|
Double Agent? Get stirred, not shaken, when you learn you won't be double-crossed by the nefarious tax agent. A 90-proof solution: double taxation conquered to save your deal.
Leader's Edge, June 2007
Fast Focus
- Tax consequences of a sale should be top of mind for insurance agency sellers.
- Allocating proceeds to personal good will can alleviate a tax hangover.
- MUM's the word when it comes to allocating personal and enterprise goodwill.
Deal killers hide like thieves in the night. From a deal that takes too
long to a greedy seller to cultural mismatches, deal killers give
investment bankers fits. "Double taxation" is a sneaky deal killer that
steals the energy of a good transaction as fast as an unlocked Beemer
disappears from Brooklyn.
When agency owners ponder the sale of their businesses, they may not
realize that double taxation can crush the life out of a sale. In the
end, without an effective, systematic methodology of reducing taxes, the
deal could be lost, sending everyone home unhappy. A major concern of an
insurance agency seller should be the tax consequences of a sale. Many a
deal has been scuttled or, at minimum, put at risk of not being
consummated when the seller calculates exactly how much tax will be owed
on the transaction proceeds.
There are many tools sellers utilize to help offset taxes, but one of
utmost importance to consider for owners of closely held C-corporations
and S-corporations subject to built-in-gains (i.e., inside the 10-year
conversion window) is the concept of utilizing "personal goodwill." In
short, to minimize tax consequences and maximize the total amount of
transaction proceeds that actually end up in their pocket, sellers
should allocate as much of the transaction proceeds to personal goodwill
as possible.
Escaping Double Trouble
How does double taxation occur? It depends whether the owner is selling
the stock or the assets of a C-corporation. Most buyers are extremely
reluctant to purchase the stock of a closely held C-corporation for a
number of reasons, such as the buyer's assumption of unknown liabilities
and the inability to amortize acquired intangibles. Because of this
reluctance, sellers of C-corporations often are faced with the choice of
either selling the assets of the corporation or selling the stock at a
reduced purchase price.
That's where taxes come into the equation. If shareholders sell the
stock to an external buyer, proceeds are typically taxed once at capital
gains rates. If selling the assets, proceeds are typically first taxed
at the corporate level at ordinary corporate tax rates, then taxed again
at the individual level when the proceeds are actually distributed to
shareholders. Hence, sellers of the assets of C-corporations are
subjected to double taxation. This is an over-simplification of the
double-taxation issue, but nonetheless it holds true in most situations.
Contrast this with tax consequences of selling the assets of an
S-corporation. If the company elected subchapter "S" status more than 10
years ago, it is subject to only one level of taxation, generally at
capital gains rates. However, if it converted to "S" status within 10
years prior to the consummation of a sale, a portion of deal proceeds
will often be subject to built-in-gains tax consequences. The
built-in-gains tax is the result of assets that appreciated in value
prior to the conversion date from a C-corporation to an S-corporation,
and the gain flows through to the shareholders, net of a 35% corporate
tax, creating a near double level tax.
For either a C-corporation or an S-corporation, a major tax hangover can
loom over a transaction. To mitigate this situation and potentially
salvage the deal, the seller may elect to allocate a portion of the
transaction proceeds to personal goodwill.
Understanding Goodwill
How can personal goodwill magically help reduce taxes on an agency
transaction? To answer that question, we must first explain total
goodwill.
Goodwill is an asset, and as with almost all assets, its value is
dependent on the future returns it is expected to generate. It is
important to realize that expected future returns are the key to any
asset's current value. Individuals can be viewed as intangible assets
based on the income stream that they are expected to generate in the
future. An asset has value not because it can be exchanged for money but
because it will provide a stream of future returns, whether they be
monetary, non-monetary or some combination of the two. For this reason,
goodwill is also an intangible asset.
There are two types of goodwill: personal and enterprise. Personal
goodwill, also called professional goodwill, is associated primarily
with specific individuals within an entity. Enterprise goodwill, also
called business goodwill, is associated primarily with the entity
itself. Total goodwill is a combination of these two types.
