Mandatory interest on owner-carried loan?

Question

I'm preparing to purchase a business and the owner wants a flat purchase price and will charge zero interest on the loan.  Her attorney told her she is REQUIRED by federal law to charge a minimum 2.75% interest or else we'll get hit with some kind of tax penalty.

The only thing I can think of is that I would take a hit because it might look as if I gained the business immediately, thereby incurring the entire value as a gain rather than purchasing it over a 5-year period.  Does this make sense?

The owner is adamant she doesn't want to charge me interest, but her back is against the wall.  This deal is still a dream opportunity at 2.75% interest, but we don't want to pay interest if we don't have to.  Can anyone enlighten me on what her attorney is talking about?

Bill Gulley · Answer

Sort of, but not exactly, since interest is compounded over the term. You'll need to discount the interest over the loan term to arrive at it's present value which will be the new sale price. My amortization program is not handy, but you can do it with a financial calculator, an easy way is to enter the desired sale price as the present value and enter the rate agreed to be paid and enter the term, like 15, 20 or 30 years, and then solve for the payment amount. That payment amount is the amount if you were to pay the sale price with interest, all that does is arrive at a fair monthly payment to be made. Clear you calculator, now enter the payment, or your numbers work out to be 716.43 on a 20 year amortization. At that payment over 60 months the present value is 37,057.74. You agreed to pay 100,000 so subtract the present value from that amount and you get 62,942.26. Now enter that difference as the future value to be earned in 60 months at 6 % and solve for the present value of that amount and you get 46,663.64. Now you have what the payments are worth in present value terms and the present value of the amount needed to make up the difference that would otherwise be owed in 60 months. So, 46,663.64 plus the present value of the payments, 37,057.74 are the two present values, add them together and you get 83.721.38 which reflects the present value of a loan earning 6%, payable for five years and amortized for 20 years with the balloon payment or amount required to be paid in 5 years. So your new sale price is $83, 725, to make it look good! Now, you can require a payment on the note of 716.43 (regardless of what the amortization is) at 6% interest for 60 months with all amounts remaining being paid in 60 months. By the wy, the amortization is 208.26 months, but that is irrelevant, that is not to be mentioned in the note, just the payment required, the interest rate and the beginning loan amount or sale price with all amounts remaing at maturity to be paid in full.

Good luck, if you have a problem with it, copy this and take it to the attorney. They will get the idea and they may have a program that runs these formulas. Good luck, Bill

Nathan Gesner · Answer

OK, that makes sense.  I like your idea of discounting the original purchase price and adding the interest, resulting in a total purchase price that is equal to what we wanted to pay.  Let's see if this example makes sense:

Original price: $100,000

New price: $94,000 at 6% interest
Total payments: $99,640

I lower the price, but add interest, bringing the total amount back to the original price without interest.  Correct?

I obviously need to get in and see my accountant before going further but this will give me a good start.  Thanks!!!

Nathan Gesner · Answer

Wait a second...something just dawned on my slow brain!

Regardless of how I finance the company, isn't it still considered a gain on my part?  So if I finance it at 3% or at 10%, the value of the company is still taxed, minus my deductions?

So how will the business be taxed?  The annual gross is $60,000 and net is around $45,000.  Am I going to be taxed based on purchase price, annual gross, or annual net?

I also have a bunch of deductions, such as the loan interest, education, health insurance, work truck purchase of $30,000, etc.  The current owner never pays company tax because there are so many deductions, so I'm expecting to be in the same boat.

OK, I'm calling my CPA...again!

Bill Gulley · Answer

Hi, the attorney is correct, the IRS has an imputed tax rate and I believe it's tied to the Treasury index, which might be at the rate metioned, maybe not. I believe your assumption of gaining the business in 5 years is incorrect. When you contract to buy and close, you own it and you have a debt secured.

Why don't you go back and offer 6% interest and discount the sale price over a five year term. That is the same thing as paying the higher price without interest. You can deduct your interest, not your principal payments. You cost will be lower so if you seel you'll have a gain, but then it's at an after tax rate for you from the reality of the deal. FIve years is not very long to establish equity in a commercial building if you are getting a high LTV loan from the seller. So, here is another suggestion;

Offer to pay a pre-payment penalty like 5% the first year, 4% in year 2, and so on to year five. FOr that ask that the loan be extended at a new rate, say no more than 4% over the 1 year T-Bill rate at that time, IF there was no event of default in you loan and the renewal would be without a pre-payment penalty. This is pretty fair, IMO, and gives you an opportunity to extend your loan in the evnt your property value does not go up significantly in the next five years...otherwise, you could get stuck having to come up with a chunk of money as a down payment in your refinance in 5 years! Good luck, Bill