Forgivable Note - Tax Implications & Working Capital

October 10, 2024

by a searcher from Texas Tech University in Austin, TX, USA

I am working on a deal that can possibly have a forgivable note that will meet SBA terms. I would like to understand

1. Tax Implications - Meaning, if the note is forgiven because business did not meet the forgivable note terms, will the buyer incur tax on the forgiven loan amount

2, Working Capital Implications - The deal will have around $600K of working capital Inventory at close, as a buyer I will be using this working capital inventory to run the business and possibly meet the forgivable note terms to earn this for the seller. And by the time, the forgivable note terms are met, there is a possibility the working capital inventory can go down. How to evaluate the working capital requirement in the light of forgivable note.

Currently, I was thinking just to have Revenue or Gross Profit as the forgivable note term, should working capital target also be part of forgivable note terms?

Reply by a professional
from Harvard University in Lynbrook, NY 11563, USA

This question comes up repeatedly and there is always wrong info given in response. Generally speaking, a forgivable note in an acquisition is NOT cancellation of debt income, but instead treated as a reduction in purchase price (with the implication to buyer being it will reduce your basis in the acquired assets because you paid less, and to seller being that seller will have less gain on sale).

See section 108(e)(5) of the Code:
https://www.law.cornell.edu/uscode/text/26/108

Reply by an intermediary
from Wake Forest University in Winston-Salem, NC, USA

1. Not taxable, see http://www.irs.gov/taxtopics/tc431.html, Exception #6, if it is "A qualified purchase price reduction given by the seller of property to the buyer", Confirm with your CPA/Atty.
2. I would guess that the NWC true-up is going to occur well before the measurement period for any forgiveness. So unless you are trying to tie the true-up settlement into an increase or decrease of the SF principal amount, I would leave them separate.

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