By Mark E. Battersby, Contributing Editor
How many convenience store retailers have failed to grow or expand their businesses because of a fear of “over-extending” themselves? All too often this fear exists simply because the convenience store operation’s executives and managers are not aware of the tremendous number of financing options that are available to expanding and growing businesses.
Interest rates remain close to their historical lows, but financing for many c-store businesses continues to be elusive. One problem: lower interest rates have translated into lenders and investors being more selective about whom they provide backing. How then, can c-store retailers hope to fund the expansion of their operations?
An increasingly popular tax-saving strategy involves transferring ownership of the building or other property owned by the c-store business to an operator, franchisee, key employee or shareholder. For many c-store businesses a sale-leaseback means liberating badly-needed cash in exchange for executing a lease and paying rent.
For others it is a method of protecting the assets of the business, such as when a lawsuit is filed or other issues arise. After a sale-leaseback transaction, the building would be at least partially protected in any legal actions.
For the building’s new owner, there are benefits that may result in a lower personal tax bill, income legitimately removed from the c-store operation and, in many cases, more financing options.
Before rushing to take advantage of this strategy, however, retailers should consider if this is a good, viable strategy for their business. Questions, such as under what type of entity should the new ownership operate, who is going to pay the mortgage and who will reap the tax deductions, require answers. As do often overlooked questions, such as what will happen if the c-store business changes hands or an operator exits.
Since a building and the land on which it sits are a necessity for many c-store businesses, a sale-leaseback enables the operation to reduce its investment in non-core business assets, such as its store building, while freeing up cash.
In a sale-leaseback transaction, an operating c-store business sells its real estate or other property it may own, occupy or use to a third party and then leases the space back, usually under favorable terms. It is a popular strategy for freeing up capital for the expansion of the c-store operation.
One of the so-called perks enjoyed by a business selling its building is that it now become the store tenant and has the ability to negotiate favorable lease terms. In a typical lease the lessee makes rental payments while the lessor pays all of the expenses for operating and maintaining the property.
With a so-called “net lease arrangement” the tenant pays rent and also pays all of the property’s operating expenses. Thus, the landlord receives a fixed rental payment, net of all property expenses.
However, the majority of sale-leasebacks are structured as so-called triple-net leases with the tenant usually responsible for taxes, insurance and maintenance of any common areas. These long-term, hands-off leases give the tenant control over the property similar to when it owned the property. The tenant can, of course, work with the building’s new owner to include options for future expansion and possible sublease of the property.
As property owners, the interest expense and depreciation were the only tax deductions usually available to the c-store business. On the other hand, a c-store business leasing its premises is allowed to write off the total lease payment as an expense. Thus, a sale-leaseback may offer greater tax advantages and produce a bigger tax deduction.
Unlike a mortgage, a sale-leaseback transaction can be structured to finance as much as 100% of the appraised value of the c-store building and land. As a result, a sale-leaseback is a more efficient financing tool for investing in real estate.
Because a sale-leaseback is not technically a financing instrument there are no restrictive covenants. And fewer covenants give c-store operators greater control over their business.
Owning commercial real estate involves risks that are different from operating a c-store business. Thus, establishing a separate entity to own the building allows the two to be kept completely separate. Ownership of the c-store business’s building can be in the form of a trust, corporation, limited liability company (LLC), or even a partnership consisting of the c-store franchisee, operator and several associates or key employees. The new owner can then lease the building back to the business, as well as to other tenants if space permits.
Regardless of the type of entity that is used to hold title to the newly-acquired building, thanks to our unique tax laws, a dilemma exists. On the one hand, under provisions in the Health Care and Education Reconciliation Act of 2010 that came into play in 2013, many individuals now find themselves subject to a 3.8% Net Investment Income (NII) tax.
Net investment income includes not only rents, but interest, dividends, annuities and royalties. Although NII does not apply to income derived in the ordinary course of a trade or business it does include income from a so-called passive activity.
If the IRS feels that an individual’s participation is not on a regular, continuous and substantial basis, they can label the activity as “passive.” Thus, regardless of the type of entity the new owners choose to own the building or other property, the NII adds an additional tax on the profits from that “passive” activity. More importantly, losses are denied or limited for all “passive” activities.
Reversing Or Getting Out
Many c-store retailers and suppliers have successfully held their business and the building that houses it as separate entities. Consider, however, someone who is thinking about retiring in a few years or selling his or her interest in the business. Many businesses are sold with seller financing, meaning the seller would get a portion of the price up front, while the buyer would pay the bulk of the purchase price over the next few years.
Should the buyer fail at operating the c-store business, the seller would receive a double whammy: not only will he or she not be getting paid for the sale of the business; the building just lost its only tenant. The building’s original owner is still required to make mortgage payments on the building, only now those payments come from his or her own pocket.
Fortunately, there are strategies that can minimize or defer taxes, resulting in a larger portion of those eventual sale proceeds going into the seller’s pocket at closing. Delaying the receipt of sale proceeds, converting from a regular ‘C’ corporation to an ‘S’ corporation or LLC, transferring stock to family members, structuring purchases to obtain a more favorable capital-gains treatment and using trusts to reduce estate taxes are all common strategies.
In most cases, any eventual sale will be influenced by two key factors: How the business is legally set up and —in the case of an incorporated business or LLC—whether it is the assets or the business entity that are being sold. Sales by all sole practitioners and almost all partnerships are asset sales. So are the sales of many closely-held corporations and LLCs.
With the current economic climate and reluctance of many lenders to provide business funding, a sale-leaseback transaction provides an efficient and effective means for generating capital needed for expansion of the c-store business.
Bottom line, a sale-leaseback with a triple-net lease can work for both buyers and sellers.
Sale-leaseback transaction can offer a number of benefits to any business selling its c-store building. First, the business can usually set its own lease terms. Because the seller is also the lessee, the seller has significant bargaining power in structuring the lease.
Because most sale-leasebacks are structured as triple-net leases with the tenant responsible for the taxes, insurance and common area maintenance the business usually retains control of the real estate.
Generally, a lessee is able to write off the total lease payment as an expense for tax purposes. As property owners, the interest expense and depreciation were the only tax deductions available to the business. As a result, a sale-leaseback may have a greater tax advantage for the business.
Unlike a mortgage, a sale-leaseback can be structured to finance up to 100% of the appraised value of the c-store operation’s land and building. As a result, a sale-leaseback more efficiently uses the business’s investment in the real estate asset as a financing tool.
A sale-leaseback investor, however, has only the real estate as collateral and a relationship with the seller through the lease agreement. As a result, the sale-leaseback is slightly more expensive to finance.
Remember though, a sale-leaseback provides cash proceeds for up to 100% of the property’s appraised value versus the 70-80% of appraised value typical with most mortgages.
Buying the convenience store business’s real estate assets offers a number of clear benefits to the buyer, including:
• a predictable, long-term cash flow;
• returns typically higher than bonds;
• low management requirements;
• rent increases and value appreciation that hedge against inflation; and
• some tax shelter from depreciation and other deductible expenses.
Lurking on the horizon are possible changes to the current accounting treatment of leases and, of course, sale-leasebacks. Although adding leases to a c-store business’s balance sheet is unlikely to impact on the popularity of these transactions, the possible changes should be kept in mind.
A local appraiser can help establish a fair sales price but every convenience store retailer and supplier will require the services of other qualified professionals.
Above all, ensure the transaction makes good business sense.