LEGAL OUTLINE FOR CALIFORNIA INSURANCE AGENCIES
CHAPTER FIVE
TRANSFERRING AGENCY INTERESTS BY SALE, ETC.
5.1 Objectives of buyers and sellers of agencies.
In the typical sale or transfer of an agency, the interests of the buyer and seller differ.
The buyer is concerned with being able to make the payments from earnings of the business, with as little down as possible. He typically wants to be able to depreciate as many of the assets he acquires over as short a time as possible, to reduce the tax cost of the acquisition. He also wants to avoid liabilities of the acquired business, such as errors & omissions exposure.
The seller may wish to defer tax from the sale. He normally wants as much of a down payment as possible. He typically would prefer to have capital gains treatment for the gain from the sale of the business, rather than ordinary income treatment, if he will be at a higher income level after the sale and the rate difference will be important. He wants to avoid employment taxes on the payments to him. He would prefer payments to him individually rather than to a C corporation, because he then does not have to worry about how to get the money out of the corporation without incurring a second tax. He wants to have security for the payments due him. He would prefer to have the buyer or the agency take over future liabilities, such as errors & omissions claims, and get him off the hook.
The Clinton 1993 tax changes (93 OBRA) have changed the cost/benefit calculations on sales. They make some formerly non- deductible items (such as good will) depreciable over a 15 year period, but also extend the amortization period of covenants not to compete to 15 years. They also raise individuals' maximum federal rates on ordinary income (39.6%) substantially above the capital gains rates (28%), making capital gains treatment more important to high bracket sellers.
The selling owner may make other retirement provisions. He may set up a qualified retirement plan (pension or profit sharing plan), which would benefit the other employees as well as the owner, but which add to the agency's overhead. He may establish a non qualified and unfunded deferred compensation plan, which depends on having someone available to continue running the agency after retirement. He may set up an Employee Stock Ownership Plan or ESOP, under which he sells out to the agency's employees, possibly using a tax deferred rollover into other securities. He may merge with a large brokerage, possibly staying on for a time as an employee.
The most typical transfer methods for an agency are sale of stock of a corporation, sale of assets of the agency, a partnership liquidation of the interest of a partner in a partnership, or a statutory merger or other reorganization of two corporations.
5.1.1. Price.
The purchase price for the agency can be determined in a number of ways.
There can be a formula, such as 1 times or 1.25 times commissions. Such formulas have a way of getting out of date quickly, so they should be used with caution if the transaction is not to close soon.
There can be an appraisal by a specialty insurance appraiser. These appraisals look at the bottom line rather than the gross commissions of the agency, and consider how the agency compares to others in the industry. They are aware of comparable sales.
There can be a combined approach, under which the parties agree to attempt to determine the price themselves, and go to an appraiser if they cannot agree.
A seller should sell the sizzle as well as the steak. An insurance specialty consultant can suggest ways to make the agency more saleable. The specialist may know of a buyer who may be interested. Structuring the taxes in a way favorable to the buyer may also enhance the agency's value. Steps to reduce litigation exposure through proper anti piracy agreements and similar steps may also enhance value.
5.2 Overview of tax aspects of the transfer.
The typical agency owner has no income tax basis in his agency, which he normally has built up with his own efforts. This means that the entire gain on a sale is subject to tax. An exception exists when the owner purchased or inherited the agency, in which case the purchase price or estate tax valuation may give him a tax basis in the agency, and make capital gains treatment more important to him.
The owner of an incorporated agency would like to avoid double taxation, once tax on the corporation's sale of the agency, and another tax when the sale proceeds are distributed to the stockholder. This can be done if the owner sells stock in the agency, or gets stock in another agency in a merger or other reorganization. It may also be done (wholly or in part) if the corporation has elected Subchapter S treatment and the income of the corporation is taxed to the shareholder.
