With New Tax Laws, What is the Best Entity Structure for your Agency
- August 14, 2018
Should your agency be a sole proprietorship, a partnership, an LLC, or a corporation (and if corporation, what type, “C” or “S”?). Most agencies are the entity they started as and have never changed. But the economy, and the tax laws have changed over time. Your agency may need to change as well.
Don’t be a “C” corporation just because that’s what you have always been. Speak with your CPA and /or tax attorney to review your situation. Ask your trusted advisor not only how your legal entity affects you today but also how it will affect you in the future when you are ready to perpetuate your agency.
The type of entity you choose could significantly impact your liability exposure and tax issues. Choosing the wrong type could result in you paying additional tax (now or when you sell). From a liability standpoint, choosing the wrong type could result in losing not only your agency but your personal assets as well.
The following is a high level overview of your options, the tax implications, and liability issues surrounding your choice.
Sole Proprietorship – As a sole proprietorship there is no differentiation between the agency owner and the business. The owner has unlimited liability for any and all business obligations, resulting in the owner’s personal assets being at risk. So if a client has a valid E&O claim that exceeds your limits, your personal assets are at risk. The same holds true if an employee sues you and the judgement exceeds your EPLI limits.
All agency income and expense flows onto the owner’s IRS Form 1040 schedule C. As a result, any profit is taxed at the owner’s personal tax rate which can be as high as 37% plus any applicable state taxes. Also 100% of income is taxed at the regular rates, unlike being under an entity which only taxes your salary and anything beyond that can be shielded from some Social Security and all Medicare taxes.
A sole proprietor can only sell the assets (primarily the book of business) of the agency and this will be taxed as capital gains. The current capital gains rate is 15% or 20% depending on your modified adjusted gross income.
Partnership – A partnership requires at least two owners. Like a sole proprietorship there is unlimited liability for any and all business obligations for all the partners and their personal assets are at risk. So even if Partner #1 causes the liability, Partner #2 can be held fully responsible.
The partnership is required to complete a Form 1065 (informational only – no taxes) which shows allocation of revenues and expenses between the partners. The proportionate share of income and expense for each partner flows onto the Schedule C of each partner’s IRS Form 1040.
Like a sole proprietor, only the assets can be sold (no stock = no stock purchase) so any sale is a capital gain.
Limited Liability Company (LLC) - An LLC, is not a corporation, but has the same limited liability characteristics of a corporation. An LLC has members, not shareholders or partners. The LLC can elect to be treated as a disregarded entity for federal income tax purposes. This means that all revenues and expenses flow onto each members’ Form 1040 Schedule C pro rata. LLCs can also elect to be treated as C-corporations or S-corporations for tax purposes.
C – Corporations - Corporations are formed under laws of a specific state. If there is more than one shareholder (there can be an unlimited number), the Corporation should have a Shareholders' Agreement to address what happens when a shareholder dies, becomes disabled, retires, etc. Multiple shareholders means that if one shareholder leaves, the others must (or have the option to) buy the stock of the departing shareholder.
The agreement should also address how the agency will be valued and any payment options for the remaining shareholder(s) when it comes to buying the stock of a departing shareholder. With insurance agencies, you should also consider including the option to discount the price if a departing shareholder doesn’t give adequate notice to the remaining shareholders, or if he does something to damage the value of the agency. Also don’t forget to include non-compete and/or non-piracy provisions in the agreement.
If the agency doesn’t have a valid reason to retain earnings (such as using the retained cash to acquire another agency), it typically distributes most or all of the profits via salary & bonuses. In this case the agency should be an S-corp.
Another tax problem can occur when it’s time to sell the agency. Corporations do not enjoy capital gains tax treatment. If the stock of corporation (which is owned by the shareholders) is sold it results in capital gains treatment to the shareholders. However, if the assets of a C-corporation are sold, it can result in double taxation. Most buyers insist on asset purchases so that they can amortize the book of business over 15 years and to ensure that they are not acquiring any hidden or unknown liabilities.
S – Corporations – A C corporation can elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. Like all the other entity choices (except C-corps), an S-corporation doesn’t pay taxes. It does however, have to file an IRS Form 1120-S, which is an informational return only (no taxes to be paid by the S-corp). The business’ revenues and expenses flow from the 1120 S onto each shareholder’s Schedule K-1. That information is then included on the personal tax return of the shareholder. Unlike C-corps, if the assets of an S-corp are sold it will result in capital gains treatment for the shareholders (no double taxation).
Summary –Don’t stay as one type of entity just because you’ve always been that type of entity. Conversely, don’t change for the sake of changing. You need to carefully analyze your situation, both now and in the future when you sell your agency. Even if you plan on gifting your agency to family members or a key employee, you need to review this important consideration. Speak with a knowledgeable CPA or tax attorney to review your options. If your circumstances (or the tax laws change) your entity selection may need to change so don’t forget to review this regularly.