TAX IMPLICATIONS OF BUYING AND SELLING AGENCIES
by Jon Persky
One of your friendly competitors mentions that he received two times revenues when he sold his agency recently. However, did he really? Although many people want to know what an agency is worth as a multiple of revenues, a revenue multiple is not the relevant factor.
Assume an agency has $1 million in revenues and a revenue multiplier of 1.5. Would you be willing to pay $1.5 million for a $1 million revenue agency whose fixed expenses are $1.1 million a year? Of course not! Why would you pay anything to lose $100,000 per year? What’s relevant is the net cash flow of the agency. Whether you value an agency as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), use a Return on Investment (ROI) calculation, or calculate the Net Present Value of Future Cash Flow, many agency owners are beginning to realize that the valuation of an agency is more complicated than a simple multiple of revenues.
However, there are more factors to consider than price. What are the terms of payment? Are you getting 100%cash up front, or are you taking payments over time? Is the deal with or without a retention factor? How s the purchase price being allocated? Most importantly, what is the structure of the deal?
What Are You Selling?
There are two ways to sell an agency: Either as a stock purchase or an asset purchase. Based on a study by The National Alliance Research Academy for the book Maximizing Agency Value II: A Guide for Buying, Selling, and Perpetuating Insurance Agencies, four in five agency sales are done as asset purchases. Depending on the deal structure and the buyer and seller’s types of entities, significant tax implications can arise.
It’s essential to know how much money the seller will keep with after paying Uncle Sam. Structure the deal the wrong way and your least favorite uncle could end up with more of the proceeds than you do.
Asset Sale
Let’s assume Joe Jones is a 100% shareholder of Jones Insurance Agency, Inc. (JIA), a C Corporation, and Bob Brown is 100% shareholder of Brown Insurance, Inc. (BII), an S Corporation. Joe agrees to sell the assets of JIA to BII for $1 million cash up front. Bob writes BII a check for $1 million payable to JIA. At this point, Joe is happy and is dreaming about what to do with his money. Unfortunately, Joe wanted to save money and didn’t bother to consult with his CPA, attorney, or business consultant.
April 15th rolls around, and Joe’s CPA tells him that JIA owes the State Department of Revenue 5% ($50,000). JIA also owes the IRS $323,000 ([$1 million – $50,000] x 34%). At this point, JIA is left with $627,000 and Joe writes out a check from the agency made payable to himself for the $627,000.
Assuming an individual state tax rate of 4%, Joe now owes an additional $25,080 to the state and, of course, the IRS wants capital gains tax (currently 15%) on the $601,920 ($627,000 – $25,080). After paying Uncles am $90,288, Joe is left with $511,632, a far cry from the $1 million sale price of the agency.
Now let’s assume that instead of being a C Corporation, Jones Insurance Agency is an S Corporation. Since S corporations generally don’t pay taxes, the $1 million of sales price will flow onto Joe’s K-1 from the corporation s income. (Although this is usually a split of ordinary income and capital gains, let’s assume the entire amount s ordinary income, for ease of example.) Joe will pay the state its 4% ($40,000) and Uncle Sam its $326,400. Joeys left with $633,600. Better, but not great.
If Joe files a plan for dissolution for JIA with the IRS, the $1 million becomes capital gains. Joe pays $40,000 to the state and $144,000 (($1million - $40,000) x 15%) to the IRS, leaving him with $816,000. If JIA is a sole proprietorship, Joe would also be left with $816,000.
In all of these cases, the tax implication to the buyer, Brown Insurance, Inc., is the same. Brown gets to amortize the $1 million purchase price straight-line, over 15 years, resulting in a tax deduction of $66,667 per year for 15 years.
Converting from C to S Status
Sellers sometimes think that they can convert quickly from a C Corporation to S Corporation status to avoid the double taxation implications of a sale. This is where the 10-year rule comes into play.
Let’s assume JIA converts from C to S status on December 31, 2010, and his basis in the agency is zero (he started the agency from scratch). If Joe sells JIA’s assets on or after January 1, 2011, the entire sales price is treated as an S-status Corporation. However, if Joe wants to sell JIA’s assets before January 1, 2020, he has a problem. It will be treated as a C Corporation unless Joe has his agency valued as of December 31, 2010, for a conversion as of January 1, 2007 by an independent third-party consultant. Let’s assume the consultant values the agency at $800,000. If Joe sells the agency’s assets any time before January 1, 2020, the first $800,000 will be treated as a C Corp, and any remaining balance of the purchase price will be treated as an S Corp.