Often the agency owner would like to defer tax. This can be done in a statutory merger or other form of reorganization to the extent that the agency owner receives only stock in the acquiring entity. It can be done with an ESOP where the ESOP owns over 30% of the stock after the transaction and the owner elects to roll over the proceeds into certain other types of securities. He will get a stepped up basis on death if he holds the other securities until death. Also, if the price is paid in installments, the tax can be deferred until payment is received.
The owner's benefit if the transaction is structured as a capital transaction is that he pays a tax at the individual federal capital gains rate of 28% IRC 1(h)) on any net capital gain over his basis, and recovers his basis (if he has one) tax free. If the owner has no basis and his marginal ordinary federal income rate (IRC 1) is only 28% (for example, married persons under $89,150), he gets no benefit from capital gains treatment. If his marginal federal ordinary income rate is the maximum of 39.6% (over $250,000), he pays an additional federal tax of 11.6% on amounts over $250,000 if he receives ordinary income rather than capital gains treatment. The numbers vary somewhat for selling C corporations, which are taxed at a rate of from 15% to 35%, IRC 11, with a maximum capital gains rate of 35%, IRC 1201(a).
The acquirer's detriment if there are non deductible payments to offset against agency income is an ordinary income tax on every non deductible dollar (from 15% to 39.6% for individuals, IRC 1, and from 15% to 35% for taxable C corporations), IRC 11. It is usually far more important for the acquirer to get deductions than for the owner to get capital gains treatment, if the owner has little or no tax basis in the agency.
In some cases, it is possible to get both deductions and capital gains treatment. Sales of expirations and good will get the same treatment as capital gains, and are amortizable over 15 years in many cases. Sales can't be amortized, however, for 'self created intangibles', or intangibles sold to a 'related person' or the agent and the acquirer are engaged in business under 'common control'. (IRC Section 197(c)(2),(f)(9). This means that it will be tricky to use amortization of expirations and good will in internal buy-outs. Outside unrelated buyers probably will not be affected.
A fifteen year amortization period is long. When possible the acquirer will wish to use methods that may lead to quicker write-offs, such as deferred compensation payments, or partnership liquidation payments.
The IRS may lump together two or more transactions and re-characterize them if they are part of a step transaction as part of a plan designed to avoid taxes. For this reason, agency owners should think ahead, consider both the business and nonbusiness reasons for their actions, and take necessary preliminary steps well before a 'sale'. Steps may include incorporation or formation of a partnership, or transfer of assets to a corporation or partnership, or establishing a partnership liquidation payment plan.
Employment taxes and income in respect of a decedent are two exposures a seller must be concerned with if payments are apportioned to compensation or deferred compensation, or if partnership liquidation payments are used.
Employment taxes
The problem of employment taxes is twofold; whether the employment tax is imposed on the payment, and whether the recipient is still eligible to receive social security payments.
Employment taxes are imposed on 'self employment income' under IRC 1401, which can include income from a partnership IRC 1402(a). Partnership liquidation payments.
Partnership liquidation payments are excluded from employment taxes if certain requirements are met-among them (a) a written plan, (b) periodic payments, (c) continuing payments until death, (d) the partner renders no services to the partnership for the payments, (e) no other obligations exist, and (f) the partnership capital account is paid to the departing partner before the end of the year. IRC Section 1402(10), Reg. 1-1402(a)17(c)(1).
Covenants not to compete
Generally, non-competition payments are not subject to withholding. H. R. Barnett (1972) 58 T.C. 284. However, where a corporate officer had a duty to consult with the corporation and could not consult for others, a duty to withhold was found. F. W. Stevens (CA11 1983) 707 F.2d. 478. The moral seems to be not to link a covenant not to compete with an exclusive consulting arrangement that looks like employment.
Deferred compensation
For income tax purposes, unfunded deferred compensation is taxable, and withholding is probably required when the payments are received or when there is no substantial risk of forfeiture (see IRC Section 83. For FICA and FUTA purposes, withholding on deferred compensation is apparently required when the services are performed, at which time the employee is probably already over the maximum level on which taxes are computed. IRC Section 3121(v).
