Legal Outline For California Agencies - Chapter 1

CHOICE OF A LEGAL FORM OF AGENCY OPERATION - PROPRIETORSHIP, CLUSTER OF INDIVIDUALS, PARTNERSHIP, OR CORPORATION.

The forms of agency organization, such as incorporation vs. partnership, may be elementary for most agents. However, the questions of how the stock and/or expirations are to be held, whether individually, by a partnership, or (for expirations) at the corporate level, are complex questions. The answers depend in large measure on how the agency interest is to be held and ultimately disposed of, and on how much control the individual agency owners want to retain. These questions will now be touched on.

There are several legal forms of organization for an insurance production agency. In choosing, the broker-agent should consider how he will ultimately dispose of the agency, as well as current operations. I will cover the most usual forms for property and casualty production agencies.

The agency business may be owned by an individual, either operating alone or in a cluster with other individuals. One or more agents may operate in a general partnership. The agency may also be operated by a corporation, owned by one or more shareholders. The corporation may be a 'C' corporation, which is taxable on its earnings. Some corporations may elect 'S' corporation status, under which a corporation is treated much like a partnership, with the income taxed primarily to the stockholders.

Some of the questions an agent should pose in choosing a form of ownership are:

• Incorporation creates additional legal protection against litigation, but at a cost of additional complications and costs. Is it worth the cost? What assets outside the agency do you have?
• Being associated with others brings business benefits, such as help from other agents, additional markets, or ability to qualify for better contingency payments. Are they worth the loss of control over the organization?
• How much control over his business is the agent willing to give up? An agent in a cluster has more control over his business than an incorporated one. Likewise, an agent who retains ownership of his expirations can leave the agency with his book of business much easier than one who has transferred the expirations to the corporation.
• Future disposition of the agency is affected by its form of organization. How does the agent plan to dispose of the agency? Merger with a large brokerage will require incorporation. Sale of assets is facilitated if the owner retains ownership of the expirations, or has elected Subchapter S at the outset. Internal purchases by producers can be facilitated by a partnership or by an ESOP.

A sole proprietorship is a business owned by one person, or by a husband and wife as their community property. It has the following advantages and disadvantages:

• Simplest to operate.
• Costs less in taxes and expenses to operate.
• No double taxation problems.
• Personal liability of the owner for debts of agency, which exposes his non-agency assets.
• Multiple owners are not possible (apart from spouses).
• Merger with another corporation is not an option without incorporation.

The term 'cluster' normally refers to a contractual arrangement between two or more individual agents that have joined together to share facilities and expenses, but have not formed a formal partnership. Cluster members commonly retain ownership of their expirations and good will, and may continue to some extent to do business under their individual business names. A 'cluster' is not a recognized legal form of organization. The cluster agreement must spell out what the rights and obligations of the members are.

I will first consider a simple unincorporated cluster. I will then discuss a cluster with an overlying corporation.

A cluster retains many advantages of individual proprietorship.

• Members retain ownership and control of their individual businesses.
• Relative simplicity of operation is preserved.
• A cluster also may bring business advantages over a proprietorship.
• Members may be able to get assistance from other agents.
• Members may be able to share markets.
• Members may qualify for other benefits not available to individuals, such as all being combined for company profit sharing purposes, or better errors & omissions coverage.
• Members may share expenses and reduce their costs.
• Other members of the cluster may be potential purchasers of the agent's business on his retirement.

A cluster brings risks as well.

• No corporate protection for lawsuits exists under an unincorporated cluster agreement. The cluster may be held to be a general partnership, with individual liability for debts of other members or the cluster. For this reason, the members must take care to avoid partnership appearances. They should continue to do business in their individual names, and with their own letterhead. They should also be certain that all members carry adequate insurance, and give evidence of coverage to other cluster members.

The cluster agreement should protect individual members from raiding of accounts by other members, should a member leave the cluster, or on a dissolution of the cluster. It should have proper covenants against unfair competition.

The cluster agreement may also provide for buying out a deceased or retiring member.

An alternative to an unincorporated cluster might be to form a corporation to conduct insurance operations, but have cluster members retain individual ownership of their expirations and good will. This provides the increased protection of a corporation, if the corporation is properly formed and capitalized. It includes most of the advantages of an unincorporated cluster. It may cause some loss of individual agency identification, and additional complexity that a corporation brings. See 1.2.6.for a fuller discussion.

A general partnership is an association of two or more persons to carry on a business for profit.

A partnership has many of the advantages and disadvantages of a cluster.

Compared to a cluster, a partnership is a more formal type of organization, it is more likely to qualify for contingency commissions and other benefits that may or may not be available to a cluster of individuals. It is also subject to more complex tax rules than a cluster. It also subjects partners to personal liability for the partnership's debts.

