With the upcoming 2024 election for President and House and Senate seats, the question is: How might this political cycle impact the sale of an insurance agency?
Biden has now twice stated he wants to double the capital gains tax rate from 20% to 40%. Should the democrats sweep the election, this could happen as soon as 2025. If that happens, chances are the Trump tax cuts will be allowed to sunset December 31, 2025. The concern here is that the Inheritance Tax exclusion will drop from $13 million to approximately $6.5 million.
In all probability, when it comes to federal tax laws affecting the sale of insurance agencies, not much will change in 2024, but long-term planning may require a closer look at what the laws are now and how they might change five years down the road.
What does this mean for agency owners thinking about selling? There are only two ways to sell an insurance 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.
Seller’s Perspective
Capital Gains and Agency Sales
The 2018 Tax Act did not make any change to the capital gains rates, but it did change the tax brackets. For 2023, the 15% capital gains bracket is for those married filing jointly with a modified adjusted gross income (MAGI) of $553,850 or less. Any capital gain that exceeds this MAGI threshold is taxed at a 20% rate. For taxpayers filing as Single, the threshold is $492.300. 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 2023 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% because $400,000 + $100,000 is less than the $553,850 threshold. But what if you have a capital gain of $400,000 and $300,000 of other income? In that case, $253,850 of the capital gain is taxed at 15%, and the balance of $146,150 is taxed at 20%. Here’s how that breaks down:
- $553,850 threshold – $300,000 other income = $253,850 remaining within the 15% tax threshold
- $400,000 capital gain – $253,850 threshold remaining = $146,150 capital gain amount over the threshold (therefore taxed at 20%)
If you have $400,000 of capital gain and $600,000 of other income, then the full $400,000 of capital gain is taxed at 20% because your other income amount is already over the MAGI threshold of $553,850.
Don’t Forget the 5-Year Rule!
It is important to note that 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, they would have 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 would be allocating some of the purchase to what is called “personal goodwill.” Still, this can be a complicated issue and is something you should discuss with a knowledgeable CPA.
Buyer’s Perspective
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.
Let’s take a look at what this means using an example. Assume the purchase price of an agency is $1.5 million. The buyer will get a maximum $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 over a period of 15 years, which equals a total of $420,000 in tax savings over that time.
If the deal is structured as a stock purchase, however, the buyer doesn’t get to amortize the purchase price, but instead they 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 15 years from now? To make the best decision, you need to value the two benefits in net present value. 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. Which one of those sounds more attractive now?
Summary
Federal tax law is very complex and constantly in flux, but the key points discussed in this article are some of the first things to consider when selling an insurance agency. 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. Keeping an eye on changes in federal leadership could make a difference in planning, so if this is a move you have on your radar, now might be a good time to start evaluating your options.
Source: Jon Persky, CIC, CPA, PHR
About the Author:
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 jon@optperform.com.
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