Payments to S corporation stockholder
Payments to an S corporation stockholder are normally not compensation, and there is no withholding. Rev Rul 59-221, 1959-2 CB 225. However, if such payments are made to an officer or director, withholding may be required. See 1992 Pub. 589, Tax Information on S Corporations, p. 11.
Continuing as a solicitor
Not infrequently a retiring producer wants to continue to place some new business as a solicitor. A solicitor should be an independent contractor if any payments are being made to him that are intended to be excluded from withholding and employment taxes, such as partnership liquidation payments or covenant not to compete payments.
Ability to draw Social Security
The ability to draw social security despite receiving payments depends on whether or not the income is considered self employment income, how much time the recipient puts in to receive the income, how much he receives, and how old he is. This outline will consider the right to social security to the extent it bears on how to structure the disposition of an agency. The outline is not intended to be a complete discussion of eligibility to draw social security.
For example, a retired partner can receive partnership liquidation payments under IRC 736 and still draw social security if he renders no substantial services, which generally means less than 45 hours a month. (However, rendering services may make him liable for withholding, as already noted). 42 USCA 403(b), 20 CFR Reg 404.446-.450.
S corporation payments and covenant not to compete payments, if they are not considered employment income (see above), should not affect the right to draw social security to any greater extent than dividends or other non-employment earnings of the retired person. The same should be true for deferred compensation payments for past services.
Income in respect of a decedent
Income in respect of a decedent is installment or similar deferred income that an estate or beneficiary receives after the decedent's death. IRC 691. It is taxed to them when received, but a deduction is allowed for estate tax purposes. In addition, it is not stepped up in basis upon the death of the producer. IRC Section 1014(c)
Any of the strategies discussed which involve transactions consummated before an agent's death with payments that may extend beyond his death may generate income in respect of a decedent. This includes postmortem partnership liquidation payments C. W. ELlis (CA2 1959) 264 F.2d 325; Rev. Rul. 71-507, 1971-2 CB 331, and postmortem deferred compensation or bonuses if the decedent had a aright to them at death E. D. Roberts (1983) 80 T.C. 619, aff'd (CA6 1985) 752 F.2d 1128.
Among the terminal illness strategies the agent might consider (a) getting fully paid before death (which would include receiving stock in a merger or an ESOP sale with a rollover, both of which would defer tax and enable a basis step-up), or (b) having the sale or other transfer triggered by or after death (and after the agency interest is stepped up in basis).
5.3 Commission splits after retirement or leaving agency.
The parties sometimes agree to continue commission splits for a period of time after a producer retires or leaves the agency, with the agency owning the new expirations information it prepares for no additional payment. This approach is primarily used in two circumstances. One circumstance occurs when a retiring producer owns his expirations. Another circumstance occurs when a producer is given deferred commissions in the business he produces for the agency, but not an equity interest in the expirations or the agency. If successful, this approach will make the commission split payments to the departing producer excludable from agency income.
The deferred commission approach is increasingly being used today when producers with small books of business join up with a larger agency with more markets. The producer exchanges ownership of his expirations for a vested deferred compensation arrangement. This approach gives a better tax result for the agency, and need not be a detriment to the individual producer if the commission split compensates him fairly.
15% of the renewal commissions actually paid for 5 years is a typical type of deferred compensation provision for a producer who did not bring a book to the agency. One who did bring a book would normally receive a higher payment, such as 20% or more for 5 years.
Deferred commissions are frequently subject to vesting requirements for new production while at the agency, though not for expirations brought to the agency by the producer. Use of ERISA/IRS vesting provisions is not a bad idea (IRC 411), though deferred compensation plans in producer agreements are probably not subject to ERISA. Dept. of Labor Advisory Opinion 89-07A (Apr. 27, 1989).
In order not to leave the agency vulnerable to future competition by the producer, the agreement usually provides that the deferred compensation is lost if the producer competes with or accepts business from the accounts of the agency. At a minimum it offsets the damage suffered by the agency due to the competition.
