SELLING YOUR AGENCY: 'C' CORPORATIONS
by Larry Morrison, CMA, CLU, ChFC and Gary Jacobson, JD
How to slash the tax bill from selling your agency.
INTRODUCTION
In our experience, most agencies are incorporated as “C” corporations, and most sales of these corporations are initially structured as “asset sales.” These sales are generally a tax disaster. If you own a “C” corporation, this article can save you money — a lot of money.
We’ll review how both the buyer and seller are taxed in a typical agency sale. We’ll then explain several options and how each of them can save you money.
What’s a “C” Corporation? There are two relevant kinds of corporations, “S” and “C.” To find the best way to sell your agency, you must know which kind of corporation you have. For those of you who aren’t sure, a “C” corporation must pay taxes on any income left in the corporation. So if your corporation must pay income taxes, it’s probably a “C.” If any income left in the corporation is taxed directly to you as an owner, it’s probably an “S.”
If you sell a “C” corporation in the usual way, you’ll pay very high taxes. If you sell it the right way, you can reduce these taxes significantly.
TYPICAL AGENCY SALE
Seller: The vast majority of agencies are sold as an “asset sale.” A “C” corporation asset sale is taxed twice. The IRS views the process as a two-stage event, even if you see it differently. As you might expect, the IRS wants a big piece of each stage.
First, the corporation sells everything, including the book of business. This generates enormous income at the corporate level, all of which is subject to full corporate taxation. Even in smaller independent agencies, this tax usually represents about 34% of the sale price.
Second, what’s left is paid to you, the owner. Usually, this payment is a “long-term capital gain,” so the IRS will want only 28% more. If this happens to you, the combined federal tax will come to 52.5%, not counting possible state and local taxes. Never forget, the buyer had to pay taxes on the money before paying you.
Buyer: Since almost all the value of an agency comes from the book of business, the primary asset sold is an “intangible” asset, which must be deducted evenly over 15 years. So someone who buys an agency’s assets for $150,000 can deduct $10,000 per year for 15 years.
Oddly enough, most people don’t get excited about deductions they can take 15 years from now.
PLANNING ALTERNATIVES: HOW TO SAVE BIG BUCKS!
There are a number of tools to improve an asset sale. An experienced planner can mix and match them to generate substantial savings.
Non-compete agreement: If the seller were free to solicit all the clients in the book of business just sold, the sale would be worth much less. This essential protection for the buyer can be assigned a value and paid separately from the sale of the business.
When a non-compete contract is done right, some of the money that would have been paid for the assets of the business — thus double-taxed — can be paid directly to the seller instead. The 34% tax at the corporate level is avoided completely since the money never goes to the corporation, but goes straight to the seller. While the seller pays income tax instead of capital gains tax, good planning can usually spread the income out and avert a problem.
Clearly, avoiding a 34% tax can help the seller, but what happens to the buyer? In this case, nothing. The non-compete contract is taxed to the buyer in the same way the purchase of the book of business from the corporation would be.
Values assigned to a non-compete embody about 50% of the business’ value, so the savings for the seller can be spectacular.
Management Contract: This tool, keeping the seller as an employee under a very generous management contract, can be over-hyped. In some instances, the seller merely has to be available for consultation on an occasional basis, and never shows up at the office. Preserving the full value of the business justifies this arrangement. Achieving this goal makes all the time invested worthwhile. Since nobody can say how much this timely advice is really worth, the sky’s the limit, right?
Management contracts help both the seller and buyer. The seller avoids double taxation, as with a non-compete agreement. But unlike a non-compete agreement, management contracts may enable the buyer to deduct the payments as they are made. This is far better than a deduction divided over a 15 year period, so the buyer benefits significantly.
The IRS isn’t blind. They have rules to discourage abuse of this tool. If the payments are intended to preserve the value of the business, the deduction must be spread out over 15 years. The only payments that will be immediately deductible are those made for actual work performed as part of daily operations.
Social security taxes can also be a factor. These won’t create a problem if the seller has other earned income to put them above the Social Security limit. Otherwise, it’s often possible to reduce the problem by combining a management contract with unfunded deferred compensation.
Stock Sale: A major alternative to an “asset sale” is to sell the stock in your company. The seller pays only personal capital gains tax on the sale of the stock. The corporate-level tax is completely eliminated.
This option sounds great and can be beneficial, but your attorney and CPA will probably advise against it. However, there are solutions to their likely objections:
The first objection centers on “carry-over liability,” meaning that any lawsuits brewing against your agency will carry over to the new owner. Even without lawsuits looming, the buyer’s attorney is likely to present this as a major problem.
