OWNERSHIP ISSUES AND COMPENSATION
by Carol Hammes
During the past several months we have been addressing methods for compensating agency staff, managers, and salespeople. How should the owners fit into these programs? For smaller agencies the tendency generally has been to compensate owners using a 'what's-left-over' method. After all the bills are paid, the owners divide up the remainder based on their respective ownership positions. This is undoubtedly the most reasonable approach for the first several years of operation, or in situations where growth has been minimal and there is only one or possibly two owners.
When the revenues have increased to $500,000 or so, it becomes important to start operating the agency more like a business organization. You must begin to treat the owners as employees for initial compensation purposes. After the owners are paid for their services in the area of sales or management (i.e., what they would be paid to do the work that they were doing if they were not owners), they can then divide up the return on ownership (when there is any). If the firm is structured as a partnership or as an 'S' corporation, the profits can be divided up according to ownership interest.
Agencies operating as 'C' corporations, however, need to be careful about the allocation. If you take large bonuses at year-end that coincidentally leave a minimal corporate profit and/or if these bonuses are given out in the same percentages as the ownership interests, the IRS (ever on the lookout for more tax dollars) may decide that the distribution of bonuses to owners is really a dividend that should be paid with after-tax dollars.
The IRS allows a business to deduct 'a reasonable allowance for salaries or other compensation for personal services actually rendered.' Factors that are mentioned by the IRS in its publications and by the courts in cases regarding the 'reasonableness' of compensation include:
- Comparison with compensation paid to executives in comparable positions
- The person's qualifications for the position
- The nature and scope of the duties performed and of the business itself
- Comparison of compensation paid with the company's gross and net income
- Company's compensation policies for all employees
The IRS does not usually raise the reasonableness issue if salaries and bonuses are not particularly high. But as the amount paid increases, it becomes important to build a case that compensation for all employees is fair. It is also a good idea from a purely business point of view to pay everyone (including owners) a level of compensation that is commensurate with their market value for performing the required managing, servicing, and/or selling duties.
At the beginning of the year, structure a written bonus plan that is based on individual and agency performance. The people who produce the most and contribute the most to the overall success of the agency will be rewarded appropriately at the end of the year. Many tax advisors recommend that this bonus plan be included in the minutes at the Board of Directors meeting at the beginning of the year to avoid the impression that the amount of salary and bonus is based simply on the amount that the shareholder-employees wish to withdraw from the corporation for a given year.
Firms that choose to look at agency ownership as an asset that is supposed to produced an annual return for its owners can creatively build in factors that will allow owners to receive bonuses that are based pretty much on their ownership interest, without making it appear that way. It is, after all, your prerogative to 'sell the agency to yourself' over a period of time and to do it in such a way that the government gets as little as possible. Just do your best to camouflage your activities to reduce your chances of losing the corporate tax deduction for your payments.
In light of the dramatic changes that have taken place in the value of insurance agencies, the tax treatment of ownership transfer methods, and the prevailing attitudes of younger producers, many successful agencies are now re-evaluating this traditional approach to agency ownership. It used to be that for a minimal investment an individual could obtain significant ownership interest in an insurance agency and then ride the growth, making good money along the way, until it was time to cash in for big dollars.
Although it is still possible to do this, it is not as easy as it once was. The potential agency profit margins are not as high as they were in the 1970s and early 1980s so there is less cash available. And more important, the perception among the younger people in the agency is that the return in the future might not be worth even that minimal investment. They want to be rewarded for their own performance but they are often unwilling to take much of a risk on the performance of the agency as a whole.
Some of the more progressive agencies nationwide are now looking at the entire ownership issue in conjunction with, and as an integral part of, their sales and management plans. Although there are certainly exceptions to any generalization, it is usually true that salespeople are most successful in building their book of business during the middle of their career - from about age 35 to 50. During this time they might be contributing much more to the growth and value of the agency than someone who has substantially more ownership due to his age and longevity in the agency. The perception on the part of the more active salesperson is that, by virtue of his ownership position, the other guy is reaping the rewards that should be going to the person that is creating the additional revenues and enhanced value.
