“Everything seemed to get better around here when we stopped worrying so much about taxes,”
Agency CEO
Are you trying to build a business — to really develop an organization? Or are you trying to operate a successful practice? Either answer is okay. There are a lot of beautiful smaller agencies with happy owners. The only requirement is that your answer be truthful. If your response is that your mission is to build a genuine business organization, there’s a pretty good chance you’ll fail, or at least be regularly frustrated, if you’re working with insufficient capital.
No one wants to develop a capital-weak company; but our actions speak far louder than our words, even if those words are smartly expressed in a mission statement and business plan. If agency principals are as serious about their financial future as other business people, why does weak capital characterize the current state of affairs among independent agencies? There are a lot of reasons, but I think the three most important are these:
- They’ve gotten away with it. To say that many agencies have weak capital is, after all, to admit that there are many agencies. One way or another, there has been enough cash flow to make ends meet. But times are changing. Decades of “automatic” revenue growth have ended, and excesses (rates, profits, costs) are being wrung out of the system by overwhelming economic forces. The financial challenges facing agencies are not political issues, susceptible to lobbying power.
- Too many small-business owners kill profit to minimize corporate taxes. Some CPAs would probably object to my saying so, but this seems to be a favorite strategy of accountants. But killing most private companies’ profit means killing their only enduring source of capital. Smaller private businesses have virtually no source of permanent capital other than their earnings. There’s very little outside-equity investing, and when such companies borrow money, they have to pay it back. Interest-only debt capital (like corporate bonds) is generally not available to private business.
- Private business owners kid themselves. They say, “We pay the profit to ourselves in bonuses, but we keep it at the ready in case the agency needs it. There’s no real line between agency capital and our personal capital.” Yeah, right! Sounds like the Life insurance strategy of buying Term and investing the difference. Intellectually, you can’t argue with the financial math showing that “side fund” mutual-fund investing outstrips the growth inside an insurance contract. And hats off to those who stay with the investing discipline — but they’re the exceptions. The majority of us just can’t follow this strategy. Many younger agency owners spend their bonuses to pay mortgages and tuition. Senior owners, who tend to get larger bonuses, might be able to keep a pool of capital at the ready, but they’re regularly told by CPAs and other advisers that they’re nuts to put money back in the company just as they’re beginning serious planning for selling their interest.
So where does this leave us? A quick recap: The only enduring source of capital for smaller, privately owned businesses is operating profit. Yet powerful traditions and arguments call for killing profit at the corporate level. The instances of personally owned money coming back into the agency are unusual; once the money leaves the company, it seldom returns. We’re left with the prescription of earning profit at the corporate level and leaving a significant portion of this income inside the company. The cost of doing that is to pay the income tax — state and federal — on those earned and retained funds.
Is that all? Nothing more creative than that? Nope. ESOPs don’t really help; they can be kind of sexy in some respects, but that distraction doesn’t change the basic point. In fact, ESOPs might decapitalize a company.
The central question a reader should ask is why a business should intentionally incur additional expense. After all, isn’t generally considered to be good operating management to control the tax expense as aggressively as we control any other operating expense? My answer is that the cost associated with killing the profit exceeds the benefits; that is, for those of you whose objective is to build a business organization and not just run a practice. Expressed more positively, the longer-term benefits associated with building a strong capital foundation exceed the short-term tax savings created by not doing so. I wish our tax code didn’t provide this disincentive to building the capital of private business. Corporate taxes, after all, are baloney: People pay taxes. But the fact of political life is that we’ll never eliminate corporate income taxes, so we live with this imperfection.
What, then, are these benefits that are so wonderful as to outweigh the intentional increase in tax expense? They’d better be pretty good!
They are. They’re the benefits of longer-term thinking, of broader perspective, and better decisions. If that sounds kind of vague and mushy, ponder this: Most agency-management jobs don’t involve much heavy lifting. They consist of decision-making and leadership.
The agency principal quoted at the beginning of this article did all the profit killing and legal tax-avoiding that his CPA would permit until a few years ago. For reasons that go beyond this piece, that stopped. And after writing some tax checks that would have been unimaginable a few years ago, things are much better.