Businesses are bought and sold often. But for the business owner who sells, it could be a one-time event and the most significant of their career. Of course, one of the big concerns for a seller is getting optimum value for the business.
Selling a Business Using Installment Payments
With many business sales, the buyer obtains a loan from a commercial lender. Lenders, typically banks, are experts at documenting their loan to the buyer to make sure they get their money back. Lenders have banks (no pun intended) of form documents to help them gather and record the details of the transaction and provide for contingencies. In deals where a commercial lender is not involved, the parties often want to forgo the formalities a commercial lender would require and carry out the sale using documents they assume are good enough. Less formality can be costly to a seller if the deal involves the buyer making a down payment at closing together with a promise to pay the balance over time.
If as a seller you agree to accept payments over time, you are a lender and you have made a loan. If you have not put agreements in place similar to the documentation a commercial lender would use, you will fail to address critical terms. A less formal agreement might fail to clearly define when payments are to be made, when the final payment is due, how interest will be accrue, how payments will be applied, or what happens when the other person doesn’t pay as promised. Trying to interpret what was meant when terms are inconsistent or missing, usually costs many times more than having a proper agreement and promissory note prepared in the first place.
There are a couple of items that come up frequently, and should not be overlooked: Interest and security (collateral). This article will address the issue of interest, and security will be discussed in a follow up.
With Few Exceptions, You Need to Charge Interest
Many transactions are between business partners or acquaintances, people who consider each other friends. The buyer doesn’t want to have to pay interest, and the seller feels funny asking for it, so they agree, no interest. Unfortunately, the IRS may “impute” interest received to the seller, even if the parties agreed to zero interest or a rate below the IRS’ published rates. As the saying goes, there’s no such thing as a free lunch. Here is how the IRS will treat various situations.
1. No or Very Low Interest Loans Between Unrelated Parties
It is not unusual to find arrangements where the seller has loaned money or entered into a purchase agreement providing that the buyer will pay over time, and no interest or interest at a very low rate is charged. When the IRS reviews these arrangements, it can disregard the parties’ agreement and “impute” interest income to the seller/lender anyway at the “applicable federal rate.” Each month, the IRS publishes a table of the minimum interest rates that must be charged, which varies depending on such things as the amount, how often interest would be calculated on the outstanding balance, and the length of the repayment period. Even if the parties agree to something else, the IRS wants all loans treated as a bona fide business transactions and will attribute interest income received to the seller/lender at the applicable federal rate. If you are the seller, even if you did not receive interest, you will still have to pay taxes as if you did. The only way to avoid having to pay tax income on income you did not receive is to receive it: charge at least the applicable federal rate in the first place.
2. Loans Between Family Members
Interest on a loan between family members will also be imputed, but can be treated as a gift, rather than reportable income. If the amount of the imputed interest exceeds the annual gift tax exclusion amount (currently at $15,000), no gift tax will be due but the excess will be applied to the lifetime gift tax exclusion. Also, there are exceptions. For instance, if the loan is for less than $10,000, or if the money was used to purchase something that will enable the family member to earn income, the IRS will not impute interest. Again, this only applies to a family member, not your best friend. If the loan (up to a limited amount) is to start a business or buy a home, the amount of imputed interest you would be taxed on is limited to the amount of your net investment income for the year; if that amount is less than $1,000, no interest will be imputed to you.
Don’t enter into payment plans with too low of an interest rate
Of course, there are nuances, and exceptions to the exceptions, but it is safe to say that no one should enter into deal with a payment plan that charges no interest or interest at too low of a rate, without checking with their accountant on the IRS rules and the current applicable federal rate. And while it may cost a little more now, working with an attorney who can spot these issues and draft the proper agreements for you will save surprises, and money, down the road. Whether you are buying or selling, the attorneys at Bartelt Grob, S.C. can help you navigate the process.