It could be that the older person was unable to take out much money during the period of time that he was at his highest level of productivity and that the current return is therefore truly justified. But, in the absence of any formal compensation plan that details this delayed and justifiable reward for performance, the perception is that the ownership percentages and/or the compensation that is based on ownership is simply not fair. Once this perception takes hold, morale issues become paramount and sales decrease. People who were the key elements of the agency's internal perpetuation plan are no longer willing participants and the plan is in jeopardy.
By re-structuring the agency's approach to compensating owners and non-owners alike for today's performance, you can keep the level of motivation high and facilitate the internal ownership transfer at the same time. There are a number of different ways to give people 'credit' now, based upon today's performance, for ownership or compensation that will come to them in the future. In a previous article, we discussed the practice of awarding deferred compensation to producers in return for their sales efforts (vesting programs). The following chart presents some other compensation/ownership options that can provide direct rewards for performance while assisting in internal ownership transfers.
COMPENSATION/EQUITY PLANS
DEFERRED COMPENSATION
Arrangement to pay employee/producer in the future for services or production rendered currently. These plans are generally nonqualified and contain contingencies which might cause the employee to forfeit the future rights. Plans can be funded with Life insurance or annuities and employees can obtain protection from loss of the benefits with Rabbi Trusts. Can provide 'golden handcuffs' to keep managers as well as producers (through vesting programs).
Employee-Payments are taxed as ordinary income when received.
Agency-Premiums for funding (if any) are not deductible. Payments are deductible when paid.
STOCK APPRECIATION RIGHT
Rights granting a portion of the increase in value of the common stock of the agency from the time when it is granted to when it is exercised. Agency can value stock lower and accrue value in the form of deferred compensation. Can be used in conjunction with other forms of stock options. Recipients can or cannot be shareholders at the time and this can be another 'golden handcuff' opportunity or can be used to secure a covenant not-to-compete.
Employee-Value of the rights is taxed as ordinary income at exercise.
Agency-Deduction in amount of employee's taxable income at payment
INCENTIVE STOCK OPTION
Option to purchase corporate shares at 100% (or more) of value on date of grant for a period of up to 10 years. Allows employee to receive lower (frozen) value but can wait to pay until more cash is available from future production/salary.
Employee-Capital gains treatment on sale of stock on increase in value from date of grant (some additional requirements might apply).
Agency-No tax deduction.
PHANTOM STOCK
Units analogous to agency stock are granted. Value of the units equals appreciation in value of stock. Units are valued at a fixed date (retirement or 5-15 years after grant). Payments may be made in cash or stock or both.
Employee-Value is taxed as ordinary income on payment date and is subject to withholding. Agency-Deduction in amount of employee's taxable income at payment.
NONQUALIFIED STOCK OPTION
Option to purchase corporate stock at stated price over time (often 10 years). Option price normally equals 100% of value at date of grant but may be set lower.
Employee-Excess of fair market value over option price is taxed as ordinary income at exercise and is subject to withholding.
Agency-Deduction in amount of employee's income from exercise.
RESTRICTED STOCK
Award of stock with no or nominal cost to producer/employee that is non-transferable and subject to risk of forfeiture. Restrictions lapse over a period of time.
Employee-Excess over price paid (if any) is taxed as ordinary income when restrictions lapse and is subject to withholding.
Agency-Deduction in amount of employee's taxable income at date employee is taxed.
JUNIOR STOCK
Opportunity to purchase junior stock for discounted value which will become convertible into regular stock (at 1:1 ratio) if specified performance goals are reached. Usually non-voting and non-transferable until converted, but may be re-purchased by corporation at original value if performance goals are not reached.
Employee-Capital gains on difference between amount paid and amount received at time of sale.
