SELLING YOUR AGENCY: ASSET vs STOCK SALE
by Gary Jacobson, JD, and Larry Morrison, CMA, CLU, ChFC
Which type of sale is right for your agency?
INTRODUCTION:
Most agency owners structure the sale of their agency as an “asset” sale because they aren’t aware that any other choices exist. The wrong decision will lead these owners to pay the IRS plenty in extra taxes.
This article can help you save money; possibly lots of it.
To simplify a complex topic, we’ve summarized the key elements, together with a table that shows which situation tends to favor each basic type of structure. Since this is an area in which “conventional wisdom” often leads agency owners astray, we’ve also provided guidelines for fine-tuning the more conventional approaches, together with an example of how much money using these concepts can save you.
The sale of an incorporated agency can be structured in two basic ways: An “asset sale” or a “stock sale.” Regardless of the other features attached, all agency sales will be built around one of these basic structures. The tax and legal implications of each are radically different.
ASSET SALE
An asset sale is what most owners have actually selected when they sell their book of business. Technically speaking, they’re selling the assets of the corporation, not the corporation itself. Usually, the original corporation itself is liquidated after the sale. Of the assets sold, the intangible “book” of business (sometimes referred to as the “expirations”) is usually far and away the most valuable.
In many cases, an asset sale will generate an entire extra layer of devastating taxation in an agency sale. This extra tax can be as much as 35% of the sale price! The entire sale price will probably be deductible to the buyer, although the deduction for the bulk of the sale (the intangible book of business) will be spread over a 15-year period.
STOCK SALE
A stock sale is the sale of the corporation itself, not just its assets. The original corporation continues in existence, only with a different owner. Since only a corporation has stock, stock sales are not relevant for limited liability companies, sole proprietorships, or partnerships. Because the issues for these other forms of ownership are different, this article won’t discuss them.
A stock sale avoids the potential double tax in an asset sale, so the financial incentive to the seller for a stock sale can be extremely high. The buyer won’t be able to deduct the price paid for the stock, but creative structuring using other tools can restore much of that deductibility.
KEY VARIABLES
ASSET SALE
Someone will have to pay sales or “use” tax (can be either buyer or seller).
Buyer
Seller, “C” Corp.
Seller, “S” Corp. subject to “built-in gain” (generally, having switched to “S” status after Jan 1, 1989)
Seller, “S” Corp. not subject to “built-in gain” (generally, has always been an “S” corp or switched prior to 1989).
STOCK SALE
No “use” tax (the new “entity ownership transfer tax”). Even “private placement” stock sales are considered the sale of a security subject to SEC anti-fraud rules. This includes errors of omission, as well as errors of commission. Liability can extend to both buyer and seller.
Buyer
-
Many contractual agreements with the corporation will remain in place, including what might be crucial producer non-competes. Depreciable assets will not get a step-up in basis (unless it’s a Section 338 election, which is rarely wise).
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Because “goodwill” is not purchased, it is not amortizable. Interest on debt to acquire “C” Corp. stock is deductible only against “investment” income.
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In other words, in most cases it will not be deductible. Interest on debt to acquire “S” Corp. stock is fully deductible if the buyer is actively involved in the business.
Seller
- Often far less tax than in an asset sale, unless it’s an “S” Corp. with no “built-in gain.”
SALE STRUCTURE CHECKLIST
Agency Organized As -- Tends to Favor:
“C” Corporation (most agencies) Stock
“S” Corporation with “Built-In Gain” Stock
“S” Corporation with no “Built-In Gain” Asset
THE CONVENTIONAL WISDOM
In spite of the big potential tax hits, the conventional wisdom is that you should almost always do an asset sale. Asset sales are so common that many agency owners with a long history of successful acquisitions have never done anything else. In many cases, their advisors (attorneys and CPAs) will have never done anything else either. It’s important to understand why.
Attorneys: The typical attorney’s argument in favor of asset sales will center on the carryover liability and securities issues. Since, technically, only the assets (not the corporation) are sold, any legal problems the business might have had, such as a future lawsuit that’s not yet even apparent, don’t carry over to the new owner.
The other major concern of most attorneys centers on securities issues. A stock sale is a securities transaction — and our securities laws are a classic example of how to encourage lawsuits. Both buyer and seller can be sued for errors of omission, as well as errors of commission. Since a creative lawyer can almost always think of information of some kind that was omitted, the potential for lawsuits is very high. Because any good attorney will try to reduce the chance of future lawsuits against their client, they’ll try to avoid the securities issues by structuring the sale on an asset basis, rather than a stock sale.
