As the department store titan Marshall Field once said, “Goodwill is the only asset that competition cannot undersell or destroy.” Increasingly in today’s insurance marketplace, a local independent agent’s or agency’s goodwill is nowadays the one thing that sets them apart from the monolithic direct writers. And if nurtured and developed, it is also the one thing that can be an agent’s biggest asset in the event of the sale or his or her agency.
Double taxation of C corporations in an asset sale
For tax purposes, businesses may be organized as various entities including “C” corporations, “S” corporations, partnerships (including limited liability companies), or sole proprietorships. In 2009, the last year for which statistics are available, there were 1.8 million corporations in the United States that were treated as C corporations for Federal tax purposes. Of those, a fair number of locally owned insurance agencies in Massachusetts are included in that number.
When it comes time for those agency owners to consider selling and retiring from the agency, however, they are often dismayed to find that the C corporation they own may have a built-in tax penalty. In the case of the purchase and sale of an agency, because the agency is treated as a C corporation, the deal is structured as a corporate asset sale, and thus, there are two taxes to pay.
A C corporation selling its assets is subject to corporate income tax on the difference between the purchase price and the carried value of the assets. Then, when the after-tax proceeds of the sale are distributed through the corporation’s liquidating dividend, the agency owner (shareholder) is required to pay taxes on the difference between his or her basis in the corporation’s stock and the liquidating dividend payment. Even though the liquidating dividend may be taxed at the more favored rate of capital gains (now up to 20%), the initial corporate tax payment likely could reach the maximum 35% corporate rate. All in all, the total taxes paid on C corporation asset sales can on occasion reach almost 50%.
Who actually owns the goodwill that is being sold in an agency’s purchase and sale and why is it important?
The largest asset for many insurance agencies is the actual goodwill generated and maintained by the agencies’ owners. Typically, goodwill is based upon a number of intangible factors that may include the agency owner’s individual name, the personal relationships the agent has cultivated with clients, the agent’s personal reputation, and his or her standing in the community from which the agency draws its customer base and thereby its expiration list.
Generally, the personal goodwill of the agency owner is often treated as part and parcel of an asset purchase through individual covenants not to compete that the buyer demands as the sine qua non for the sale to occur. Until the late 1990’s, however, there was no overriding tax reason to structure agency asset sales differently.
However, since that time, taxpayers successfully urged the Tax Court, in several contested tax cases, to rule against the IRS in treating a C corporation owner’s personal goodwill as the owner’s property that could be sold in conjunction with the C corporation’s assets. The result is that if the personal goodwill is sold separately, agency owners with C corporations are only taxed once at capital gain rates for the value of the personal goodwill that they individually sell as part of an agency’s purchase and sale.
Notwithstanding the recent tax reform upping capital gain rates to 20%, the difference between capital gains and ordinary income at the federal level is still approximately 18 percent. So for each $100,000.00 of capital gains a person receives, they would pay $20,000.00 in taxes but if that were ordinary income at the highest level they would now pay $35,000.00 in taxes or a $15,000.00 difference on a gross basis and on a tax basis almost 80 percent more in taxes.
Many insurance agents are good candidates for allocating personal goodwill in the purchase and sale of a C corporation.
Insurance agents, many times being local business people with direct contacts with their clients, may in the correct circumstances have the possibility of having their cake and eating it too. Several Tax Court cases have established that the “personal goodwill” of certain types of C corporations can be found to be an asset of the owner rather than the company.
In other words, if a C corporation agency sale involves the acquisition of some or all of the owner’s personal goodwill by contract, such as the use of the owner’s name, his or her services, talent, relationships, experience and knowhow, the purchase and sale may be able to be structured to avoid the double taxation that ordinarily would occur in the payments to the C corporation.
A third-party valuation can also be helpful in establishing the existence of the personal goodwill and support the purchase price allocation if the Internal Revenue Service questions the transaction.
In an agency purchase and sale where it might apply, the recognition and sale of personal goodwill is a tax saver.
The tax savings from the sale of personal goodwill in a qualifying agency sale can be compelling. For example, assume an insurance agency that is a C corporation sells its expirations for $500 thousand. If there is no personal goodwill allocated in the sale, the Federal income tax to the corporation is $170 thousand. The $330 thousand remaining after tax gets distributed to the shareholder as a liquidating dividend with the result that an additional 20% tax is payable in the amount of $66 thousand for a total tax on the $500 thousand (assuming a zero basis for the illustration) of $236 thousand. However, if the purchase and sale involved an allocation of 90% to the shareholder for personal goodwill and the remaining 10% to the corporation’s ownership of the expiration information, the total tax on that $500 thousand sale would be approximately $107 thousand.
The above summary does not contemplate state taxes as well as the new Medicare tax on investment income that began in 2013. The medicare tax of 3.8% on those with $250,000 or more of income and state taxes should be considered as part of any transaction.
Also, while a 90% allocation for goodwill in many cases can be justified, other cases where a lower percentage is warranted based upon the particular circumstances of the agency will result in a corresponding lower but still substantial tax saving. While the recognition of personal goodwill in a purchase and sale has to be tailored to the actual facts that support the allocation, in any case where a personal goodwill allocation can be justified, whatever the percentage, the seller will benefit.
Negotiating and documenting the sale of personal goodwill in an a C corporation purchase and sale requires competent legal and tax advice
Since the original taxpayer victories in the Tax Court, there have been several favorable results for the IRS in contesting the sale of personal goodwill. These cases do not invalidate the sale of personal goodwill, however, as a tax-advantaged procedure but, instead demonstrate that the sale of personal goodwill requires careful professional planning and legal documentation. For example, one of the IRS victories resulted from a taxpayer who signed a purchase and sale agreement allocating all goodwill to the business sold but subsequently filed an amended return based upon the claim that he had sold personal goodwill. He lost.
If an agent with a C corporation is going to gain any tax advantage from personal goodwill the planning and documentation must be built into the whole purchase and sale process. Allocating personal goodwill should never be attempted as an afterthought to a purchase and sale agreement.
In any case, remember that if a C corporation is involved in selling an agency the possibility of a separate transaction between the owner and the buyer can be structured for tax advantages is something to be seriously considered, if the owner can show that personal goodwill is involved.
By Owen Gallagher and Jason Nuttall.
Jason Nuttall is a Shareholder at Damiano, Burk & Nutall, P.C. where he focuses on Business Consulting and Strategic Tax Planning. In addition, he provides general accounting and auditing along with financial and tax compliance to businesses large and small. He has counseled independent insurance agencies on a variety of tax and accounting matters in both Massachusetts and Rhode Island.