SEVEN REALLY BIG ONES:
TAX SECRETS THE IRS DOESN'T WANT YOU TO KNOW ABOUT AGENCY PERPETUATION
by Gary Jacobson and Larry Morrison
These secrets are the really big ones. Much bigger than an extra tax deduction in this year's taxes.
Some of them concern potential tax disasters and recommendations on how to prevent them. Some are hidden ways of greatly reducing the taxes you always thought everyone had to pay. Every one of them can save you more than your total tax bill this year, and probably more than your tax bill for several years combined.
Because the disasters can be so bad, let's start with naming them and describing how to avoid them. Because everyone needs hope (especially when it comes to dealing with taxes), we'll finish with tips on greatly reducing the taxes most people think are simply unavoidable.
1. HUGE SELLER'S DISASTER: STRUCTURE THE SALE OF YOUR AGENCY AS AN ASSET SALE
How bad can bad be? Assume a worst-case sale of an agency worth $1 million. The agency must earn $2,083,333 for the new owner to have just enough after taxes to pay the seller $1 million. The seller gets to keep $409,500 of that $1 million. Total taxes: $1,673,833. Combined tax rate: 80.3%. And this does not even include estate taxes.
All it takes is a high-income buyer (our examples use top federal tax rates and 9% state taxes) plus an asset sale in the wrong circumstances. It happens all the time.
An 'asset' sale is the way 'everybody' does it. Before 1986, it was not usually a problem, and in some cases it still works fine. But if your agency is a 'C' corporation (most are), the seller will be double taxed. You will owe corporate income tax on the full sale amount, plus capital gains tax on what is left. If your agency is an 'S' corporation that switched to 'S' status after January 1, 1989, not only will you owe corporate income tax, but that tax will be computed at the maximum corporate rate of 35%. Only if you are not incorporated at all, have never been a 'C' corporation, have switched to 'S' status in time, or have been an 'S' corporation for 10 years can you avoid this problem.
Structured wrong, the corporate income tax will be due right away even if the cash is not actually received for many years. The seller can end up owing more in taxes the first year than he or she receives for the down payment, even with a down payment of 40% or more. In other words, you can sell the agency and pay the government more than everything you receive the first year as your reward.
Although this is an absolutely horrible tax disaster, it can be avoided. Lots of tools exist to change the technical nature of the money received into things that are not double taxed. One of the most common is to characterize part of the money received as payment for a personal agreement not to compete. You cannot make the whole problem go away with this tool, but it's a good start.
A way to vanquish the problem completely is to structure the sale as a stock sale instead of an asset sale. This saves the seller, but-you guessed it:
A stock sale can be a disaster for the buyer.
2. BUYER'S DISASTER: STRUCTURE THE PURCHASE OF AN AGENCY AS A STOCK PURCHASE
None of the purchase price in an acquisition structured as a stock purchase is deductible. All of the purchase price in an asset purchase is deductible. So is the buyer taking a huge hit just to save the seller?
Yes and no. The buyer does pay more tax with a stock purchase. But the extra cost to the buyer is not nearly as much as the savings to the seller. Part of the reason for this is that the deduction the buyer gets with an asset sale must be spread out over 15 years. Waiting to get a deduction is not nearly as valuable as getting all of it right away. So think of the buyer's deduction as really worth only half as much as it seems.
In other words, the total combined taxes paid by the buyer and seller are much less. A buyer and seller who are willing to be reasonable about things can simply renegotiate the terms and split the savings between them. Unless, of course, they would rather pay more taxes to help reduce the national debt. The rest of us will thank them.
3. BIGGEST DISASTER, BIGGEST OPPORTUNITY, HIGHEST EMOTION: ESTATE TAXES
Nothing is as certain as death and taxes, right? Death, yes. Taxes, no.
Let's say you want to pass your agency on within your family. If you do not need the money for your own retirement, you might want to give it to your kids, or let them inherit it in your will. No problem. Once you've won the court battle with the IRS over the value of the agency (they often think it is worth twice its real value), your kids get to pay the IRS $550,000 for the privilege of getting a $1 million agency free. If they lose the court battle, they may get to pay $1.1 million to get a $1 million agency 'free.'
How can this be? If you are successful, the IRS thinks it owns over half of everything you have, including your agency. Since establishing the value of an agency when it is passed on within a family is essentially a judgment call, the IRS has a vested interest in as high a value as possible. There are many instances where the IRS has claimed a value much higher than the real value of the business involved, sometimes as much as 10 times higher. IRS valuations double the real value are common.
Estate planning is emotionally charged and incredibly complex. Even a whole book on the subject would only scratch the surface. If you are like most people, you have not done what you should. You'd probably rather not even think about it.
As a starter, if your estate is over $600,000, including Life insurance and the full value of your agency, then you need at least basic estate planning. Estate taxes top out at 55% of the fair market value of everything you own. The estate tax is the highest in the tax code. It also has an incredible number of loopholes to reduce it. Some experts even refer to it as a voluntary tax because there are so many ways you can reduce it. The key is to plan. Without planning, the IRS gets its full share (or more).