Here’s the solution. First, don’t let the agency’s E&O policy lapse, even for a day. This will provide the new owner with the same protection the seller had. Second, don’t pay all cash for the purchase (few sales are all cash anyway). Retain the right to reduce the money owed on the purchase by any out-of-pocket costs the buyer experiences as a result of the uninsured portion of liability claims arising from the seller’s actions before the sale.
The second objection regards deductibility of the purchase. In an “asset sale,” the buyer can deduct the entire purchase price over a 15-year period. In a stock sale, the purchase price is entirely nondeductible. No deduction is worse than having to wait 15 years, so a stock sale seems to place the buyer at a great disadvantage.
The “deductibility problem” also has a solution: Because the savings to the seller exceed the extra cost to the buyer, the seller can give the buyer a break on the price and still come out ahead. Both sides win. The bargain might be improved by combining a stock sale with other techniques, such as a non-compete agreement, to restore much of the deductibility for the buyer. These two steps eliminate the deductibility problem.
Unfunded Deferred Compensation: Planned ahead, this can be the best tool on the list. When paid, the purchase is fully deductible to the buyer. This avoids the corporate tax, so the seller is better off. The amount can be spread out to keep the seller out of the worst income tax brackets, and can be designed to avoid most social security taxes. The only problem is that this process requires preplanning.
Basically, you create a customized retirement plan for the owner. Because no money is provided to fund the plan, most of the rules restricting traditional retirement plans will not apply. When the agency is sold, every dollar in the plan avoids the seller’s double-tax problem and is immediately deductible for the buyer.
Unfunded deferred compensation has other applications for an agency, some of which we discuss in our article “Ownership of a Producer’s Book: A Better Way.” This article includes a brief explanation of the key tax factors, including how to control the timing of income taxes and reduce Social Security taxes.
SUMMARY
A short example provides the best way to summarize methods of structuring an agency’s sale for tax purposes. Assume that the agency is worth $1 million and is a “C” corporation. The owner is retiring in good health and will be taxed at 28% on personal capital gains and an average of 31% on ordinary income.
THE SALE
Seller: The seller pays $340,000 tax at the corporate level and $184,800 in personal capital gains tax on what remains. The total tax is $524,800. The seller keeps $475,200.
Buyer: The buyer receives a deduction of $66,667 per year for 15 years. In other words, the buyer’s purchase is almost entirely nondeductible for the first few years.
Non-Compete Agreement
Assume that 50% of the value of the agency can be assigned to a non-compete agreement, which is $500,000 in this example.
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Seller: The seller pays $170,000 tax at the corporate level, $92,400 in personal capital gains tax, and $155,000 in personal income tax. The seller’s total tax is $417,400. In other words, the seller saves $107,400.
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Buyer: The taxes’ effects on the buyer are unchanged.
Management Contract
For this example, assume that a management contract of $100,000 can be justified. Remember, a management contract is very useful in the right circumstances, but can lead to unintentional rule violations if written improperly. It’s most effective when combined with other tools in a comprehensive plan.
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Seller: The seller pays $306,000 tax at the corporate level, $166,320 in personal capital gains tax, and $31,000 in personal income tax. The seller’s total tax is $503,320. In other words, the seller saves $21,480.
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Buyer: The buyer deducts the $100,000 when paid and then deducts $60,000 per year for 15 years.
Stock Sale
Assume that the entire sale is a stock sale instead of an asset sale.
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Seller: The seller pays $280,000 in personal capital gains tax, and this is the only tax the seller pays. Total savings equal $244,800.
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Buyer: The buyer loses his 15-year $66,667 per year deduction. If the buyer pays an average of 31% in taxes and his time value of money is 10% per year, this lost deduction costs the buyer $157,193.
Although this technique can save money overall, using it requires cooperation between the buyer and seller. It’s often combined with other techniques such as a non-compete, management contract, and/or unfunded deferred compensation to restore some deductibility for the buyer.
Unfunded Deferred Compensation
Assume that the forward-looking seller installed an unfunded deferred compensation plan several years in advance, and that plan is now worth $500,000.
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Seller: The seller pays $170,000 in corporate tax, $92,400 in personal capital gains tax, and $155,000 in personal income tax. When performed correctly, a minimal social tax applies. Total tax is $417,400. In other words, the seller saves $107,400.
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Buyer: The buyer also benefits by deducting the deferred compensation (half the total purchase price) on payment. The remainder is deducted in equal increments over 15 years.
CONCLUSION
The techniques introduced here are certainly not the only ways that a sale can be improved, but they are time-tested ideas that help direct agency sellers and buyers devise a good plan. Each of them can improve a sale; when combined, they can have a more dramatic effect. For maximum benefit, start well in advance with an unfunded deferred compensation plan.
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, 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].