It used to be so simple. Through December 31, 2012 if you sold your Agency you paid a flat 15% federal tax on any capital gain. As a result, sellers wanted to get as much money as they could up front. There was no advantage to receiving payments over time. Oh, how times have changed.
Capital Gains Tax
Effective January 1, 2013 the capital gains rate went up. While it is still 15% for capital gains under $450,000 if married & filing jointly ($400,000 if single), over these amounts it jumps to 20%. 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 the capital gain you receive in 2014 from the sale of your agency is $250,000 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 $250,000 and $250,000 of other income? Then $200,000 of the capital gain is taxed at 15% and $50,000 is taxed at 20% (assuming you are married). And if you have $250,000 of capital gain and $500,000 of other income? The full $250,000 of capital gain is taxed at 20%.
When during the year you sell your agency can have a significant impact on your tax liability. If you sell at the beginning of a tax year you should have significantly less income (from your salary, agency profit, etc.) than if you sell at the end of the tax year.
To reduce your capital gains tax liability you may want to take the income over time by structuring it as an installment sale. While you should receive interest on the amount due (which is required by the IRS) also consider the risk of the buyer failing to make payments to you. Is it worth it to save on taxes if there is significant risk that you won’t get paid?
In addition to the increase in capital gains tax, there is now also an additional 3.8% tax on unearned income (which includes capital gains). This 3.8% tax is on capital gains in excess of $250,000 for a married couple or $200,000 for an individual. This tax was imposed to help pay for Obamacare. It functions the same way as the capital gains tax. If you have $250,000 of capital gains and no other income, you don’t pay the tax. But when you combine the capital gain with your other income, you pay 3.8% of tax on every dollar of capital gain that exceeds the $250,000 total income threshold. Like the capital gains tax issue, timing of you sale can impact your taxes.
Ten Year Rule
Many agencies are still C corporations. While this may be OK for internal perpetuation, the owner runs into significant tax problems if he wants to sell to a third party. The vast majority of 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 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 ten years before getting full tax treatment as an S corp.
While this change doesn’t help you if you are still a C corporation, you should seriously consider converting to S status as soon as possible to start the clock running on the ten year period. To convert to an S corporation all you need to do is file a Form 2553 within 75 days after the end of your fiscal year. You should also consider having your agency valued by a third party so that you can limit the amount subject to the built in gains tax should you sell before completing the waiting period.
If you aren’t selling, there are still some significant tax saving measures you should consider. A lot of agency owners are sole proprietorships. If you are, you pay Medicare tax on the entire income you generate from the agency. So if you take home $300,000, you pay 2.9% in Medicare tax, or $8,700. And you are also subject to a 0.9% Medicare Surtax on income over $250,000 ($200,000 if single) which will cost you an additional $450.
But let’s assume you become an S corporation and decide to take a salary of $150,000 and let $150,000 become K-1 income. which then flows onto your personal tax return. Now your Medicare Tax is only $4,350 and there is no surtax to pay. This results in a savings of $4,800 in this example.
Whether you are selling your agency now or keeping it for many years, tax planning can be very complex. Don’t stay a C corp or a sole proprietorship because “that’s what I’ve always been.” Speak with a tax professional. A little bit of planning now can save you hundreds of thousands of dollars in the future.
This article was originally published in Resources Magazine.
About the Author:
Jon Persky, CIC, CPA, PHR
Jon is the President of Optimum Performance Solutions, LLC (www.optperform.com), an insurance agency consulting firm providing valuation, merger and acquisition, agency perpetuation, strategic planning, and marketing and retention services to insurance agencies nationwide. Jon is on the national faculty of the Society of Certified Insurance Counselors and lectures on agency management topics throughout the United States. He can be contacted at 813-835-7337 or email@example.com.