Succession planning insights – Part III
Installment payments to buy out a business interest—not as simple as it sounds.
A common technique to buy out a co-owner’s business interest is through installment payments. This method allows the purchaser some breathing room since it doesn’t require the full purchase price to be paid upfront and also provides a steady income stream to the seller over a period of typically 5, 10 or 15 years. Seems logical and simple enough.
Let’s assume we have a company, M&E Inc., a profitable S Corporation valued at $10 million that is equally owned by Mark and Edward. Additionally, the business owners had the foresight to establish a Buy-Sell Agreement which would legally dictate what would happen in the event one of the owners departed the business for a variety of reasons including death, disability and retirement.
The Buy-Sell Agreement requires the remaining owner to purchase the selling owner’s interest through a ten-year installment for $5,000,000 plus interest. Sounds fairly common, right? Let’s look at some of the potential issues with installment payments, issues so severe that they could cause the forced sale of the company.
The installment payments are not deductible by M&E Inc. and Mark and Edward are in a 40% combined marginal federal and state tax bracket. M&E Inc. operates on a profit margin of 10% for every dollar of sale.
Installment method financial reality
The annual installment payment is $500,000 (not including interest), which means that the remaining owner has to earn nearly $850,000 to net the $500,000 in a 40% combined marginal tax bracket to satisfy the annual obligation. Earning $850,000 in income means that the remaining owner will have to generate annual sales of $8.5 million just to generate the $500,000 needed—which is $85,000,000 of annual sales needed to meet the ten-year required financial and legal obligation.
Installment method issues
Will the remaining owner be able to generate enough profits to pay the installment payment and still pay himself the salary that he’s been accustomed? Also, will the death of an owner have an impact on sales? If so, how is this going to be made up? Most likely the remaining owner will have to hire someone to take over the responsibilities of the departed owner. Where will this money come from and how much more will be needed? Additionally, the installment method may have a direct negative impact on the ability of the corporation to pay employee salaries, borrow money, expand and fulfill other business purposes.
Another issue that often isn’t given consideration with an installment method is if the remaining owner or business becomes insolvent during the time period of the installment payments. It could mean that the departed owner and his family may only receive a fraction of the expected payout. Another possibility is that the remaining owner could pass away during the installment period which is even yet another potential risk that the original departed owner and his family incurs.
Although installment payments as a technique to satisfy a business owner’s buyout may seem basic, it is wrought with a number of potential risks, many of which are not thought through when the installment arrangement is entered into. There are other planning techniques that not only substantially reduce the inherent risk of installment payments, but are also less costly to the remaining owner.