The advantages and disadvantages of a partnership are:

• No income tax on the partnership. The income of the partnership is passed through to partners for income tax purposes. Double taxation is avoided.
• Deductibility of retirement payments for retiring or deceased partners. Most liquidation payments to retiring partners can be structured to be deducted or excluded from partnership income by the remaining partners.
• Unlimited liability for partnership debts. Partners are fully responsible for the debts of the partnership. This is a major drawback of a general partnership. This liability may be insured against to some extent by errors & omissions insurance and other liability and workers compensation insurance.
• Corporate stock can be held by a partnership. Use of an corporation, which actually conducts the agency business, but which is owned by a partnership rather than individual stockholders, can reduce liability exposure, yet retain partnership benefits such as deductible liquidation payments to retiring partners.

A properly formed corporation is a separate entity from its shareholders for liability and tax purposes. This means that if the corporation is property formed and operated, a shareholder is not personally liable for corporate debts. He only risks losing the value of his stock. It is possible to 'pierce the corporate veil' of an improperly formed or operated corporation, so the corporation must be adequately capitalized and corporate formalities must be observed.

An officer or shareholder may still be liable for his own wrongdoing. For example, a shareholder agent may be liable for his own errors and omissions, and his corporation may be liable for them as well. However, the shareholder will not be personally liable for another shareholder's errors & omissions.

An ordinary business corporation (or 'C' corporation) is subject to income tax, and its shareholders are also taxed on dividends they receive. The possibility of double income taxation exists for a C corporation, once at the corporate level and once at the shareholder level. This double taxation can be reduced by proper operation of the corporation, such as paying shareholder employees salaries and bonuses.

Advantages and disadvantages of a C corporation are:

• Protection of corporate shield to protect the shareholder from personal liability for corporate debts. However, to avoid 'piercing the corporate veil', the corporation must be properly formed and operated. A shareholder may still be personally responsible for his own errors & omissions.
• The corporation is a second taxable entity, which may have lower federal income tax rates than the shareholder. Corporate rates range from 15% on the first $50,000 of income, to 35% on income over $75,000. Individual rates start at 11%, but go to 39.6% on income over $250,000. There are limits on how much income a corporation may accumulate in this manner. In addition, tax savings at the corporate level may be defeated by double taxation on its dissolution, as explained in the following paragraph.
• Possible double taxation problems exist for retained earnings. Income may be taxed to the C corporation when the corporation earns it, and again to the shareholder when profits are withdrawn by dividend or on liquidation. This double taxation can be avoided to some extent by taking income out in salaries, bonuses, lease payments, etc., which generate deductions to offset income at the corporate level.
• When winding up a C corporation, the law no longer permits you to sell the corporate assets but avoid a tax on the gain at the corporate level. Taxes may be deferred by mergers or some other reorganizations, but the tax will be paid if the stock received in the reorganization is sold during the shareholder's lifetime. On the shareholder's death, however, the basis of the stockholder's stock is then stepped up to its' date of death value, so that his heirs will escape the tax when they sell.
• Minimum California franchise tax. California imposes a minimum franchise tax on corporations. That tax is presently $800.
• Some added employment taxes. The combined social security tax on the corporation and the employee exceeds the self employed rate, though the corporation's portion of the tax is deductible.
• More complicated to operate. A corporation has more records to keep and returns to file.
• Possible effect of corporate securities laws. For the typical insurance production agency, where all stockholders reside in California and are directly involved in the business, the federal and state corporate security laws usually pose no problem. Securities laws will affect an agency acquired by a larger brokerage, particularly one listed on a national
• exchange.

The Subchapter S corporation is an ordinary business corporation which qualifies for and has elected Subchapter S treatment. It is taxed like a partnership in most respects.

Not all corporations can qualify for subchapter S status. For example, it can have no more than 35 shareholders, it can have only one class of stock, and the shareholders must be individuals (or estates or certain trusts). This means that a partnership can't hold S corporation stock.

Limited liability of shareholders is a feature of an S corporation, just as for a C corporation.

Passthrough taxation of income to shareholders is the major feature of an S Corporation. An S corporation for the most part passes income and deductions through to the owners free of most income tax at the corporate level, much like a partnership. Complications arise, however, when a corporation is not an S corporation for its entire life. Also, California (unlike the federal government) has a minimum franchise tax of $800 on any corporation, and in addition imposes a 1.5% tax on subchapter S income.

In other respects, an S Corp. has most of the same advantages and drawbacks as a C corporation, discussed previously.

The question of how to hold the stock and/or expirations of an incorporated agency is a complex one. It is determined by what is important in the agents' plans for the future; (a) freedom to leave the agency with one's expirations, (b) facilitating an internal buy-out, or (c) facilitating a merger with an outside party.

1. Ownership of corporate stock.

2. Ownership of expirations.

One combined form of organization would be for the individual agents (rather than a partnership) to own stock in the operating corporation, but retain individual ownership of their expirations. The corporation would employ them, and would handle both the solicitation and the office administration of the agency. The individuals could, however, retain substantial control over their individual accounts.