To reduce the potential of the IRS questioning the assigned value. Have a qualified third party do the valuation. Further, Form 1120S, page 2, should be filed with the IRS with the December 31, 2010 tax return, indicating the amount of unrealized built-in gains at the date of conversion. This amount is put on page 2, so that the IRS can track the gain if a sale happens within the 10-year period. This amount is based on the valuation as of the date of conversion (January 1, 2011 in this example).
Stock Purchase
In a stock purchase, the buyer will be buying Joe’s stock in JIA from Joe personally. The buyer writes out a check to Joe for $1 million, and Joe will end up netting $816,000 after paying the 4% state tax and federal
capital gains taxes.
Although this might seem an easy solution to the double taxation problem of a C Corporation, most buyers are reluctant to enter into a stock purchase. With a stock purchase, the buyer increases his basis (in this example by $1 million) but never gets to amortize the purchase price. In essence, Bill trades a $66,667 ordinary income tax deduction for the next 15 years, for a $1 million capital gains tax deduction at some future point. Not only is there an impact due to the time value of money, but Bill is potentially trading 34% tax deductions for a 15% tax deduction.
Of even greater importance, if Bill buys Joe’s stock, Bill is assuming all of the hidden or unknown liabilities of JIA. Although you can mitigate this somewhat by having Joe sign an indemnification agreement, Bill will still have to pay the liability and then seek repayment from Joe. Will Joe have the funds to repay Bill? Will Bill even be able to locate Joe?
These are the reasons why most stock purchases are between family members or between multiple shareholders
of a corporation.
Trading Vested Books for Stock Ownership
Some agencies allow producers to vest in their personal books of business. At some point, the agency owner wants to bring in a vested producer as a stockholder for agency perpetuation purposes. The agency owner suggests that the producer “swap” his vested interest in his book of business for a similar value of agency stock. Unfortunately, it’s not as easy as it sounds and will have significant tax implications to the producer.
Before the producer even considers the swap, there are several issues to address:
- How will the agency and/or the book of business be valued? This will affect the percentage of stock the producer will receive.
- What’s the tax impact to the producer?
- Does the agency have an acceptable Shareholders Agreement that specifically addresses death, disability, retirement, divorce, voluntary and involuntary termination, both with and without cause?
Let’s assume ABC Agency is worth $2.5 million, (including Pete’s book of business) and Pete the producer has a book of business with ABC Agency worth $500,000. Pete is 50% vested in his book; and the owner of ABC Agency approaches him about “swapping” his $250,000 ($500,000 x 50%) ownership in his book for 10% of the stock of the agency. Unfortunately for Pete, this is neither a “like-kind exchange” nor a corporate reorganization. When he receives 10% of the stock of ABC Agency, he should also receive another piece of paper, a W-2 for $250,000 (10% of the $2.5 million) on which he will have to pay taxes. Assuming Pete resides in a state with an income tax rate of 4%, he will pay $10,000 to the state and $81,600 to the IRS (assuming a marginal tax rate of 34%). Does he have the money?
Note that if an agency is considering hiring a seasoned producer who’s coming with a book of business, it might be possible to treat the producer as an independent contractor with his own corporation, and later consider doing a stock swap to mitigate the tax impact to the producer.
Summary
Buying, selling, and perpetuating insurance agencies can be highly complex transactions that have significant impact on both the buyer and seller if not structured properly. Planning, sometimes years in advance, is crucial for agency owners to maximize the after-tax money they receive for their agencies. Agency owners are wise to hire qualified consultants who can help with agency valuation, corporate structure, perpetuation planning, shareholders agreements, and the related tax implications.
Jon Persky, CIC, CPA, PHR, is president of Optimum Performance Solutions, LLC, an agency consulting firm that provides valuation, merger and acquisition, agency, perpetuation, strategic planning, and marketing and retention services to insurance agencies nationwide. He is also a member of The National Alliance faculty and a speaker at Ruble Seminars. For more information, contact John at (813) 835-7337; e-mail [email protected]; or visit www.optperform.com. Reproduced from Resources Magazine, with permission from The National Alliance for Insurance Education and Research.