Can I pay dividend/profit sharing with investors before debt is paid off ?

searcher profile

October 22, 2020

by a searcher from Harvard University - Harvard Business School in San Jose, CA, USA

Hi :
I am wondering what is the best practice to pay the investors for dividends/profit sharing after the acquisition. Does SBA loan prevent it before the debt is paid off? What is the tax consequence for the recipients?

Angela

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commentor profile
Reply by a lender
from Nova Southeastern University in Lancaster, PA, USA
The short answer is yes. The SBA allows distributions of earnings.


The loans docs typically say that the bank has to approve distributions but that is rarely enforced. And it isn't unusual for the bank to limit how much can be distributed.

If there is a technical (non-monetary) default you will need to get approval from your bank first. If there is a monetary default (your payments are late) or if you're about to declare bankruptcy I would suggest but taking distributions.

The tax consequences depend upon the entity type, the nature of the distribution and the investors personal situation.
commentor profile
Reply by a searcher
from Harvard University
The model tends to break down if you can't make payouts--everything depends on your ability to pay that SBA loan at low interest over a 10-year term while giving your investors returns faster (thus boosting ROI). In my experience you should be able to get a debt structure where as long as you are making your monthly debt service obligation and the business remains healthy, there aren't any restrictions on your ability to make distributions. (It would be understandable to have covenants where if the lender saw the business deteriorating significantly that they would have the ability to then prevent distributions.)
As far as taxes, that is a really tricky area to model. Any principal repayments you make on the loan represent taxable profit that is not available as cash flow. And (though I'm not an accountant) my understanding is that for S-Corps or LLCs all of the business' profits pass through to their shareholders' individual tax returns one way or another--regardless of whether those profits were distributed. So with S-Corps and LLCs you can have some tricky situations where investors might be incurring tax liability even if they haven't received a distribution. But I don't think distributing the funds incurs any additional liability.
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