5.4 Sale of shareholder's stock in corporation.
If an agent sells his stock in an incorporated agency, he (not the corporation) receives the proceeds. There is no tax at the corporate level, and hence no double taxation. The seller will normally receive capital gains treatment of gain in excess of his basis in the stock.
Purchase of stock generates no deductions for buyer, unless part of price is allocated to other assets (such as a covenant not to compete) which can be amortized. Under 93 OBRA, purchased good will, expirations, and covenants not to compete may be amortized over a 15 year period. A sale of stock normally will not permit good will and expirations to be amortized.
Although a sale of stock could be followed by an IRC Section 338 election to allow the buyer to treat the stock sale as an asset sale, this treatment may trigger a tax on the seller and on the seller's corporation both. The net tax effect of a stock sale followed by a Section 338 election has in most respects the same tax consequences as a sale of assets, and the seller should be aware of this. It defeats the reason for a stock sale from the seller's viewpoint.
In valuing expirations, good will, or a covenant not to compete, potential problems were formerly created by the IRS's 'residual method' of allocating payments. The IRS will first allocate payments to the hard assets of the agency, and then allocate any residual value to the intangible assets. Since all these assets are now amortized over 15 years, the distinction among them seems to have disappeared.
The buyer of stock takes over the corporation's liabilities, as well as its assets. Buyer may ask seller to indemnify him against some liabilities, such as taxes, E&O claims, or major accounts lost within a short time after the acquisition.
If a corporation agrees to redeem its own stock, it may be precluded from doing so if it cannot meet certain net worth and liquidity tests set forth by Calif. Corporations Code 500-501. An individual shareholder has no such limitations. Sometimes an agreement provides that if the corporation cannot make the payments, an individual will do so.
5.5 Sale of assets - expirations and good will.
A seller may sell the assets of an agency instead of its stock. It may have tangible property, such as computers, office equipment, etc. However, normally its expirations and good will are its most valuable assets.
Under the Clinton tax law changes, the buyer normally may amortize expirations and good will over a 15 year period. Exceptions apply to 'self generated intangibles', and to sales to related persons or where common control existed, which are bootstrap arrangements to try to deduct expirations and good will without true ownership changes. IRC 197.
The payments for these assets should be treated as capital gain to the seller, to the extent they exceed basis.
Potential double taxation exists in an asset sale if a C corporation owns the expirations and good will. The first tax is paid by the corporation on the sale. A second tax is paid by shareholders on distribution of the sale proceeds. Double taxation may be avoided if the expirations are individually owned by the stockholders or a partnership, and only administered by the corporation as an independent contractor. A Subchapter S election at the outset should also avoid double federal taxation.
The California version of the bulk sales law does not apply to sales of insurance production agency assets. Calif. Commercial Code 6103.
5.6 Allocation of part of the payments to a covenant not to compete, consulting agreements, & interest; use of deferred compensation, etc.
In either a sale of assets or of stock, some of the price may be allocated to deductible or amortizable items such as a covenant not to compete. The covenant is now amortizable over 15 years. IRC 197. If the IRS disallows part of the value of the covenant, the remainder is capitalized in a stock sale, but not in a sale of good will.
Deferred compensation arrangements that the agency entered into before the sale are liabilities that will reduce the net value of the agency for sale purposes. Deferred compensation to the owner will be deductible to the agency when paid, to the extent it is reasonable in amount. IRC 212. The same is true of consulting fees.
Interest payments on the sale should be deductible in most circumstances. IRC 163(d).
These payments will be received as ordinary income by the recipient, and may generate employment taxes in the case of compensation for services. In the case of a C corporation, they may be used in appropriate cases to avoid double taxation at the corporate level as well as on the individual owner.
5.7 Merger or other combination with another corporation.
Mergers and other reorganizations between two corporations are complex, particularly when one is listed on an exchange. This discussion will try to show the uses of a merger, but cannot get into the complex details of corporation, corporate security and tax law involved.
