Intercompany Loan involving real estate

I am an accounting student and I am looking for feedback:

Company A is a medium-sized company that produces wall paneling. and is a wholly-owned subsidiary of another holding company (company B). Both companies are owned by the same individuals as principal shareholders. Company A has fallen on hard times due to a downturn in the construction industry in the primary market area the company serves. The company is in dire need of cash but the owners of both companies know that additional financing from a bank or other source is unlikely due to the company's weakened financial condition.

The owners have proposed to the independent auditors a plan whereby company B would obtain a loan from a bank and then make an intercompany loan to Company A. Under this plan, the owners would sell their personal residences to the holding company. Lease agreements between the holding company and the owners would be drafted. These lease agreements would allow the owners to continue to occupy their homes. Title to the homes would pass to the company B and that company would become involved in property management in addition to holding the stock of company A. Company B would have no additional properties other than the personal residences of the owners. The acquisition of additional properties by Company B is unlikely.

If any of you were partners in the public accounting firm performing the audit of these companies, what would be a good response to the owners of these companies regarding the plan to obtain additional financing ?

Answers

Paul Benedetto CFO, Director of Finance, Consultant • September 4, 2010

Interesting approach. I am not a public accounting auditor currently, but started my career as such. In my experience on being on both sides of the table, the following issues will most likely need to be dealt with:

1. From a banking standpoint, will the loan to company B be approved in the first place without a personal guarantee? It is standard practice to attach such a provision; which could restrict the sale of the personal residences and obviously put a kink in this approach.

2. If an audit were performed on company A, their dire cash flow situation could result in a going concern opinion. Obtaining the loan, although stems the immediate cash need, ends up degrading the working capital ratio through the additional debt. In addition, Company B may now be dragged into the going concern ratio, since the note receivable could be categorized as a doubtful account.

Give me a shout if you would like me to go into a more technical discussion; would be happy to assist. - Best regards, Paul

Wilma G Bauer Student • September 4, 2010

Paul, You have given me some great feedback - Thanks. 1. Nothing up to this point has been brought up about a "personal guarantee". 2. Good point about the going concern being tagged onto company B. So it IS legal to do this ? Just a bit risky and would possibly raise some flags, correct ?

Paul Benedetto CFO, Director of Finance, Consultant • September 5, 2010

Hi again. From my viewpoint, I don't see anything illegal in loaning funds from one company to another, especially since the parties are related. As others have chimed in, I think we all agree that the approach is a bandaid at best and probably not the best business decision in that it could bring down company B if business prospects further deteriorate. Seeking equity capital might be the better long term approach (if they can get it) and would help the working capital ratios instead of deteriorating them, for both companies.

Lastly, from a tax standpoint I believe it will depend on the corporate structure (e.g. LLC or S-corp being pass through vs. corporate). The loans themselves are simple interest income/expense b/t parties and essentially nets out due to common ownership. If there becomes a default situation then it might get knarly and out of my focus. A tax accountant would be able to better comment; I know enough to muddle through things and then call in expertise when necessary.

All the best,

Paul

Linda Rodezno Treasury Manager • September 4, 2010

Assuming that Company B can obtain a loan, the loan may solve Company A's temporary cash problem but nothing in the plan says what is being done to solve Company A's business problem and prevent Company A from needing money again in a few months.

Linda, I appreciate your feedback. No, nothing is brought up about solving anything for the future. I'm suprised this appears to be legal. Something just occured to me; wouldn't there be some tax implications involved ?

Linda Rodezno Treasury Manager • September 7, 2010

There may be tax implications but there is not enough info to assess them. Do the owners have a mortgage now? If so, they are giving up a tax deduction for an expense (lease/rent) that probably is not tax deductible. Company B may have taxable income/more taxable income after the transactions. If the property is being sold for more than the purchase price, the owners could have a taxable gain on the sale. The tax consequences of interest income and interest expense of Co. B & Co. A will net out if they are both tax-paying in the same state.

I believe the proposed transactions are legal. If the real estate is purchased at a price higher than market value and recorded as an asset in the financial statements of Co. B at the higher price, that is a misrepresentation.
The bank would not likely make a loan of an inflated price/amount.

John Falliers CFO • September 13, 2010

If A is primary beneficiary of what may be a VIE (B), then A would have to consolidate B in its financial reporting. That could very well occur if there is cross collateral or interco guarantees , esp running from A and its owners to B's lenders

John Jepsen Consultant • September 15, 2010

There is not enough info here to give a complete answer. What are the legal and tax structures of these entities and how do the owners account for them on a personal tax basis? None of these maneuvers will address the most basic question which is the viability of Co A.
Does Co B has any existing debt? Will existing lenders be willing to go along with this scheme? Right now it looks more like 3 Card Monte than a legitimate business plan. (I am not suggesting it is illegal by any means but the basic question - "what is the business purpose?" has not been addressed. A clever financing scheme will never rescue a failed business model.) Is Co B profitable and how much can it absorb in terms of additional deductions? Do you want to trap unusable deductions at the corporate level?
If the owners are willing to incur additional debt themselves why not simply take home equity loans and infuse the capital in whatever form makes most sense? Are the homes of equal value? If one is twice the value of the other how do you balance that out in accounting for the relative contributions and the potential benefits to be derived from the infusion?
From a banker's standpoint, if I am not willing to lend directly to Co A why would I do so indirectly and share collateral with existing or future creditors?
If they are truly unrelated businesses and there is a reason to keep them separate why taint the financial health of Co B by making it a Holdco?
Sorry, I have probably raised more questions than those I answered.

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Intercompany Loan involving real estate

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