Goodwill has been defined as the favor or prestige that a business has
acquired beyond the mere tangible value of what it sells. The true,
going-concern value of an insurance agency lies not in its tangible
assets (the market value of equipment and furniture), but rather in the
value of intangible assets. These include: customer lists, client
relationships, reputation of the business, reputation of individual
staff members, personnel knowledge base and carrier relationships.
Goodwill also can be broadly defined as the probability (stated in
dollar terms) that customers will continue to patronize a business, plus
the probability (stated in dollar terms) that existing customers will
refer individuals to the business and that these referrals will
inevitably become customers.
From an accounting perspective, the two primary criteria that serve as
evidence of the existence of goodwill are a payment in excess of an
established value of a resource and enhanced earnings power. Under the
first valuation approach, total goodwill is the difference between the
market value of the identifiable tangible assets less total liabilities
(i.e., tangible net worth) and the total fair market value of a
business. Under the second approach (called the "formula approach"),
total goodwill is essentially any rate of return in excess of a "normal"
return on the tangible assets of a business; excess returns are
considered excess earnings, and goodwill is the capitalized value of
these excess earnings.
The formula approach to valuing goodwill has been used for many years.
In the sale of an insurance agency, however, this approach is often
inappropriate, given that insurance agencies maintain very little value
in terms of tangible assets. Most of an agency's value exists in
intangibles. This is especially true for the sale of a "going concern."
For owners wanting to sell their agencies, goodwill encompasses a
relatively large number of qualitative factors that are directly or
indirectly attractive to prospective buyers. Over time, valuation
analysts have identified more than 130 intangible assets that can be
categorized under the umbrella of goodwill, including: location,
suppliers, specialized knowledge, relationships with customers, length
of time in business, reputation in the industry and reputation in the
community.
Some of these factors are personal goodwill; some belong to the
enterprise. How they are categorized and calculated can greatly affect
the bottom line in an agency transaction.
Realizing Tax Savings
If you are a seller subject to either double taxation or built-in-gains,
you will generally want to allocate as much of the total transaction
consideration as possible to personal goodwill. Because personal
goodwill belongs to the individual and not the company, it is taxed only
one time. Since it exists separate and apart from the C-corporation, it
is taxed outside of the corporation at individual capital gains tax
rates. The same holds true for S-corporations subject to built-in-gains,
as the portion of the transaction that is allocated to personal goodwill
is subject to built-in-gains tax but taxed outside the corporation. In
some instances, a separate check is actually written by the buyer and
made payable to the seller as an individual for the acquisition of the
personal goodwill.
Here's the problem: How do we accurately and effectively segment total
goodwill into its two underlying components, personal and enterprise?
This seemingly simple question has been a stumbling block for business
valuation professionals, accountants, investment bankers and other
transaction advisors since the beginning of time. However, now there's a
systematic way to gauge total goodwill between personal goodwill and
enterprise goodwill.
Adapted from the field of decision science, the Multi-Attribute Utility
Model (MUM) helps the transaction advisor evaluate and quantify the
specific attributes of personal and enterprise goodwill that exist
within total goodwill. In fact, it is, in my opinion, the most effective
methodology developed to date to logically and accurately distinguish
between personal and enterprise goodwill. MUM was first applied to the
question of goodwill allocation by David N. Wood of Wood
Forensic/Valuation Services in Mount Vernon, Ill. MUM has become a
proven method in cases where marital dissolution has required the
division of assets. In fact, the model was recently upheld in a
September 2006 divorce case in front of the 5th District Appellate Court
of Illinois. That case showed that, in the division of assets caused by
a divorce, if part of the goodwill value of a business can be shown to
be personal goodwill, the amount of a business' fair market value that
can be allocated to personal goodwill is not marital property and not
subject to marital property distribution. (This could, of course, vary
by the laws of each state.)
