Could a Shareholder Loan Satisfy Your Surety?

For ambitious contractors, sureties can be difficult to please. You want to expand your bonding capacity to take on bigger, more risk-intensive jobs. But your surety, perhaps understandably, keeps tightening its underwriting standards and slowing you down.

One strategy that may satisfy your surety: Execute a shareholder loan. Although a move like this has its risks, doing so may enhance your capital standing expediently without pushing you into the complexity of outside financing.

Getting the right treatment

Naturally, many contractors ask why they shouldn’t just beef up their balance sheets via capital infusions such as owner contributions or outside investors. The answers are fairly simple: Additional owner contributions can lead to undesirable tax consequences, while bringing in outside investors may dilute current owners’ interests.

If your construction business is organized as a C corporation, for example, any paid-in capital would be subject to taxation at the shareholder level — if it were later paid out as a dividend. For other types of entities, double taxation isn’t an issue, but distributions generally reduce an owner’s basis, which may have negative tax implications.

From a bonding perspective, as long as loans made by shareholders are subordinated to bond claims, most sureties will treat the proceeds as a capital equivalent in evaluating capacity. In addition, principal payments typically aren’t taxable — unless, in the case of certain pass-through entities, the shareholder’s basis in the loan has been reduced by business losses or other adjustments.

Plus, interest payments, though taxable to the owner, are deductible by the construction company. Loans also provide an advantage in the event of bankruptcy, because debt is generally paid before equity is returned.

Structuring it right

A surety will view a shareholder loan as a capital equivalent only if the loan is evidenced by a promissory note and the contractor signs a subordination agreement. The loan should be structured and documented carefully, with a market rate of interest and commercially reasonable terms, to ensure that it’s treated as a legitimate loan rather than a contribution to equity.

A subordination agreement provides that the loan is subordinate to all of the surety’s rights and claims against the business in connection with furnishing a bond. In addition, it provides that the surety will be paid in full before any payments are made to the shareholder. In the event of the construction company’s bankruptcy or insolvency, the agreement assigns to the surety any rights the shareholder may have against the company in relation to the loan. Subordination agreements are, however, challenging to word properly and may be difficult to remove once the business owner wants the money back.

Beyond the subordination agreement, a surety will consider the source of the funds. Loans should come from the owners’ personal funds, such as salaries, bonuses, dividends or distributions from the company. Sureties generally frown upon loans made from borrowed funds (for example, an owner borrows money from a bank and lends the proceeds to the company), for fear that shareholder loan proceeds will be used to pay back the lender.

Finally, you may want to make a formal Uniform Commercial Code filing regarding the loan. Doing so can help define the loan as secured debt vs. unsecured debt in a bankruptcy situation.

Fortifying the effort

Of course, merely taking out a shareholder loan may not, in and of itself, push your bonding capacity over the top. Be sure to take all of the usual steps to remind your surety that your construction company is a successful business.

If you have multiple projects open, you may want to close a few before you execute the loan. Review your job charges, as well, to ensure they’re as defensible as possible. In addition, if necessary, update your organizational depth chart to demonstrate your ability to stay in business and repay the loan if a key leader leaves unexpectedly.

Considering and executing

To be clear, shareholder loans are hardly risk-free and can be complicated to set up and carry out. But, with your financial advisor’s counsel, they’re an idea worth considering and perhaps even executing. Call any member of our construction team at 404-874-6244 for help deciding if this is the right path for you.