Seller Financing Series: Taxes, “Bad Books,” and Bridge Loans

Before you make any decisions on how to structure the sale of your business, educate yourself on the tax consequences, bridge loans and several tried and true methods of minimizing the amount of taxes you must pay on your sale proceeds. Take some time to meet with your CPA and your business broker to create a plan for payments by the buyer that optimizes the amount of the sales price you get to keep.

Seller financing can be an important tool in this process.  Instead of getting a lump sum payment for the sale of your business, you can use seller financing as a mechanism to defer taxes until the period when you receive the payments (per IRS publication 537).  This may also have the ancillary effect of putting you in a lower tax bracket than you might be with getting the entire purchase price at one time.  I’m not trying to take the place of professional advice specific to your own finances, just showing you the outline of options available to you in a business sale.

Consider that while you were running your business, you probably made a salary. Then, when you sold your business, you received the net proceeds of the down payment. These two items may push you into the highest tax bracket possible for your earnings. Now, if I’m you, the last thing I want to do is waste 30% to 40% of my money on taxes if there are other options.

You can defer taxes to a later tax period by splitting the proceeds into monthly (or quarterly) payments from the buyer versus a lump sum.  This may keep you from being pushed into the highest possible tax bracket. If you, along with the expert advice of your business broker and CPA, can create the best schedule of payments for you tax-wise, you can pay a lot less in taxes on the overall sales price of your business, this could be a significant savings indeed.

I have seen many sellers choose to amortize the loan over a full 10 years so that they are never pushed into the higher tax bracket. This tax savings depends on your particular situation and tax position. Ask your CPA for more specific information about your particular situation.

What is “Bad Books”?

Spreading out the timing of payments to minimize tax burden is only one reason to use seller financing. Another reason is to avoid the stigma of “bad books.”

Candidly, “bad books” is one of the main reasons business owners have no other choice but to offer seller financing. What I mean by “bad books” is when sellers minimize their tax burden along the way, for instance, by expensing everything in the world that you can, thereby making your company look less profitable.

Now, I’m not saying you did this, but if you did, you know what I mean. You expensed items that a new buyer would not have. That may mean you paid less in taxes, but it also makes your company less profitable (the difference between income and expense), and less valuable, and the end result may be that a bank may not finance the business acquisition.

Another side effect of “bad books” is that a buyer will not pay cash. Why would they? Yes, they may have the money (in fact, when I sold my business, the buyer DID have the cash), but they want to MAKE SURE that the “discretionary” expenses really are discretionary.

Candidly, while I do not recommend keeping your records in this manner, we see this in a good portion of the cases we come across. The buyer may have come out of corporate America, where they received a salary and a benefits package that was clearly reported to the IRS. Therefore, while the buyer may understand what you did, they may not completely understand if the money will be there for them in quite the same amount.

One way or the other, the buyer wants you to have confidence in the business at the level that you will finance the business. This shows that these “discretionary” expenses really can translate to profit for the buyer.

Bridge Loans

You could consider offering a bridge loan to the buyer. Many banks will not offer financing for any amount of the purchase over the “liquidated value” of your assets. Why? Because they do not have someone like you on their staff – someone that understands the business the way you understand the business. They have no one that the buyer can call to ask questions. When banks loan businesses money in excess of their assets, they have a relationship with the business and the borrower (both).

However, many banks that will not finance the acquisition of a business WILL offer financing to an established business for the use of consolidating debt. If you do not want to carry the note for a longer period of time to realize the most money for your business, consider offering a bridge loan.

Why is it called that and what, exactly, IS a bridge loan? This type of loan is called a “bridge loan” because it helps the buyer get to the place where a bank will offer financing. You may offer financing for as short as 24 months to as long as 5 years. Typically, a bridge loan is for a period of three years.

Here is how it works: the loan is amortized for 10 years, but with a balloon payment after 3 years. At the point of the balloon payment, the buyer goes to a lender and acquires a loan to pay off the original loan. Once a buyer has had the business track record of three years combined with financials that truly reflect the profitability of the company, it is much easier for them to get the needed loan to pay off the seller.

Note Buyers

Another option that you have as a “bank” is to sell your loan to a note purchaser. While I am not a big fan of this method, it is an option for some. The note purchaser will purchase the loan from you once the loan is “seasoned” – or 3 to 6 months after closing. A note purchaser pays you a discounted amount for your note. For example, if you have a $1,000,000 note at 9% interest, the purchaser (depending on a number of variables) might give you $800,000. You would take a “hit” of $200,000 plus the interest that you have lost (which is the main reason that this is a problem), but it is an option. Furthermore, because you actually got 30% more for your business, you could STILL sell the note and make more money over a 12- to 24-month time frame than if you had received 100% cash at the closing table.