NOTE: In some states, an asset sale is now arguably considered a securities transaction as well, so the asset sale structure might not provide protection.
CPAs: The typical CPA’s financial advice (at least to the buyer) will tend to favor an asset sale. This is because an asset sale is fully deductible to the buyer. In an agency sale, most of this deduction will have to be spread over a 15-year period. But 15 years still beats no deduction at all.
Personal Experience: Many agency owners have a long history of successful agency acquisitions. If they were done as asset sales years ago, why do them differently now? The answer: Tax laws have changed.
A CONTRARAN OPINION
Although the conventional wisdom might be technically right, it doesn’t take into account the dramatic tax improvement from selling your agency on a stock, rather than an asset, basis (see the example below).
Structuring a stock sale properly can eliminate the liabilities, securities, and deductibility problems involved — and lead to significant tax savings. Here’s how:
Carryover Liability: The carryover liability problem can be solved in two steps. First, make sure the selling corporation has always had adequate E&O and other Liability coverage, and that this coverage doesn’t lapse during the transition. Second, provide for a “right of offset” against the unpaid balance of the purchase price for any loss or damage not covered by the selling corporation’s insurance. Combining these two steps will fully protect the buyer up to the limit on the selling corporation’s insurance, plus the unpaid balance on the purchase price. Although catastrophic losses beyond this level are not protected, this is not likely to be a problem for an adequately insured agency.
Securities Issues: The securities exposure can also be reduced. A Supreme Court decision, Gustafson v. Alloyd Co. Inc., held that the most onerous rules applied only to initial public offerings (IPOs), so this issue might now be mostly solved.
However, to be on the safe side, we’d recommend these steps:
First, instead of litigating securities issues, require them to be submitted to binding arbitration (as permitted by another Supreme Court decision). This alone should be enough to return sanity to future disputes. Also, require each side to acknowledge responsibility for its own due diligence, and sell only to a knowledgeable buyer. If the seller has any adverse information, be sure to disclose it.
Buyer Deductibility: Although a stock sale will not be deductible to the buyer, the tax savings to the seller are so substantial that they can be shared with the buyer to make both buyer and seller come out ahead. In addition, there are a number of other techniques for creating deductibility in a stock sale. Any portion which cannot be deducted will establish “basis” in the stock for the buyer, which will reduce the buyer’s future capital gains tax.
EXAMPLE
A good way to see just how substantial these tax differences can be is to look at a hypothetical example that could easily apply to most agency sellers.
ASSET SALE
“C” Corporation
| Agency Sale Price: | $1 million |
| Corporate Income Tax @ 34% | -340,000 |
| Paid to Seller | $660,000 |
| Personal Capital Gains Tax @28% | -184,800 |
| Seller's Cash, After-Tax | $475,200 |
STOCK SALE
"C" Corporation
| Agency Sale Price: | $1 million |
| Corporate Income Tax @ 34% | 0 |
| Paid to Seller | $1 million |
| Personal Capital Gains Tax @28% | -280,000 |
| Seller's Cash, After-Tax | $720,000 |
| IMPROVEMENT | $244,800 |
This is an after-tax improvement. A seller in the top income tax bracket would need to earn $405,298 to generate this much after-tax income.
This example illustrates the taxes and improvement for the seller only. The effect on the buyer would depend on the other tools used to structure the sale.
SUMMARY
The most basic question in structuring the sale of an agency is deciding between a sale of assets or of stock. All too often, the answer is to automatically select an asset sale. As the example shows, this can be a costly decision.
Taxes are not the only issue involved. To help you sort out the most important factors, we’ve provided an explanation of the key variables, together with a checklist of which situations tend to favor which type of sale structure, an explanation of the conventional wisdom favoring asset sales, and solutions to the problems involved in stock sales.
Gary E. Jacobson, JD can be reached at Vander Wel, Jacobson, & Bishop PLLC, Bellevue Place/Seafirst Bldg., 10500 N.E. Eighth St., Ste. 1900, Bellevue, WA 98004, Phone (866) 498-0008, toll-free, Fax (208) 361-5064, e-mail [email protected].
Larry Morrison, CPA, can be reached at the Business Transition Network, Bellevue, WA,) Phone, (425) 957-4754, Fax, (425) 603-9149, or e-mail [email protected].