Can you take distributions or tax distributions while you have a business loan?

Why lenders restrict distributions at all

A lender sizes a loan on the cash the business generates, then relies on that cash staying in the business until the loan is repaid. Every dollar paid to owners is a dollar that is not available for debt service, capex or a bad quarter. The restricted payments covenant is how the lender protects that cash. It is a negative covenant: the borrower may not make restricted payments except as expressly permitted.

The definition is broader than most owners expect. It commonly covers:

• Dividends and distributions to shareholders or members, in cash or property.
• Redemptions and buybacks of equity, including buying out a departing partner.
• Payments on debt that is subordinated to the lender, such as a seller note or a loan from the owner.
• Management fees and other payments to owners or their affiliates above ordinary compensation.

Salary for work actually done is not a restricted payment, but lenders will look at owner compensation that jumps after closing. Repaying a shareholder loan usually is restricted, and is often subordinated outright.

The tax problem pass-through owners face

An S corporation or an LLC taxed as a partnership does not pay federal income tax itself. Its income is allocated to the owners, who pay tax on their share whether or not the company distributes any cash. At the same time, the company uses its cash to repay loan principal, and principal is not a deductible expense. The result is phantom income: taxable profit that has already been spent on debt.

A worked example makes the gap plain. The figures are illustrative.

In the example the problem is partly structural: a business that must repay principal faster than it earns after-tax cash is carrying more debt than it can support. A good lender sizes the loan with taxes in the fixed charges, which is what the fixed charge coverage ratio does. But even a well-sized loan leaves the owners exposed if the agreement does not let the company pay their taxes. Add an excess cash flow sweep that takes a share of whatever is left, and the owners can find themselves with a large tax bill and no access to the profits that created it.

In a pass-through company, the tax on the business's income is a business cost that happens to be paid by the owners. The loan agreement should treat it that way.

How a tax distribution carve-out is written

Most lenders to pass-through companies will agree to a tax distribution carve-out. The fight is over the details, and those are where owners lose money:

The assumed rate matters most. Owners in different states, or with other income, pay different rates. A carve-out keyed to an average leaves the highest-taxed owner short, and because distributions in an S corporation, and in many LLCs under their operating agreements, must be pro rata to ownership, the company cannot simply pay that owner more. The highest-rate convention solves that at the cost of over-distributing slightly to other owners, which lenders generally accept.

C corporations do not need the carve-out: the company pays its own income tax, as an expense, before anything reaches the owners. Their owners' question is only about ordinary dividends.

Distributions beyond taxes: the baskets

Owners who expect to take cash out of the business beyond their taxes need a basket for it. The common forms:

• A fixed annual basket. A set amount each year, sometimes with carry-forward of unused room. Simple and predictable, and usually small.
• A leverage-based basket. Unlimited or larger distributions while pro forma leverage, measured after the payment, stays below a set level. This rewards paying debt down and is the most useful basket for a growing business. The total leverage ratio is the usual test.
• A builder basket. A cumulative amount that grows with a share of net income or retained excess cash flow, less what has already been used. Common in larger agreements.
• Permitted payments on junior debt. Scheduled interest and principal on a seller note or shareholder loan, subject to the subordination agreement and usually blocked in a default.

Nearly every basket carries the same two conditions: no default exists or would result, and the company is in pro forma compliance with its financial covenants after the payment. Negotiate the definitions, the covenant levels and the headroom with the baskets in mind; a distribution permitted on paper is useless if paying it breaks the fixed charge test.

SBA loans and distributions

SBA adds a rule of its own: SBA loan proceeds cannot fund a distribution to owners, or refinance debt that did. A business that took a distribution funded by a bank loan cannot later move that loan into a 7(a). This is also why a recapitalization that pays owners is financed with conventional or private credit, not SBA.

After closing, SBA loan agreements commonly restrict distributions and changes in ownership, and the lender's own terms decide how tax distributions are handled. SBA lenders underwrite global cash flow, which includes the owners, so owner taxes are already in their analysis. Ask the lender to state in the loan documents that ordinary tax distributions for a pass-through borrower are permitted while payments are current.

What to settle before you sign

• Put the tax distribution carve-out in the term sheet, with the assumed rate, the timing and the default blocker spelled out. Do not leave it to "customary" language.
• If you have made or plan a state pass-through entity tax election, say so and get it addressed.
• Decide what distributions beyond tax you expect over the life of the loan, and negotiate a basket that fits: fixed, leverage-based or both.
• Check that the financial model the lender approved includes the distributions you plan, so the covenant levels already allow for them.
• Read the restricted payments definition for buyouts of departing partners, payments on seller notes and management fees, which can all be caught.
• Look at the interaction with any excess cash flow sweep: the sweep should be calculated after tax distributions, not before.

When Transparent builds a financing model for a pass-through borrower, owner taxes and planned distributions are modeled as their own lines, so every lender sees the same assumptions and the term sheets can be compared on how they treat them. More on how we underwrite.