Agency-No deduction if sold at fair value; may get deduction on discounted amount.
CAREER SHARE
Opportunity to purchase book value (career) shares that are convertible upon reaching performance/longevity goals into agency stock at market value. Conversion ratio of book to market value is usually set at time of purchase.
Employee-Capital gains on difference between amount paid and amount received at time of sale.
Agency-No tax deduction.
PERFORMANCE UNIT/CASH
Performance award granted as units that are either fixed dollar with the number of units based on predetermined goals or a fixed number of units with the payment value varying based upon performance goals. Goals can relate to production or to department growth or profitability for managers. Payment can be cash or stock.
Employee-Value is taxed as ordinary income on payment and is subject to withholding.
Agency-Deduction in amount of employee's taxable income at payment.
COMBINED PERFORMANCE UNIT & OPTION
Simultaneous grant of performance units and non-qualified stock options. Cash payout from units enables employee to pay taxes on option exercise.
Employee-Payment for value of units and for excess of market value over option price is taxed as ordinary income and is subject to withholding.
Agency-Deduction in amount of employee's taxable income at payment.
GOLDEN PARACHUTE
Compensation arrangement for non-owner producer or employee to receive severance benefits in the event that the agency is sold. This is often part of the employment contract and the payments are based on the size of the book of business, ending salary, and/or longevity.
Employee -- Earned income.
Agency -- Deductible as compensation.
General Guidelines: Check with your accountant or tax attorney for specifics in your situation. In most of these plans, the recipients receive promises of either cash or ownership to be received in the future, with the amounts based clearly on the production or management expertise exhibited during the current year. With these programs, employees can participate in the growth of the agency value even when a true equity position is not available for one of the following reasons. The agency may be owned by a third party (such as a financial institution) where internal employee ownership is not possible. Or the existing owners may not be willing to share current ownership or promise ownership in the future because they have not yet decided whether they want to sell externally. Or they may be 'saving' the agency for their children.
Sometimes it does not make sense to track the rewards with total agency performance. For example, producers might write a certain type of business that complements but does not fit into the mainstream of the agency's business (Life, Group, Professional Liability, Surety). In those situations, the programs can be set up to reward the producers on a more individualized basis. For example, it could be more appropriate to have them 'vest' in a deferred compensation plan that will pay them a return on their book of business or on the profits of their department.
The beauty of most of these plans is that the reward can be set up so that it could eventually be converted into equity in the agency if circumstances change or if the individual proves to be the type of ownership material that the current owners are looking for. And in the meantime, you are providing something of present and future value that keeps the employees motivated.
Of course, there are some negatives to be considered in assessing whether these approaches are right for your situation. Many of them can be funded for death or disability but not for retirement or termination. This could put a cash bite on the agency in the future. Most are not qualified plans and therefore do not fall under ERISA protection, which might be of concern to the employees. And the conversion period from the more traditional buy-in and buy-out approach to ownership to a performance-based compensation/ownership system can be difficult in an agency where current owners are getting close to retirement and hbeen counting on receiving the formula value in the existing buy-sell agreement. This value could be as high as two times annual commissions, and a lot ave probably of agreements still use 1.5 times. Many agencies barely have enough cash flow to support such high values, even without the added financial burden of the new performance-based stock or ownership incentives. During the conversion period, the existing owners might have to take a discount off of the value that they had originally been expecting so that the agency can implement the new perpetuation program.
The reality is that, without the revised approach, they might have difficulty accomplishing an internal transfer at ANY valuation level. And the chances of finding an external buyer who is willing to pay two times or even 1.5 times are getting slimmer. Taking a discount might be the only way for current owners to sell out. So why not do it in such a way that you create a dynamic group of motivated employees who are, through their own efforts, buying into the future of the agency? If you stick around for a couple of years, you might even recoup the discounted amount!
The late Carol Hammes, principal of the Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed. Reproduced, with permission, from The Middleton Letter.