What's Your Structure?

In 2017, 81% of independent agencies were organized as pass-through entities, including sole proprietorships, partnerships, LLCs and S-corps, while 19% were organized as C-corps, according to the 2018 Future One Agency Universe Study (AUS).

Those numbers didn’t budge over the previous two years, and they’re approximately consistent with 2018 Best Practices data, says Brian McNeely, partner at Reagan Consulting. Among firms between $10-25 million, for example, 16.2% are C-corps, 59.5% are S-corps and the remainder are organized as another type of pass-through or use multiple structures.

But among firms over $25 million, the proportion of C-corps nearly doubles, according to Best Practices—and the AUS reports that compared to longer-established agencies, newer agencies are much more likely to be organized as pass-throughs: 94% compared to 78%.

How do you determine which legal structure makes the most sense for your agency? Answering that question in full depends on a host of different factors—and requires leaning heavily on your agency’s trusted accountant and attorney.

“That’s really the only way this analysis can be done,” says Aaron Nocjar, partner at Steptoe & Johnson LLP, an attorney who specializes in tax issues. “Unfortunately, Congress and the Treasury Department, whether intentionally or not, have created an incredibly complex tax system that’s accessible only to people who devote their professional lives to understanding it.”

But in the meantime, here are a few insights to help you develop a basic understanding of the challenges and benefits each type of structure could present to your business.

The Case for C-Corps

The primary challenge with the C-corp structure relates to the fact that insurance generates “a tremendous amount of cash flow,” McNeely says.

“If you’re a C-corp, it’s tough to get those dollars out without being forced to pay double taxes—a tax at the corporate level, and then when the dividends reach the shareholders, they pay taxes on those too,” McNeely explains.

Under the Tax Act of 2017, a C-corp is taxed at the entity level at only 21%, compared to the previous rate of 35%. That’s a significant drop, especially considering the top individual tax rate was reduced only slightly, to 37% from 39.6%.

Still, “if you want to get that cash out of the C-corp to the owner, you have to dividend it out of the C-corp, and that dividend is subject to another level of tax at the shareholder level—generally somewhere between 20% and 23.8%,” Nocjar explains.

But if “you’re generating so much income that you have enough money to pay your employees, pay all your expenses, and then you have all this money leftover that you’re just reinvesting into expanding your business, the C-corp structure might make some sense,” Nocjar points out. “It works out because you’re eliminating that shareholder-level tax on the distribution of those earnings out of the C-corp.”

While Nocjar stresses that there are no hard lines regarding when an agency “should absolutely be a C-corp,” McNeely agrees that the issue of distributions is a good big-picture guideline.

“The corporate tax rates went down so significantly that for firms that do not distribute profits but rather retain profits to reinvest in the business and other related initiatives, you have a pretty compelling case to either remain or convert to a C-corp,” McNeely says. “If you’re not distributing, you pick up the decrease in the tax dollars, and your shareholders won’t be subject to the double taxation.”

Reinvest how? Maybe you’re using equity or stock grants in order to grant individuals shares in the company based on performance, McNeely suggests. Or you might reinvest through new hires, acquisitions, products and services.

“Because those dollars don’t get distributed, the company’s able to invest them in the value of the company, which allows it to grow faster than it would otherwise,” McNeely explains. “So I might not have the cash in my pocket, but my actual net worth has increased because the company’s grown faster as a result of those investments.”

The Case for Pass-Throughs

Unlike C-corps, “pass-throughs do not pay tax at the entity level,” Nocjar explains. “Instead, all of their income flows up to the equity owners’ personal tax returns, and the equity owners pay tax on that income.”

And because “most independent agencies are likely going to be distributing their profits,” McNeely points out, it makes sense that so many Big “I” members—particularly smaller and newer agencies—are sticking with the pass-through structure.

Dave Evans, president & co-founder of 401kSleuth, a consultancy that helps organizations and their employees improve their financial literacy, says the operative word here is “flexibility.”

Let’s say you own a 15-person agency that operates as a pass-through entity with over $300,000 in profit annually. Considering the Federal Insurance Contributions Act (FICA) wage base for 2019 is $123,900, one strategy for lowering your payroll taxes would be paying yourself $100,000 in compensation and taking the rest of your income as a distribution.

Of course, you must be able to defend that allocation as “reasonable,” Evans warns—in the event of an audit, the old adage “pigs get fat, hogs get slaughtered” rings true. “You need to consider what you would have to pay someone to do your job aside from your ownership,” he explains. “But the pass-through structure does allow for flexibility in how you determine what you get paid as an agency owner compared to your share of ownership.”

Burke Insurance Group, LLC, a Best Practices Agency in Las Cruces, New Mexico, has gone through several legal structures in its nearly four-decade history. After spending several years as both a C-corp and a single-member LLC, the agency is now organized as an LLC that is taxed as a partnership.

Why? First, because an insurance brokerage is not considered a specified service business under the new tax law [see sidebar], the agency qualifies for the 20% reduction in taxable income that reduces pass-through company profit from a 37% tax to a 29.6% tax. In other words, “big savings,” says Shawn Gustafson, managing member.

