So today we are going to have our last discussion in regards to our 3 part mini-series regarding business Buy-Out options. As I mentioned in part 1 and 2 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 & 2 of our series, please click here for Buy-Out part 1 & Buy-Out part 2.
BARGAIN INTEREST RATES
Can the parties pass the stock from one generation to another using a fair price but using no interest or an ultra low interest rate and spread payments out over many years?
The answer is “NO.” Interest must be paid on the unpaid balance. In fact, if a buy-sell agreement allows for deferred payments, but does not provide for an “adequate” (according to the IRS) rate of interest on the payments the buyer owes but has not paid, the IRS will “impute” an interest rate.
In other words, the IRS will treat the parties as though they had agreed upon a payment for the right to defer part of the sales price. That payment (the imputed interest) will be set by reference to discount rules that reflect current market rates.
INSTALLMENT SALE TERMS
The rate is ascertained based on the time the buy-out is effected rather than the date the agreement is entered into. That rate might be much higher than the parties anticipate.
A seller allowing the buyer to defer payments will almost inevitably insist on security for the unpaid amounts. Corporate assets can secure the unpaid balance but this security may hinder the firm’s ability to borrow money to finance expansion or even raise working capital. Corporate assets may not be sufficient to satisfy the seller (who is now a creditor).
The seller may insist on the personal guarantees of the remaining shareholders in addition to the securing of corporate assets.
Of course, if the agreement was structured as a cross-purchase buy-sell, the corporation’s assets could not serve as collateral for the unpaid balance. Such an agreement would be void for lack of consideration - and therefore the purchasing shareholders would be personally liable.
An installment sale can be incredibly expensive from the buyers’ perspective. Illustrated below is the cost of a ten-year payout with installments totaling $200,000, assuming 13% interest is paid on the remaining balance, and the buyer is in a combined federal and state death tax bracket of 35 percent.
at 13 %
The bottom line is that deferred payments should be used as a last resort “escape valve” in case there is an inadequate amount of insurance rather than as the primary means of financing a buy-out at a shareholder’s death.
Life insurance is the only means of guaranteeing that death, the event that creates the need for cash, also “creates the cash” to satisfy that need. This makes it possible for a stockholder’s surviving spouse to receive the full fair-market value of the business interest and bail out of the business before it loses value. Adequate amounts of life insurance demonstrate to bank loan officers and other creditors that the shareholders are financially responsible as well as financially capable.
Premiums can be viewed loosely as advance installment payments that are easily budgeted, so the event of the buy-out does not hurt the cash flow of the business.
There are, of course, disadvantages to the use of life insurance. “Up front” dollars and the after-tax income they might have earned are required. That money is paid long before the parties feel the urgency of the situation. Occasionally, clients may be psychologically offended by an outlay without an apparent immediate economic benefit. Of course, peace of mind attained by all parties when the buy-sell is fully and properly funded justifies these “costs.”
If the buyout occurs during a business owner’s lifetime, the cash values of a life insurance policy can be used to help provide at least a portion of the purchase price. These cash values can be obtained from the policy on a tax-favored basis either by policy loan, withdrawal or by a partial surrender of the policy.
Unless the policy falls into the classification of a MEC (modified endowment contract), a policy loan, withdrawal, or partial surrender can be made income tax free up to the policy owner’s basis.