Tax Implications of Selling an Insurance Agency in 2021 & Beyond
- January 11, 2021
Now that Biden has won the Presidency and the Democrats control both houses of Congress, the question is: How does this impact the sale of an insurance agency?
With the Democrats getting control of the Senate, Biden has stated that on “Day One” he wants to rescind the Trump tax cuts. Well the 2018 tax cuts did not change the capital gains rules so we would still maintain the current tax status quo.
However, Biden has also stated that he wants to change the capital gains rate to as high as 39.6% from the current top level of 20%. This would take congressional approval and would take some time. If this happens, it probably wouldn’t take effect until January 1, 2022.
Chances are that for 2021 the tax laws won’t change in regard to selling insurance agencies. Let’s take a look at them.
There are only two ways to sell an agency, a stock transaction or an asset sale. A stock transaction is where the buyer purchases the stock of the corporation from the prior shareholder. The corporation itself changes hands. With an asset sale, the assets of the agency are sold to the buyer with the seller retaining the corporate shell. Nine out of ten deals between third parties are structured as asset sales.
Buyers prefer asset purchases for two main reasons:
- The buyer is not picking up any hidden or unknown liabilities.
- The buyer gets to amortize the purchase price straight-line over 15 years.
Assume the purchase price is $1.5 million. The buyer will get a $100,000 tax deduction for each of the next 15 years. Assuming the buyer is in the 28% tax rate, this will save the buyer $28,000 in taxes x 15 years = $420,000 in tax savings.
If the deal is structured as a stock purchase, the buyer doesn’t get to amortize the purchase price but does get $1.5 million in basis. Assuming the capital gains rate is still 20% when the agency is sold 15 years in the future, the buyer would save $300,000 in taxes.
What would you rather have, $420,000 received over the next 15 years or $300,000 fifteen years from now? The $28,000 per year for 15 years equates to a net present value of $290,630 (assuming a 5% discount rate). The $300,000 savings received 15 years in the future only equates to a net present value of $144,305. (It should be noted that the above example assumes no recapture of amortization).
Capital Gains and Agency Sales
As previously mentioned, the 2018 Tax Act did not make any change to the capital gains rates but did change the tax brackets. Effective January 1, 2021, the 15% capital gains bracket is for those married filing jointly with a modified adjusted gross income (MAGI) of $501,600 or less. Any capital gain that exceeds this MAGI threshold is taxed at a 20% rate. For taxpayers filing as Single the threshold is $445,850. But it's not as simple as just looking at the capital gains amount. You also need to factor in the rest of your income.
Assume you are married and the capital gain you receive in 2021 from the sale of your agency is $400,000 and you have $100,000 of other income. It's simple, your capital gains rate is 15%. But what if you have a capital gain of $400,000 and $301,600 of other income? Then $200,000 of the capital gain is taxed at 15% and $200,000 is taxed at 20%. And if you have $400,000 of capital gain and $501,600 of other income? The full $400,000 of capital gain is taxed at 20%.
Don’t Forget the 5 Year Rule
Agencies that are C corporations run into significant tax issues when selling to a third party. 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. However, an asset sale of a C corporation can result in double taxation for the seller, whereas the asset sale of an S corp, an LLC, or a sole proprietorship is taxed one time at the capital gains rate.
If the seller wants to convert from a C corp to an S corp he has to wait five years before getting full tax treatment as an S corp. Failure to wait for the full waiting period results in the sale being subject to the built-in gains tax at a flat 35%. A potential work-around is allocating some of the purchase to personal goodwill. This can be a complicated issue and something you should discuss with a knowledgeable CPA.
Federal tax law is very complex and constantly in flux. Agency owners planning on selling their agencies in the next few years would be wise to discuss their situation with a tax professional and plan for the future.
Source: Jon Persky, CIC, CPA, PHR