By: Jon Persky, CIC, CPA, PHR
There is significant news about a proposed increase in the federal Capital Gains rate from the current 15%/20%/23.8% level to as high as 39.6%/ 43.4% for those taxpayers with more than $1 million of income. What is getting less press, yet may have a bigger impact on agency owners and their heirs, is the proposed elimination of the step-up in cost basis on inherited assets.
As an agency owner, your basis in your agency is the cost of your agency that has not been expensed for federal tax purposes. If you started your agency from scratch, you have zero basis. If you purchased stock in your agency from a prior owner, your basis is what you paid for the stock.
If you acquired agency business assets from another agency (an asset purchase), your basis is the amount paid and not yet amortized for tax purposes. Since tax amortization is expensed straight line over 15 years, any agency book acquired more than 15 years ago would have zero basis as it would be fully amortized. For acquisitions within 15 years, your basis is the unamortized amount, and will continue to decrease.
If you have an existing agency and then acquire the book of business from another agency (an asset purchase), your basis is the amount not yet amortized. Since amortization is expensed straight line over 15 years, any book acquired more than 15 years ago would have zero basis. Acquisitions within the past 15 years result in you having some basis, but this will continue to decrease.
Elimination of the step-up in basis would result in your estate receiving your same basis in inherited value. The proposed law change allows for a $1 million exemption for increase in basis, but this is for all inherited assets, not just the agency.
Assume you started the agency from scratch, have zero basis, and you pass away. Upon inheritance, your heirs receive a one time step-up in basis. The heirs inherit the agency at current value. If your heirs immediately sell the agency, what they sell it for is the current appreciated value. Thus, under current law, your heirs would owe no capital gains tax since the sales price is the appreciated current value at the time of inheritance.
If your heirs decide to keep the agency, they should hire a third party to appraise the value of the agency upon your death and validate a one time step-up in basis. This appraised value becomes their basis. Let’s assume the agency is valued at your death for $2 million. Your heirs keep the agency, then sell the agency a few years later for $3.5 million. Under current law, your heirs would owe capital gains tax on the $1.5 million increase in value from the time of inheritance until sold.
With the proposed change if your heirs sell the agency immediately for $2 million, $1 million is subject to capital gains tax. If they hold the agency for a few years and sell it for $3.5 million, $2.5 million is subject to capital gains.
The above is dealing strictly with federal capital gains and not estate tax. The estate only pays estate tax on any cash and assets that are passed to heirs if the amount exceeds the estate tax threshold. The current estate tax exclusion is $11.7 million. This exemption is set to sunset at the end of 2025, and will drop back to $5 million in 2026 if no laws are changed. However, President Biden has indicated that he wants to see this exclusion drop to $3.5 million.
For agency owners, the agency is typically the largest asset you own. Tax law is complicated and the IRS Code is tens of thousands of pages long. Agency owners should meet with an estate planning specialist to advise them on tax planning as well as when they should consider selling their agency.
About the Author:
Jon is the president of Optimum Performance Solutions, LLC, 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 the author of Starting, Buying, Selling & Perpetuating Insurance Agencies as well as Hiring, Managing & Compensating Insurance Agency Personnel. Jon can be contacted at 813-835-7337 or jon@optperform.com.
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