In a nutshell, a merger usually (a) requires no cash for the acquirer (at a cost of dilution of the stock), and (b) defers tax for the acquired shareholder, but (c) generates no cash for the acquired shareholder until the stock is sold (normally on an exchange). Mergers are normally used by large brokerages which are expanding by acquiring local agencies. They are used much less frequently in acquisitions by smaller firms.
There are several types of tax deferred reorganizations involving two or more corporations, including statutory mergers, stock for stock exchanges, and stock for asset exchanges. IRC 368.
If the agency game plan is to grow through mergers, or to be acquired down the road by a large brokerage, much advance planning is advisable. This is an area in which specialty insurance consultants can perform a valuable service, both in preparing for merger and in finding appropriate merger partners.
- Potential advantages of a reorganization.
In a corporate reorganization, usually the acquirer pays little or no cash to acquire an agency, by paying with its own stock.
The owners of the acquired agency normally receive stock of the acquiring agency. Normally tax is deferred on this stock until it is sold. If they receive cash or its equivalent (referred to as 'boot'), the 'boot' is taxed when received.
A statutory merger or stock for stock reorganization normally eliminates double taxes (that is to say, on the acquired corporation and on the individual shareholder when the corporation is wound up), since the new stock is normally received by the individual acquired shareholder in exchange for his stock in the acquired company.
The acquired shareholder often receives more liquid new stock in place of the stock of his old agency. Frequently the new stock is listed on an exchange, whereas the old stock had no ready market.
- Potential disadvantages of a reorganization.
A merger or reorganization usually will bring with it the obligations of the acquired corporation, such as potential errors & omissions claims.
A reorganization also makes it extremely difficult to amortize the expirations without creating additional problems. Amortization is possible through an election to treat a stock for stock exchange as a sale of assets under IRC 338, or by a simple sale of assets instead of a reorganization. However, such a sale or Section 338 election will normally result either in an immediate tax to the acquired shareholder on all or part of the gain, and may also result in a double tax (if the acquired corporation is a 'C' corporation). A Subchapter S election by the acquired corporation may reduce or even eliminate the double tax in the case of an election, particularly if done early on. However, it may leave the acquired shareholder with a tax but without cash to pay it because the stock he received is tied up by corporate securities laws. It may also result in a cash outlay by the acquirer if the acquired shareholder does not want to be paid in stock.
In short, it is difficult if not impossible to have your cake (in the form of amortizable expirations) and eat it too (in the form of payment of stock by the acquirer and deferral of tax by the acquired shareholder. If you plan to use a reorganization, don't plan on being able to amortize the expirations. You can still amortize a covenant not to compete.
The sale of the new stock received by the 'seller' to a public company may be restricted for a period of time under the securities laws. Frequently two or more years must elapse before the seller can cash out the stock he receives on a reorganization.
The acquirer suffers dilution of the ownership interest of its shareholders. This is normally not an important consideration for a large public company, but it usually is a consideration for a smaller company acquiring a book of business.
Frequently the acquiring agency employs an acquired shareholder for a period of time to help retain the acquired business. Often this shareholder will be paid a substantially lower salary than he received under his old agency, particularly in acquisitions by public companies. Many newly rich agents are shocked when they try to make their children's college payments on what they are paid in salary by a national brokerage, particularly if sale of their new stock in the brokerage is tied up by securities regulations.
5.8 Partnership retirement agreement.
A partnership may enter into a buy-sell agreement with a partner, but it has another option for a partner who wishes to retire. A partnership liquidation agreement usually can make most liquidation payments to a retiring partner fully deductible to the remaining partners or the partnership. IRC 736. If the retiring owner is willing to accept ordinary income treatment, it is easier to make acquisition payments fully deductible through a partnership liquidation agreement than through a sale of stock or assets.
In the case of a deceased partner, the payments may be income in respect of a decedent, suffering both estate and income tax (with