second, a large percentage of the total company cash flow is going to taxes. Of the $400,000 in company cash flow, the new owner is paying $140,000 (35% rate), then if we assume annual principal payments of $200,000, the owner is paying another $40,000 [($200,000 – $40,000 in basis) x 25%] in capital gains. Therefore, $180,000 of the total cash flow of $400,000 (or a whopping 45%) is going for taxes. This gives the company a small margin ($17,000) in the event of a loss of a key customer, need for new product development, equipment purchase, etc. Uncle Sam and Uncle Tom Wolfe are your senior partners on this deal and they demand timely payment every year. The tax burden makes the deal more risky and less likely that the owner will get paid out.
So what can we do? Plenty if we have a few years to plan and structure the transaction.
First, make best use of qualified retirement plans. The departing owner is usually older and more highly compensated than the other employees. This creates opportunities for using age-weighted/cross-tested profit sharing plans and cash balance plans to put away extra cash for the departing owner. It is common to be able to increase retirement contributions for the departing owner by $50,000–$100,000 per year without any greater burden on the company. Furthermore, these payments are fully deductible by the company and are not taxable to the recipient until she makes withdrawals on turning 70½. Typically the owner is in a lower tax bracket in retirement, so there is a double benefit—all taxes are deferred and then are actually lower when withdrawals are made.
Second, use Non-Qualified Deferred Compensation (NQDC) to create a retirement fund for the departing owner. Typically, in an S corporation, the owner’s salary is kept to a minimum to avoid paying excess Medicare Tax. So let’s say our owner has been taking a salary of $125,000 per year (taking the rest of the profits as S corporation distributions) and the true market value for the services provided in growing and managing the company are $250,000 per year. This means that our owner has been “underpaid” by $125,000 per year for many years. Now that our owner is getting ready to retire, the company establishes a NQDC compensation program as partial “make-up” for the years of below-market compensation. Say the plan that we establish requires payment of $250,000 per year to the owner for 5 years. Now these payments will be treated as ordinary income to the owner subject to ordinary income rates. True, but these payments are also fully deductible by the S corporation resulting in a total effective tax rate of 35% on the company cash flow or 10% less than the installment loan payments taxed at a total of 45% above. The deferred compensation by itself reduces the total tax burden by $125,000 ($250,000 x 5 x 10%). There is cash flow available to increase total payments to the departing owner to make-up for additional taxes he pays.
From the owner’s perspective, a better solution is to use bank financing rather than depend on the company cash flow for the buy-out. How might this work?
How do sales to key employees look from the bank’s perspective? Banks are in the business of lending money and want to make loans, but we must understand under what circumstances the bank will be “comfortable” making a loan to key employees for the purpose of buying the business. First, the lender must be confident that the new owner/key employee is capable of running the business. This is absolutely critical—if the bank lacks confidence in the business ability of the prospective new owner, it will not make any loan, regardless of other favorable circumstance. Second, the bank’s normal lending requirements regarding equity and collateral must be satisfied.
The collateral available to the bank will vary depending on the character of the business. Some businesses have a plethora of “hard” assets—inventory, receivables, and equipment which are preferred collateral in addition to receiving the company stock as collateral. Other businesses—e.g. service businesses—have very little by way of hard assets. This is not necessarily fatal. Some banks—especially with SBA guarantees—will make these loans based on anticipated cash flow.
The bigger problem is that any lender will require that the borrower/key employee have some equity in the business. In the best case, SBA guaranteed loans might require as little as 15% equity, with 5% provided by a seller note, and only 10% “real” equity. Other lenders might require 30%–35% equity. Getting this much equity to the borrower in a way that is palatable to the seller requires some planning. For example, one tax efficient way to get equity to a key employee is by way of stock bonuses. Rather than give cash bonuses, a bonus of an equal value of shares of stock will get ownership to the key employee. The stock bonus is deductible to the corporation to the extent of the fair market value of the stock and is taxable to the employee. Because the shares paid to the key employee represent a minority interest in the company, they will be subject to a valuation discount which might be as high as 40%. Therefore, a given dollar amount will transfer more shares. At worst, this is a tax “wash” with the corporation receiving a tax deduction equal to the income reported to the employee (some cash will need to be paid to the employee so he can pay the tax on the stock bonus). A stock bonus program can be combined with deferred compensation to the selling owner to make her “whole” for the stock going to the employee without her receiving any cash compensation. Over 3 years, it might be possible to get 20%–30% of the stock to the key employee. We are then in a position to go to a lender and try to structure a deal that might involve a seller note for 10%–20% with the bank financing 50%–70% at closing.
It is important to realize that there is a national market of potential lenders. They will range from local community banks (with the strictest credit standards) to private investor groups to insurance companies to pension funds. There are a few excellent brokers who for a fee of 1%–1.5% will find a lender for a particular transaction. Your sale to a key employee might be financed by an investor group based in Atlanta or a niche lender in Tennessee.
Every situation is different and not all of these techniques will be available in every case. But in every case, there will be tax planning available to reduce the taxes going to Uncle Sam and Uncle Tom, increase after-tax business cash flow, and make the deal much more attractive to the departing owner. For many deals, it will be possible to find third-party lenders who will finance the deal and help the seller dramatically reduce her risk.
Published in Business2Business magazine, December 2015