This form of organization can be used by a cluster. The cluster corporation can undertake certain functions, such as placing insurance with the companies, handing profit sharing and contingencies, and obtaining errors & omissions insurance, while the individual agencies still retain their identities.

This form of ownership might also permit the corporation to elect Subchapter S status if the statutory requirements are met, passing through the earnings to the individuals. The income could also be passed through in salaries, or in a commission split payment because of the agent's retention of ownership in his expirations. However, Subchapter S is useful in passing through capital gains on the sale of corporate assets, and in reducing employment taxes.

This form also might make it possible for the remaining agents to purchase and amortize a departing agent's book of business and good will, while giving the departing agent capital gains treatment. This is a somewhat risky proposition in light of the 'anti churning' rules applying to amortization; it would be necessary to show that there was no common control of the two businesses. Before this is attempted, it would be wise to make a calculation on what the tax effects actually might be. If the true difference is between a 28% capital gains rate and a 32% ordinary income rate, the capital gains advantage probably is not worth taking an additional risk. In such a case, use of a partnership liquidation to retire an agent probably would make more sense.

Combining a corporation and a partnership can gain certain advantages of both forms of organization. Frequently a C corporation will handle the actual agency operations, but its stock (and often the ownership of its expirations and good will) will be held by an underlying general partnership.

Flexibility of a partnership agreement in defining relations among partners is preserved. Partnership interests can be more easily adjusted to reflect production than stock interests can be. It is also easier to bring new producers into a partnership than into a corporation.

Better tax results may be one result of the combination. Ownership of expirations at the partnership level may avoid double taxation, by eliminating difficulty of getting the expirations and good will of the agency (or the proceeds of their sale) out of a corporation without incurring a double tax at the corporate and individual level. If the partnership (or the corporation) owns the expirations, however, it is still a tricky problem to allow a partner/shareholder to take expirations and leave without triggering a tax on them.

Ownership of stock by a partnership will preclude a subchapter S election, since a subchapter S corporation cannot have a partnership as a stockholder. A double tax can be avoided by passing through income in the form of reasonable salaries or bonuses.

Buyers can purchase expirations and good will from the partnership and depreciate them over 15 years, and the sellers should get capital gains treatment and avoid a double tax at the corporate and individual levels.

Liquidation payments for retiring partners is also possible, which increase the ease of making the payments deductible, though at a cost of ordinary income treatment to the recipient. This may permit deduction of the payments in less than 15 years, which may be a major reason for using this approach. Getting cash from the corporation to the partnership to make liquidation payments in a deductible manner to the corporation can be tricky. There should be an agreement between the corporation and the expirations owners/partners under which the corporation manages the business and expirations for a reasonable share of the commissions.

The combination gives the partners corporate protection from individual liability, provided that the corporation is adequately capitalized, though the protection is probably not as great as when the stock is individually owned.

1.2.9 Combining corporation and ESOP.

• It is also possible to have part or all of the stock of a corporation owned by an Employee Stock Ownership Plan and Trust.
• There are a number of advantages to an ESOP:
• Fully deductible payments by the corporation to the ESOP are available within the limits of the tax law on qualified plans.
• Tax deferred rollovers are available for shareholders selling 30% or more of the stock of an agency to an ESOP. They may roll over their payment into securities of domestic operating companies and defer the income tax. If these new securities are held until death, their income tax basis is stepped up to the date of death value, and the income tax on the increase is entirely avoided.
• Interest deductions are available for interest paid to banks and insurance companies for loans to funded ESOPs owning over 50% of the agency stock. This should lead banks and insurers to give more favorable treatment for ESOP loans, though they often do not do so. To qualify, however, the plan participants must be able to vote their stock on all matters. The ESOP stock is usually voted by management, except on extraordinary decisions such as mergers. The owners may not want to give up some control in order to obtain the 50% deduction for the lender.

The ESOPs also create potential problems.

• Formation and operating costs for ESOPS are often substantial, though they don't have to be. The cost of complying with requirements of a lender for leveraged ESOPS can be particularly high. Formation costs may be in the neighborhood of $15,000, and lender expenses could be an additional $15,000 or more. Caveat emptor.
• Repurchase costs for buying back the stock of retiring plan members can also be substantial. Particularly for leveraged ESOPs which borrowed the money to buy out the first generation of owners, the ESOP and agency can wind up paying for the retirement of the original owners and the second generation of retiring employees at the same time. Vesting schedules and provisions for payment over time can reduce repayment problems, so that most second generation payments are deferred until the original loan is repaid.
• Early establishment of an ESOP can also eliminate many of the bunching problems. Too often, an ESOP is set up only when the first generation is ready to retire, requiring a loan for funding. If the ESOP were set up earlier, and could gradually build up funds to buy out stockholders, financial problems could be substantially reduced.

CHECKLIST FOR CHOOSING A FORM OF ORGANIZATION.

1. Is the corporate shield against personal liability important? Does the agent have substantial personal assets aside from the agency? Is there more than one agency producer? (An agent may be person