Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success
Q: We often see "Distributions limited to tax purpose" or something along those lines, but the covenant usually does not also specify "No Loans to Shareholders". Is that typical? Or does the language assume limited distributions and no loans to owners?
A: Loans to owners is a general escape route that can be used if owners agree that distributions will not exceed the income tax obligation on taxable company income. Many lenders have war stories about imposing a tax-based limitation which is honored by the owners, but then the lender observes simultaneously that loans to owners suddenly appear or increase greatly. As a result, the next set of limitations on distributions would define loans to owners as equivalent to distributions in setting the limitation. But the language must be specific. Best practice is to include limits to both loans to Shareholders and Distributions in the language if you are trying to limit the cash an owner can take out in tax-free compensation.
Note, too, that it is generally impractical to set a distribution limitation to the tax obligation for a partnership or LLC, since – in the absence of guaranteed payments – distributions represent the sole source of compensation for the partners. According to the IRS, salaries for partners or members are not a tax-deductible expense. Therefore, salaries are not used as a means of providing compensation to partners or members.
Course overview: Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success