I am currently looking into purchasing a business with approximately
$140k in gross revenue per year and $70k in expenses (expenses include
royalties, building and land lease, payroll, electricity, phone,
water, etc.).

I am having a rather difficult time coming up with financing options
due to the fact I do not have a sufficient sum of money in the bank
for a down payment. Someone recently suggested the only way I may be
able to purchase this business is in a Lease-To-Own situation. And I
strongly think the seller would accept this proposal due to the fact
there is little-to-no interest from other potential buyers.

The concept sounds pretty simple, but I guess I do not understand it
fully. An example of how it would work is as follows:

$20k annual payment to the seller for the next four years with 100% of
the payment going to the purchase price (total $80k). An attempt will
be made to get the seller to agree upon a purchase price of $150k in
advance, and if that is possible, the $80k already received would mean
instant equity and only $70k remaining to finalize the purchase. The
final $70k would then be financed through a bank and the deal would be
finished between the seller and myself.

How is the accounting done on the buyer and seller's side during the
Lease-To-Own period? What are the pros-and-cons for the buyer and
seller? What are the tax implications for the buyer and seller?

I am attempting to get feedback so that I can present this to the
seller in a way it is a good deal for each of us. Any assistance would
be greatly appreciated.

Some form of seller financing is extremely common when small
businesses of the size you describe are sold.  Leasing to own is but
one of several methods, the most common of which is the owner giving
you a loan in the form of a promissory note, which is then paid back
from the business' cash flow.  Another method is
an "earn-out," which involves you paying the seller ongoing payments
based on the business' performance for a specified period of time up
to a set amount.

The accounting for both parties during the lease-to-own period and
once the business is sold is potentially quite complex depending on
how the deal is structured.  The seller has the advantage of deferring
at least a portion of the capital gains taxes on the sale of the
business until he or she actually sells it to you.  Furthermore, the
seller gains the benefit of the lease payments, which would otherwise
go to a bank providing financing.  Finally, the seller gets a sale,
which otherwise may not occur because most people looking to buy
businesses of that size have difficulty obtaining bank financing.

The IRS probably would characterize your lease as a sale, so you would
be eligible to depreciate a portion of the property and to deduct a
portion of your rental payments as effective interest.  "Tax
implications of Leasing" Business Owner's Toolkit (2005)
http://www.toolkit.cch.com/text/P04_5180.asp

A good series of articles is accessible through "Structuring the
Business Sale" Business Owner's Toolkit (2005)
http://www.toolkit.cch.com/text/P11_2400.asp.  The sections on
"Payment Terms" http://www.toolkit.cch.com/text/P11_2420.asp and "Tax
Aspects of Selling Out" are likely to be of considerable interest to
you.

I have provided a number of references for you to review regarding
seller financing and the sale of small businesses.  They explain how
this is commonly structured, along with the many variations that are
possible, and how these can benefit both the buyer and the seller. 
The range of possibilities is considerable; you are really limited by
only what you can get the seller to agree to and how motivated you
want the seller to be to remain involved in the business until the
final sale is completed.  Because the tax consequences can vary
considerably based on the specifics of how the sale is structured, I
encourage you and the seller to consult with a CPA before finalizing a
transaction.

Sincerely,

Wonko

"Seller Financing Basics" by Glen Cooper, BizBuySell (2002)
http://www.bizbuysell.com/guide/b_finance_2.htm

"Understanding Seller Financing" by Loraine MacDonald,
Entrepreneur.com (October 1, 2001)
http://www.entrepreneur.com/article/0,4621,293172,00.html

"Exit Strategies" by Chad Simmons, BizQuest (2000)
http://www.bizquest.com/resource/exit_strategies-20.html

"Selling A Business" 'Lectric Law Library http://www.lectlaw.com/files/bul18.htm

"Make a Clean Break When Buying a Firm" By PAULETTE THOMAS, Startup
Journal http://www.startupjournal.com/columnists/startupqa/20031020-qa.html?refresh=on

"Tax Concerns When Selling Your Business" AllBusiness (2005)
http://www.allbusiness.com/articles/BuyingSellingBusiness/1447-29-1842.html

"Corporate Accounting" by Richard Daigle, Business Leader (December
1995) http://www.businessleader.com/bl/dec95/corpact.html

Search terms:  seller financed business; accounting for seller
financing business; accounting for lease with option to purchase
business

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Request for Answer Clarification by flashingbeacon-ga on 03 Dec 2005 17:18 PST

You wrote, "The IRS probably would characterize your lease as a sale,
so you would be eligible to depreciate a portion of the property and
to deduct a portion of your rental payments as effective interest."

This deals primarily with equipment leasing and not so much a
"lease-to-own" business. Were you able, or can you, find anything else
on the accountability of a "lease-to-own" business?

---

Clarification of Answer by wonko-ga on 04 Dec 2005 00:02 PST

When you are leasing to own a business, you are leasing to own the
assets of that business in most cases.  According to the following
reference, you nearly always want to just purchase the assets of the
business rather than the business' stock.  Those assets are then
depreciated, and if you are leasing them, you get to treat a portion
of your lease payments as an interest deduction.

Sincerely,

Wonko

"Tax Benefits

When you purchase physical assets like tools, you qualify for a tax
deduction called "depreciation." Usually assets are depreciated over
their useful lives.

For example, if $10,000 is paid for a machine, you, as an "asset
purchaser," would be able to depreciate the machine over its useful
life, 10 years, and claim a deduction of $1,000 in each of the 10
succeeding years.

But if you had purchased Howard's stock, you could only deduct the
depreciation Howard & Sons, Inc. could have claimed. If the machine
was 15 years old and fully depreciated when you purchased the stock,
then no more tax depreciation could be claimed."

"Buying a Business: Tips for the Unwary" Tax & Business Professionals
Inc. (Jan/Feb 1995) http://www.unclefed.com/AuthorsRow/TaxBusProf/BuyingBus.html

Thank you very much for the very thorough information, in addition to
the response from the "answer clarification". The answers and the
links provided are great for my continued research.