According to a number of recent articles, small business owners should sell their businesses today to avoid large increases in capital gains taxes. On the surface, this argument makes sense and, indeed, someone thinking of selling either this year or next should take a hard look at selling before taxes increase.
However, these articles often create fear, fright and frustration, all with the appearance of being educational. The authors take advantage of business owners who don’t have the time and/or ability to analyze the situation for what it really is.
A number of these articles have been almost adamant that every agency owner should sell ASAP to avoid higher tax rates. They allow for almost no exceptions. However, the reality is that while a small percentage of agency owners should sell soon to avoid higher taxes, most should not sell this year or next. The logic is simple: even with higher tax rates in the future, the agency owners will make more money by not selling today.
There are two common scenarios in which agency owners will make more money by not selling today.
First, consider the following example: Suppose an agency’s owners are making the equivalent of 25% of revenues annually as a combination of their sales and dividends/bonuses. This is a reasonable, even conservative, assumption. (The most recent Growth and Performance Standards by the National Alliance Research Academy shows that the average agency with revenue of $3,000,000+ averages a 10% profit margin and executive compensation equals 16% of revenue. Assume the agency has $3,000,000 in revenue, a 25% pro forma EBITDA and the agency is valued at 6.0 times EBITDA. This means the owners are today making $750,000 annually, and the agency is valued at $4,500,000 (assuming the balance sheet is neutral).
Assume the sellers get a 15% tax rate (which doesn’t apply to all sellers). Their tax bill is then $675,000, making their net $3,825,000. If the owners don’t sell for five years, the tax rate goes to 35%, the agency doesn’t grow by even a dime, and the agency’s value doesn’t increase a dollar, then the agency owners make $750,000 x 5 = $3,750,000. In addition, they still net, $2,925,000, for a total of $6,675,000 or 1.75 times more than they would have made if they had sold when told to.
Even assuming a 40% tax rate on ordinary income (which is high, considering that not all this income might be taxed at such a high rate), the owners still make $5,175,000 or 1.35 times more. Moreover, their retirement savings don’t have to last as long and they get to be their own bosses for longer.
The difference might not be as great in situations where the owners continue working for the new owner. The point is that, for a completely honest perspective, agency owners should consider much more than the simple examples cited in these articles.
A second possibility - one I believe the late agency consultant Dr. Edgar J. (E.J.) Leverett cited many years ago - is simply to create a wasting asset. Let the agency die a slow death. Although this strategy won’t work for all agencies, it’s possible for some. For these agencies, the potential earnings far exceed the net sales price today. Besides, in this scenario, the owner never has to retire, which is a major relief to some people.
These articles also often mislead readers by using worst-case assumptions, without making it clear that they’re doing so. For example, tax rates might go from 15% to 35% for some sellers, but the reality is that some sellers are already paying 35%. Right now no one knows for sure exactly how, or if, the tax code will be rewritten. I believe it’s safe to assume that it will remain complex. Owners often overlook alternatives to decrease their tax rate, even though almost any complex tax code provides opportunities to do just that. In the independent insurance agent’s world, one of the least known options is using professional goodwill to decrease a tax rate at sale. I find that even large numbers of CPAs don’t know this strategy.
CONCLUSION
Some authors might write such articles to motivate more agency owners to sell because their own business depends on deals being done. In other cases, the authors of these misleading articles haven’t thought through all the options, which is precisely why I wrote this article. Determining what’s best for a particular agency is a complex process. No single recipe works for everyone, and what works for one partner in an agency won’t necessarily be best for the other partner. If owners want to maximize the value of their firms, as well as their peace of mind, they should hire a knowledgeable person who can provide a complete and unbiased analysis of all options.