When it comes time to sell an insurance agency, the principal naturally focuses on maximizing the selling price. However, another important factor is how much of that price the seller will get to keep after paying capital gains and income taxes.
Fortunately, there are strategies an agency owner can implement to reduce the tax bite, says Jon Persky of Optimum Performance Solutions, LLC, an insurance industry management consulting firm. In addition to being an insurance counselor, Persky is a Certified Public Accountant.
One long-term strategy for agencies that are organized as “subchapter C” corporations is to convert to another type of organization. So-called pass-through organizations such as “subchapter S” corporations, limited liability companies and partnerships are taxed differently.
Persky explains that C corps can be taxed twice when they sell their assets. “Most buyers insist on an asset sale so that they can amortize the purchase price and so they don’t acquire hidden or unknown liabilities,” he says. S corps, on the other hand, are taxed only once and then only at the capital gains tax rate, which is almost always lower than the ordinary income tax rate.
The catch: The agency owner must wait five years after converting from a C corp to an S corp before he can take full advantage of the lower tax rate. If he sells the agency before the five year period is up, he will pay a flat 35% capital gains tax, rather than the 15% or 20% that would otherwise apply.
Persky recommends that agencies file a form with the Internal Revenue Service to make the conversion and start the waiting period as soon as possible. Getting a third party appraisal of the agency’s value is also a good idea. This sets the basis for calculating the capital gain should the agency sell before the end of the waiting period.
Under current law, capital gains (the difference between the selling price of an asset and the cost of purchasing it) are taxed in two brackets. The rate is 15% on capital gains for gross incomes up to $496,600 for married couples filing jointly ($441,450 for singles,) but it jumps to 20% for incomes above those levels. The total amount of gross income determines the bracket, not the amount of capital gains.
For example, if the agency sale produced a capital gain of $250,000 but the seller also had $400,000 in other income, $96,600 of the gain is taxed at 15%. The rest gets the 20% rate. If the other income is $500,000 instead of $400,000, the entire capital gain is subject to the 20% rate.
Persky says that sellers can work around this problem by financing the purchase for the buyer. By taking the proceeds of the sale in installments, the seller reduces the amount of taxable income in any single year, making it more likely that the gain will be subject to the lower rate. The downsides:
● The seller is gambling that the buyer will not default on the payments.
● Congress may increase the tax rate. The seller must pay the rate that applies during the year in which he receives the payment.
Persky said that the tax changes enacted in the 2017 reform law and the coronavirus relief measures Congress passed in 2020 have no impact on agency sales. Future congressional actions might, however.
The outcomes of the elections in November could mean tax law changes as early as 2021. Chances are if the Trump presidency continues, it’s unlikely we will see any immediate change in the tax laws. Proposals by candidate Joe Biden have been made to increase the top marginal income tax rate from 37% to 39.6%. There is also a proposal that he may also make all capital gains taxable as ordinary income for taxpayers with incomes above $1 million.
With a Biden Presidency, agency owners would potentially pay the 39.6% rate on capital gains rather than the current rate of 15% or 20%. Also, the effective date could be either January 1, 2021 or the following year. Agency owners who plan on selling and not risk the impact of a potential change in the Presidency may want to sell their agencies sooner rather than later.
It is inevitable that the government will get a piece of the proceeds from an agency sale. However, with some advance planning, sellers can keep the size of that piece to a minimum.