Restricted payments are payments to or for the owners: dividends, distributions, share buybacks and redemptions, and often payments on subordinated debt such as a seller note or shareholder loans. A credit agreement prohibits them, then allows exceptions called baskets. The usual ones are a tax distribution for pass-through owners, a fixed amount each year, and a larger amount while leverage stays under a set level and no default exists. So yes, owners can usually take distributions, within those limits. Negotiate the baskets before closing, because lenders rarely add them afterwards.
- What counts
- Dividends, distributions, buybacks, redemptions, and usually payments on subordinated and shareholder debt
- Default position
- Prohibited, except through baskets
- Most important basket
- Tax distributions for S corporation and LLC owners
- Other common baskets
- A fixed annual amount; a leverage-tested amount; a share of excess cash flow
- Usual conditions
- No default; pro forma covenant compliance; on a line, minimum availability
- SBA loans
- Proceeds cannot fund a distribution; a standby seller note gets nothing for the life of the loan
What counts as a restricted payment
The definition is written to catch every route by which cash can reach the owners ahead of the lender. It usually includes:
- Dividends and distributions of any kind, in cash or property, on any class of equity.
- Redemptions and buybacks: the company buying back shares or units from an owner, including in a partner buyout or when an owner retires.
- Payments on subordinated debt, including seller notes and earnout-like obligations, beyond what the subordination agreement permits.
- Payments on shareholder loans, the money owners put into the business as debt. See shareholder loans and lenders.
- Management and monitoring fees paid to an owner's holding company or sponsor, in agreements where a sponsor or independent sponsor is involved.
Ordinary salaries and bonuses to owners who work in the business are usually not restricted payments, but the affiliate transactions covenant may require them to be reasonable. Lenders look closely at owner compensation that jumps after closing.
Why lenders restrict them
A lender sizes a loan on the cash the business generates. Every dollar paid to the owners is a dollar not available to service the debt or absorb a bad quarter. The lender also relies on the owners' equity sitting beneath its loan; paying it out, or repaying owner loans ahead of the lender, moves the owners up the line.
That is why most coverage covenants subtract distributions. On a fixed charge coverage test, distributions come straight out of the numerator, so a distribution permitted by the restricted payments covenant can still cause a coverage breach at the next test date. The two covenants have to be read together.
The common baskets
| Basket | How it works | Usual conditions | What to watch |
|---|---|---|---|
| Tax distributions | Lets a pass-through company distribute enough for owners to pay tax on the income allocated to them | Calculated at an assumed tax rate on taxable income; paid around estimated-tax dates | The assumed rate, whether state taxes are included, and whether it survives a default |
| Fixed annual amount | A set amount per fiscal year, sometimes with unused amounts carried forward | No default | Whether it is per year or for the life of the loan |
| Leverage-tested | Unlimited, or a larger amount, while pro forma leverage is under a stated level | No default; leverage calculated after the payment | The level: set too low, it never opens |
| Excess cash flow share | A share of the year's excess cash flow after any required sweep | Annual, after the financial statements are delivered | How excess cash flow is defined; see excess cash flow sweep |
| Named items | Specific payments listed at closing, such as scheduled seller note interest or a planned buyout of a minority partner | As stated | Anything not listed is not permitted |
| Availability-tested (asset-based lines) | Payments allowed while excess availability stays above a threshold, before and after the payment | Often also a minimum fixed charge coverage | The availability forecast in the month of payment |
The leverage-tested and availability-tested baskets are incurrence tests: they are checked only when a payment is made, on a pro forma basis. A leverage basket works like a ladder. While the business is highly levered after closing, only the tax and fixed baskets are open; as debt is repaid and EBITDA grows, leverage falls below the threshold and larger distributions become possible.
The tax distribution carve-out
A large share of owner-run businesses are S corporations or LLCs taxed as partnerships. Their income is taxed on the owners' personal returns whether or not any cash is distributed. A restricted payments covenant with no tax carve-out can leave owners owing tax on income they are not allowed to take out of the company.
A worked example. An S corporation earns taxable income of 2,000. Its owners' combined tax on that income, at the rate the agreement assumes, is 700. The business must also repay 900 of principal this year, which comes from after-tax cash and is not deductible. Without a tax carve-out, the owners pay 700 from personal funds on income that stayed in the company to repay the lender. With one, the company distributes 700 on the estimated-tax dates and the owners are whole.
Tax distribution baskets are standard in most bank and private credit agreements for pass-through borrowers, but the details vary: the assumed rate, whether state and local taxes count, whether it is calculated on the company's income or each owner's, and whether it stays open during a default. Those details are covered in tax distributions under a loan.
If the owners are taxed on the company's income, the tax distribution is not a perk. It is how the owners avoid paying the lender out of their own pockets.
SBA loans and restricted payments
SBA loans work differently. SBA loan proceeds cannot fund a distribution to owners, or refinance debt that did, so a recapitalization that pays owners out is not an SBA transaction. See recapitalization for business owners for the alternatives.
In an SBA-financed acquisition, a seller note that counts toward the equity injection must be on full standby: no principal or interest payments for the life of the SBA loan. Interest may accrue and be paid after the SBA loan is repaid. A seller note that is not on standby is allowed, but it is debt: it counts in debt service, and its payments are scheduled from the start. See seller notes and SBA standby.
Beyond those rules, SBA lenders set distribution limits in their own loan documents. Terms vary: some allow tax distributions and further distributions while the loan is current and coverage holds; others require consent for anything beyond taxes. The loan authorization and note are where to look.
Why to structure them before closing
A lender has no reason to widen a restricted payments basket after closing: it gains nothing and gives up cushion. Before closing, when several lenders are competing for the loan, the baskets are part of the offer, and a lender that wants the deal will often accommodate a reasonable distribution policy.
The practical approach is to decide the distribution policy first and build it into the model: tax distributions every year, a fixed amount once the business is past its first year, and larger distributions once leverage has come down. The model then shows whether the policy still passes every coverage test, and the term sheets can be compared on whether their baskets allow it. Transparent's financing model carries the owners' distribution policy through every test date for exactly that reason.
Buyouts are the other thing to plan. If one partner may buy out another during the life of the loan, the company buying back the shares is a restricted payment, and often a change of control too. Naming the buyout, with a price range or formula, in the agreement is far easier than seeking consent later. See buying a business with partners or investors.
Common questions
- Can I take distributions if I have a business loan?
- Usually yes, within the agreement's baskets: a tax distribution for pass-through owners, a fixed annual amount, and larger amounts once leverage falls under a set level. Distributions beyond the baskets need the lender's consent.
- Are owner salaries restricted payments?
- Usually not, if they are ordinary compensation for work in the business. Large or sudden increases can fall under the affiliate transactions covenant and will affect coverage covenants either way.
- Is paying a seller note a restricted payment?
- Often, yes. Payments on subordinated debt are commonly included, and are permitted only as the subordination agreement allows. On an SBA loan, a standby seller note receives no payments for the life of the SBA loan.
- What happens to tax distributions if the loan is in default?
- It depends on the agreement. Some keep tax distributions open during a default; many close every basket, including taxes, during a payment default. Negotiate for tax distributions to survive non-payment defaults.
- Can SBA loan proceeds pay a distribution?
- No. SBA loan proceeds cannot fund a distribution to owners, or refinance debt that did.
- Why not just pay distributions and ask forgiveness?
- An unpermitted distribution breaks a negative covenant, which is usually an immediate event of default with no cure period, and can trigger cross-defaults in other loans.