Thinking of selling? Beware of proposed capital gains changes.
President Joe Biden proposed raising the top capital gains tax from 20% to 39.6% before a joint session of Congress on April 28. “We're going to get rid of the loopholes that allow Americans who make more than $1 million a year pay a lower rate on their capital gains than working Americans pay on their work," he said.
You might be thinking, “I don't make $1 million, so why worry?" Selling an agency often results in large tax gains, particularly for those agents who started from scratch or have minimal tax basis in their agency. At current sale multiples, books over $4 million in written premium could generate $1 million in sale proceeds.
As you are likely aware, the current 20% tax paid for long-term capital gains is lower than the ordinary income tax rate that many Americans pay. For tax year 2020, individuals earning between $40,126 and $85,525 paid 22% on ordinary income, and those earning between $85,526 and $163,300 paid 24%. Individuals earning more than $518,400 paid the top rate of 37%.
The proposed capital gains tax increase could compel some agents to sell before the tax hike takes effect—if the proposal becomes reality. Others will look at alternatives to lower their taxes.
Most sellers make the mistake of not consulting with a tax advisor prior to the sale of their business entity or assets. Because of this, they could end up paying more taxes than they expected.
It is important to figure out ahead of time how much you're going to pay in taxes before the sale of the agency even takes place. Here are four items to discuss with your tax advisor:
1) Type of company. The first tax consideration you need to make is regarding the type of company that your business is operating under. Do you have a limited liability company, sole proprietorship, C corporation, partnership, or S corporation? The answer to this question has a significant impact on how much you will owe in taxes.
For example, if you sell the assets of a limited liability company for a profit, then it will only be taxed as a capital gain once. This is because the IRS usually considers sole proprietorships and limited liability companies to be disregarded entities. This means that these companies won't get taxed separately, and you won't have to file a commercial income tax return.
Instead, any profits made from these capital assets will only have to be paid on the owner's personal income tax form. Of course, you have the option of making your limited liability company a separate entity if you want to, but most people don't because the tax benefits are so much better when keeping it as a disregarded entity.
If you own a C-corp and you sell its capital assets for a profit then you will be taxed on the sale twice. The first tax you'll have to pay is the corporate tax, which coincides with the commercial income tax return. Since corporations are considered separate entities from their owners, the IRS requires each entity to pay its share of taxes from it. The corporation must pay whatever the current corporate tax rate is on capital gains. Then, each shareholder of the company will be subjected to a capital gains tax on their personal income tax return. However, they won't have to pay taxes on the full amount of the capital gains. The profits of capital assets get distributed equally among the shareholders of the company. Therefore, the amount that was distributed to each shareholder will get multiplied by the capital gains tax rate. The result is the amount that each shareholder must pay in personal taxes.
S corporations and partnerships have a similar tax structure in that there is no double taxation like there is with C-corp. When you sell assets through an S-corp or partnership, the individual owners or shareholders are each generally responsible for paying the taxes on their personal income tax returns. The upside is they don't have to pay another set of taxes on the commercial income tax return of the company.
2) Determine your tax basis. Remember that the tax gain is generally a function of sales proceeds less tax basis in the assets being sold. If you are selling the stock of your agency, which would not be common today, you would need to know the tax basis of the stock. More likely, you would be selling assets of the agency. The tax basis for tangible items such as furniture and fixtures is straightforward, but if you have intangibles recorded for tax purposes, “goodwill." for example, you may need your tax advisor's assistance.
3) Timing of sale. Capital gains taxes, unlike income taxes, are discretionary. This means that owners have greater flexibility on when to sell their agency and can therefore determine how much tax they will have to pay in a specific tax year.
If you are an agent that has multiple books or offices, consider selling each in different years to spread the gain over multiple periods. If you are an agent that also owns your commercial building or office, consider selling the property separate from the agency and in a different period.
4) Seller financing. It is safe to say that sellers generally desire to be paid all of the purchase price upon turning over the keys to the office. However, you can offer seller financing to the buyer as part of the sale process.
The obvious downside is that you must let your buyer run the business and hope they run it well and pay the loan as agreed. On the flip side, as the seller, you may be able to get a tax deferral on the monthly payments until you receive the total amount of the agreed price.
President Biden's plan will likely change as it moves through Congress, and both chambers will have to approve it before the president can sign it into law. However, doing a little work in advance may take some of the sting out of the tax burden.
Mark Nondorf is the senior vice president of First Mid Agency Finance (formerly Providence Bank) a lender specializing in lending to insurance agents since 2007. Prior to starting what is now First Mid Agency Finance, Nondorf, a former CPA with Ernst & Young, has worked in the banking and insurance segments for over 30 years in a variety of senior leadership roles with significant experience in mergers and acquisitions, capital transactions and specialty lending.
This is not a tax advice. All decisions regarding the tax implications of a business sale should be made in consultation with a qualified tax professional.