So today we are going to discuss part 2 of our 3 part mini-series regarding Business BUY-OUT options. As I mentioned in part 1 of our series, there are many ways to be able to fund a "Buy-Out" for a company. If you have missed our discussion in part 1, please click here for Buy-Out part 1.
The first alternative to the use of life insurance as a buy-sell-funding vehicle is cash. This approach has the apparent advantage that it is simple, and no immediate outlay of cash is required.
The problem is that the purchaser does not know precisely when or how much cash will be needed (or who will be the survivor), and thus must always keep a large cash reserve available to meet the anticipated need.
Regardless of the identity of the purchaser, after-tax dollars must be used to accomplish the buy-out. This means (depending on the purchaser’s federal and state income tax brackets) that more than one dollar must be earned to net a dollar of purchase money.
Monies that had been held in reserve may not be earning a return (or as high a return) as if invested personally or in the corporation. Unfortunately, this drain on the buyer’s cash flow occurs at the worst possible time.
If the corporation accumulates cash in anticipation of a need, will the liquidity trigger an accumulated earnings tax? If the surviving shareholders are to be the purchasers, will the corporation have the cash to increase its salaries enough for it to make payments of both principal and interest, and will these increased salaries be considered “reasonable?”
Borrowing is a second alternative to the use of life insurance as a funding vehicle. The advantage of borrowing to finance a buy-out is that no outlay is needed until death or disability occurs.
The problem is, will a bank lend money to a business that has just lost its most important asset, the person whose mind or drive or contacts made the corporation what it was?
If the bank will make the loan, will the terms or rates be reasonable - from the borrower’s viewpoint? What impact will cash flow demands of repaying the loan have on the operation of the business?
The cost to borrow $100,000 over a given period of time is substantial, as shown by the following figures that assume the buyer is in a 35% combined federal and state income tax bracket and is able to deduct interest payments:
TOTAL COST - INTEREST AND PRINCIPAL
10 Yr. Loan
15 Yr. Loan
20 Yr. Loan
TOTAL EARNINGS REQUIRED TO MAKE PAYMENTS
10 Yr. Loan
15 Yr. Loan
20 Yr. Loan
This, of course, does not reflect the effect on current earnings (before taxes) that is considerable, even after taking into account the tax deductibility of interest payments that has been severely limited.
An installment payout is often thought to be a feasible means to purchase the interest of a deceased shareholder.
The apparent advantage of an installment sale from the buyer’s position is that it is simple and relatively small outflow is required each year. Nothing is needed until death occurs.
Therefore, action can seemingly be put off for many years.
The decedent shareholder’s heirs appear to profit because they will receive interest on the unpaid balance. Gain can be spread over a number of years. Furthermore, the heirs are creditors of the buyers rather than shareholders of what may now have become a financially shaky business.
Keep in mind that the installment payout method merely delays the pain. From the buyer’s perspective it does not provide the cash to affect the buy-out and from the seller’s point of view. It does not provide the large sums of cash often needed for estate settlement costs, debts, and leaves substantial sums at the risk of the business. Therefore, it does not protect the family of the deceased shareholder.
Ironically, from the surviving shareholders’ viewpoint, an installment payout creates almost as much nuisance value as if the surviving spouse still owned the stock. These may be some of the very problems the buy-sell was instituted to avoid. Where will the surviving shareholder, if he or she is the purchaser, obtain enough after-tax cash to pay both principal and interest?
If payments are strung out too long (say more than 15 years), the IRS may argue that in reality, the seller has remained a shareholder rather than a creditor. That would mean payments from the corporation might be treated as dividends (nondeductible to the corporation taxable to the recipient) rather than payments for stock. The longer the term of the payments and the greater the obligation, the more adverse the affect on the credit rating of the business.