Compare that to a C-corp, which would face two layers of taxation if it planned to distribute, or even an S-corp, where “we would have had to draw a reasonable salary taxed at 37%, and then only the excess would be at 29.6%,” Gustafson explains. “That is why we have a good CPA.”

Also important is the fact that Burke is currently in the midst of an ownership transition. Gustafson says the partnership structure allows for the most tax-advantageous perpetuation: “As the new owners buy in, they get very favorable depreciation and amortization based on the buy-in. That amount can be specially allocated to the specific partner.”

Then, as selling partners, the current owners “still get long-term capital gain treatment,” Gustafson adds. “It is truly a win-win for both sides.”

This type of perpetuation question is critical—but unfortunately, it’s “often lost” in the legal structure discussion, McNeely cautions.

“If you decide to sell your business, you can only sell your assets with a pass-through entity, in which case the buyers get to write the purchase price over 15 years,” McNeely explains. “It’s much more difficult to do that with a C-corp because of that double taxation. The corporation would have to sell the assets, the corporation would be taxed on the sale of those assets, and then they would have to distribute the profits to the individuals, which would be taxed via dividend tax.”

“If the agency is thinking of selling or acquiring five or 10 years down the road, they need to be thinking about the implications and communicating with their accountant about that,” Evans agrees. “What’s your long-term strategy? As a business owner, you want to make sure you’re not being short-sighted.”

When to Change

Does it ever make sense for an agency to change from one legal structure to another? “People generally shouldn’t change structures if it merely offers a minimal advantage,” Nocjar says. “You don’t need the initial headache.”

But that’s not always the case. Consider VW Brown, an independent agency headquartered in Columbia, Maryland, which was founded in 1960 and made a C-corp in the 1970s. “We did some acquisitions as a C-corp, but then in 2007, we acquired an agency that was almost three times the size of our own,” explains Angela Kokosko Ripley, president. “When we did that, our accountant recommended we form an LLC”—but keep the C-corp, too.

Then, as VW Brown continued with the LLC, the agency’s accountant suggested turning the LLC into an S-corp. Today, VW Brown uses multiple structures: both the C-corp and the pass-through S-corp, which run side by side.

An aggressive growth plan is one of the primary motivations for a change, says Nocjar, who outlines several situations in which you might want to talk to your accountant and attorney about changing your agency’s legal structure:

  • You’re expanding the business in one of the following ways:
    • Your taxable income levels are increasing significantly.
    • The business is getting so big you need to hire a significant number of employees.
    • The business is getting so big it needs debt—involvement from either a bank, an alternative lender or outside equity investors.
  • You’re shifting from a distribution model to a retention model, or vice-versa.
  • Your equity owners are approaching retirement or otherwise transitioning out of the business and passing it on to the next generation.

While Gustafson says his agency hasn’t considered going back to the C-corp structure due to the issue of double taxation, he “can’t say that in the future our form of business won’t change. We are happy with where we are at, but in the future, as we grow, we are looking at options such as an employee stock ownership plan as a way to transition ownership to the employees and provide great benefits.”

“Never say never” is a good attitude to have about anything involving corporate tax, Evans agrees. “Theoretically, the corporate rates were made permanent and the personal ones weren’t—they’re set to sunset at the end of 2025,” he says. “But the concept of ‘permanent’ is dubious. The tax code is not the Old Testament.”

Jacquelyn Connelly is former IA senior editor.

Serious Savings

In January, the IRS issued final regulations governing Section 199A of the tax code. The rule confirms that owners and shareholders of insurance agencies and brokerages organized as pass-through entities are eligible for a tax deduction of up to 20% on “qualified business income”—regardless of taxable income level.

The deduction is available for taxable years 2018 through 2025 and reduces the top effective tax rate on pass-through income to approximately 29% from 37%. For those in the 24% bracket, it can reduce the rate to as low as 19.2%.

Since passage of the Tax Act of 2017, which also lowered the corporate tax rate for C-corps from 35% to 21%, the Big “I” aggressively advocated to ensure that insurance agencies and brokerages organized as pass-through entities fully benefit from tax reform.

Based on a survey conducted by the Big “I,” C-corp agencies report the following tax savings thanks to the new tax law:

  • $1,000-5,000: 51%
  • $5,001-15,000: 21%
  • $15,001-25,000: 15%
  • $25,001-50,000: 6%
  • More than $50,000: 7%

Pass-through agencies, meanwhile, report the following:

  • $1,000-5,000: 34%
  • $5,001-15,000: 29%
  • $15,001-25,000: 15%
  • $25,001-50,000: 15%
  • More than $50,000: 7%

“It’s hard to quantify the number,” says Angela Kokosko Ripley, president of VW Brown, an independent agency headquartered in Columbia, Maryland. “But we know we’ve gotten that benefit—we’ve seen it in what we’re paying on our quarterlies. It’s a dramatic difference.” —J.C.