Our clients don’t like to talk about taxes and neither do we but, as Ben Franklin said, nothing is more certain in life than death and taxes. So we put together a little summary about the differences between stock and asset sales when selling an insurance agency and how the IRS treats various assets in the sale of a business. This is meant to be a primer on the subject and should not replace a detailed conversation with your CPA.
Stock vs. Asset Sale
Insurance agencies are acquired either via stock purchase or asset purchase. Agency owners are often surprised to hear that most buyers do not want to purchase the seller’s corporation, i.e. do a stock purchase. In fact, I would estimate that 90% or more of agency sale transactions are done as an asset purchase.
There are two main reasons for that: (1) acquiring the corporation’s stock opens the buyer up to hidden past liabilities – such as for taxes, E&O claims and employment disputes – even if the seller agrees to indemnify the buyer, and (2) the buyer in most cases loses the ability of taking a step-up in the tax basis of the assets. Simply speaking, under an asset purchase the IRS allows the buyer to take a tax deduction for the value assigned to those assets over what the IRS deems as the useful life of the assets. The fixed assets, such as furniture and equipment, can be depreciated over a five to seven year period, while the intangible assets can be amortized over 15 years. For a transaction with $1M of intangibles, the buyer picks up a deduction of $66,666.67 per year which could save $20k per year in taxes ($300k over 15 years) assuming a 30% income tax rate.
Stock purchases do occasionally happen though, particularly when the selling entity is a C corporation. A C corporation shareholder is subject to a double tax – once at the corporate level and once at the individual level – if the corporation were to sell the assets and distribute the cash. The double tax factor can cause a shareholder of a C corp to lose over 50% of the gain to taxes, which often makes selling the assets of a C corp a hard pill to swallow. If a buyer agrees to acquire the stock of the corporation, then they typically want a price discount to offset the loss of the stepped-up tax basis. With so few reasons these days for operating as a C corp, we strongly recommend owners of a C corp to go through the process of converting to an S corp. Based on current law, the company must wait until after five years from the first day of the first year that it converted to an S corp or face a built-in gains (BIG) tax. Prior to January 2016, the conversion hold period was actually ten years so the now is a great time to file a conversion.
Allocating the Purchase Price
The Internal Revenue Service requires both the buyer and seller of a business to file a special form (IRS Form 8594 – Asset Acquisition Statement) with their income tax return after a sale transaction. The parties are required to allocate the purchase price to specific asset classes:
Class I Assets include cash and bank deposit accounts (including savings and checking accounts). In most insurance agency sale transactions, the seller typically retains the operating cash but not cash on hand to pay the premiums payable.
Class II Assets are actively traded personal property, certificates of deposit and foreign currency even if they are not actively traded personal property. This class of assets is rarely included in agency sale transactions.
Class III Assets are assets that the taxpayer marks-to-market at least annually for federal income tax purposes and debt instruments, including accounts receivable. This class is often applicable because accrued revenue is included in the transaction – such as direct bill commissions – since the buyer will have on-going expenses after the closing and cannot wait 30-45 days for revenue to come in.
Class IV Assets are stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. Since insurance agencies do not sell tangible products or carry inventory, this asset class is not applicable.
Class V Assets are all assets other than Class I, II, III, IV, VI, and VII assets. Furniture and fixtures, buildings, land, vehicles, and equipment are considered Class V assets, so this asset class is common in the sale of an insurance agency since buyers typically want the operating assets.
Class VI Assets are all of the intangibles except goodwill and going concern value. This includes: the workforce in-place; books, records, processes and systems; customer-based intangibles; supplier-based intangibles; licenses; trademarks or trade names; and covenants not-to-compete. Given the nature of an insurance agency, this asset class is always included.
Class VII Assets are goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a section 197 intangible). This is generally determined as the balance of the purchase price after accounting for all other asset classes.
It is recommended that the allocation of the assets be included in the purchase agreement, and the negotiated values be used by both parties when filing IRS Form 8594 to avoid an audit. Consult your tax advisor before agreeing to a set allocation to understand the implications for you, personally.
Taxes on Asset Classes
Since the majority of the value of an insurance agency is intangible, most of the sale price will be allocated to class VI and VII assets. Generally speaking, the seller’s gain on these assets (excluding a non-compete allocation – more later) will be taxed as a long term capital gain. The base long term capital gains rate is 15% for single filers with taxable income of under $415,050 and $466,950 for married couples that file jointly (as of 2016). Any gain above that amount, is taxed at 20%. Additionally, most agency sales will also be subject to the Net Investment Income Tax of 3.8% – thanks to Obamacare, and possibly state capital gains taxes or reductions for itemized deductions under the Pease Limitations. Speak to your tax advisor if you have purchased intangible assets and have a balance on your books because a portion of the sale could be subject to a recaptured amortization tax at the ordinary income level.
Class V assets (e.g. furniture and equipment) are taxed at the ordinary income rate for the amount allocated above the seller’s book value. For example, if the current book value of the fixed assets included in the sale is $10,000 but the parties allocate $15,000, then the seller is subject to a recaptured depreciation tax on the $5,000.
Class I (cash) and III (accounts receivables) assets do not trigger a tax on the seller since there is essentially no taxable gain to the seller.
Non-compete, employment and consulting agreements with the seller are treated as ordinary income to the seller for tax purposes. A non-compete is amortized over 15 years for the buyer, regardless of length, while employment and consulting agreement can be expensed in the year they are paid to the seller. From a tax perspective, using a lower value on the non-compete is favorable to the seller without being detrimental to the buyer. It is recommended that a non-compete agreement be a separate document from the purchase agreement that is executed at the closing.
Any adjustment to the purchase price after the transaction has been reported to the IRS – such as when an earn-out is involved – requires that the parties refile IRS form 8594. The adjustment will generally affect the amount allocated to goodwill in such cases.
Please note that this is general discussion and should not be construed as legal or tax advice. Consult your tax advisor for a specific calculation of the tax implications related to selling your insurance agency.