You guessed it. One way to save big dollars is to plan ways to keep the 'value' of your agency as low as possible. This has to be done in advance to have any hope of working. There are many ways to do this, some of which you may already know. We have a few little known ways of our own, and they just happen to save money in non-family situations as well. If you plan to pass the business to a son or daughter working in the business, use idea #5 as part of your child's compensation package. If you plan to pass the business to key employees, use idea #6. Every dollar you set aside in either of these ways can save your estate up to 55 cents. If you plan in advance, these tools alone can easily cut the estate taxes owed on your agency in half.
4. DEATH: A BIG TAX BREAK.
The government giveth, and the government taketh away. We just mentioned how the government can take up to 55% of everything you own when you die. Our amazing tax code also gives you a huge tax break at the same time.
The basis of everything you own is adjusted to fair market value when you die. This means your heirs can then sell anything you owned, including your agency, and not pay any capital gains tax.
This has major implications for the sale of an agency. If you have decided to sell because of failing health, then arrange the sale to occur after death, not before. It takes someone who knows how to structure the transaction, but it puts 28% more on the bottom line after taxes.
In our $1 million example, this could put an extra $280,000 on the bottom line for the seller. The worst thing you can do is sell today and die tomorrow.
You should also consider this if you are buying an agency from an ill seller, especially if other people are also bidding to buy the same agency. This technique alone can give you a 28% edge over your competition in buying the agency.
5. CUSTOM RETIREMENT PLANNING: TOP PEOPLE ONLY!
Big savings for the future sale of your business, your future retirement, and estate planning, all at the same time.
The technical term for this technique is 'unfunded, non-qualified deferred compensation.' A similar concept, with Life insurance, is usually funded. 'Unfunded' means you do not set aside any money for the future payments (no Life insurance). 'Nonqualified' means it is not a qualified plan such as a 401(k) or profit-sharing plan. Since it is not qualified, you cannot offer it to anyone other than top people.
Basically, you are creating a legal obligation of the agency to pay money in the future. Since no money is set aside to fund this obligation, the price of the agency is reduced dollar for dollar. The benefits depend on what you are trying to achieve, and to whom the money must be paid.
Future sale of the business: Put in a plan for the current agency owner. All the money paid will be deductible to the buyer as it is paid (beats 15 year amortization!), and the seller will not be double taxed. The benefits can be massive. It helps with any kind of future sale, including sales to key employees, family, and third parties. Everyone wins except the IRS. Family business transition: Put in a plan for the children who will be the future owners. This takes money out of your estate and thus save estate taxes.
Just how big can this be? If you plan enough in advance to put $1 million into one of these plans, it could save your estate $550,000 and create a $1 million tax deduction for the buyer on the future sale of the agency. The buyer and seller split the benefit of the tax deduction, and everyone wins big (except the IRS).
6. STOCK OPTIONS: KEY EMPLOYEE BUY-OUTS
In any agency purchase, the agency earns the money to pay for the buyout. Not counting the possible double tax on the seller, the purchase is still double taxed. The first level of tax is on the money the agency pays to the new owner. The new owner uses what is left to make payments to the old owner, which is taxed again.
Paying a key employee in the form of stock options (or restricted stock) instead of cash can eliminate one of these levels of tax. There are many different ways to tailor this compensation and pay with stock instead. Use the cash you save to pay more to the current owner. Result: less total tax.
How big is this? It carries the same basic result as in No. 5: hundreds of thousands in our basic $1 million example.
7. SECTION 736: FULLY DEDUCTIBLE BUYOUT
This is so obscure that very few agency owners in the country have ever heard of it. Neither have their advisors. Too bad, because it represents the ultimate in agency buyouts. You can arrange for a fully deductible buyout if an owner retires, coupled with non-taxable capital gains treatment if the owner dies before retirement (remember the 'basis' adjustment).
For those who plan ahead, it just doesn't get any better than this. No double tax at any point. Payments are deductible when the buyer makes them, unless purchase is the result of death. If purchase is due to death, the heirs pay no capital gains tax.
It relies on an obscure loophole in the tax code, section 736c. To get this treatment requires the business to be non-capital intensive, and organized as a general partnership. Property/Casualty agencies are considered non-capital intensive, so this part of the test is met. Once you know about the loophole, the challenge is how to meet the general partnership requirement without taking on the liability exposure of a general partner. This is done by making the partners 'S' corporations.
Since the tax benefits are so good, why haven't more people heard of this? Because most advisors are not aware of the loophole in section 736c, and most advisors have no experience combining 'S' corporations into a general partnership.
Those agencies interested in sophisticated planning to reduce taxes will find this the best tool available. How much can you save? It will not reduce taxes to zero, but in many cases will easily cut them in half.
CONCLUSION
EaCh of these seven areas represents a major opportunity to save money and avoid major tax traps. These are not minor issues. In some cases, you can save more in future taxes than you currently make working full time for two years. Which would you rather do, take the time to plan the future, or work for two years?