The goal of MUM is to establish the actual values of personal goodwill
and enterprise goodwill given the total goodwill value associated with a
business. The first vital action in a MUM analysis is the definition of
company-specific personal and enterprise goodwill attributes. Then,
these attributes are weighted based on a determination of their "utility
of importance" and "utility of existence." After the MUM attributes are
weighted and calculated to determine a percentage of value relative to
the sum of all attributes, these results are brought together in a final
analysis to determine an allocation of total goodwill between personal
and enterprise goodwill.
While a detailed review of the actual MUM mechanics is beyond the scope
of this article, a simple example can show how it works.
Goodwill + MUM = Successful Deal
Using MUM theory, WFG Capital Advisors has been successful a number of
times at keeping the buyer and seller at the table through the
successful adoption of MUM and a goodwill allocation that significantly
reduced the seller's tax burden.
Figure 1 represents the attributes that we often
use. It is important to note that, while some attributes may be
consistent across industries, each case must be evaluated on its own
company attributes. In this case, insurance industry and agency-specific
attributes needed to be incorporated into the model. For this reason, an
experienced, industry-specific expert should be utilized to ensure an
accurate measurement of personal goodwill that exists within an
insurance agency.
Notice that many of the personal goodwill attributes are specific to the
name, relationships and activity of one person. Many of the enterprise
attributes could be seen as tools to be used by any manager to operate a
successful business. In our example, the seller put on the market
substantially all of the assets of a C-corporation. By separating
personal goodwill, WFG was able to help the seller partially avoid the
dreaded double taxation of C-corporation asset transactions. The final
result looked something like Figure 2.
In this example, an allocation of total goodwill showed that a majority
of goodwill would be considered personal, and would thus not be
calculated as part of the corporate assets. As shown in Figure 3, this
saved the seller approximately $2.2 million in taxes, which was
approximately 22% of the total deal consideration of $10 million.
This simple example shows how MUM provides an essential valuation tool
for individuals involved with the buying or selling of insurance
agencies, whether owners of C-corporations, S-corporations subject to
built-in-gains, or those unfortunately involved in divorce situations.
By understanding the value that an individual brings to a
relationship-based business such as an insurance agency, the valuation
analyst can contribute significantly to the attractiveness of a
transaction package. It is in the best interests of both the buyer and
the seller to not allow the deal killer of double taxation to sneak into
the negotiating room.
Figure 1
MUM - Attributes
Personal & Enterprise Goodwill |
| Personal | | Enterprise |
| Lacks Transferability | | Number/Location of Offices |
| Lacks of Capital Investments | | Covenant Not to Compete/Solicit |
| Specialized Knowledge | | Underwriting Facilities |
| Personalized Name | | Enterprise Staff |
| Personal In-Bound Referrals | | Marketing |
| Personal Reputation | | Number/Distribution of Producers |
| Age and Health | | Years in Business |
| Underwriting Relationships | | Product Diversity |
| Personal Contact Network | | Management Infrastructure |
| Direct Client Relationships | | Size and Scale |
| Personalized Culture | | Technology & Systems |
Figure 2
| Total Tax Basis of Assets Sold | $ -0- |
| Total Purchase Price | $10 million |
| Total Gain on Sale (Goodwill) | $10 million |
| |
| Allocation of Goodwill Utilizing MUM | |
| Personal Goodwill - 75% | $7.5 million |
| Enterprise Goodwill - 25% | $2.5 million |
Figure 3
| Tax Without
Allocation to
Personal Goodwill | Tax With
Allocation to
Personal Goodwill |
| Total Proceeds | $10 million | $10 million |
| Corporate Tax on Gain | $3.5 million
($10mm @ 35%) | $875,000
($2.5mm @ 35%) |
| Tax on Distribution/Dividend | $975,000
($6.5mm @ 15%) | $243,750
($1.625mm @ 15%) |
| Tax on Personal Goodwill | N/A | $1,125,000
($7.5mm @ 15%) |
| Total Tax | $4,475,000 | $2,243,750 |
| Net Proceeds | $5,525,000 | $7,756,250 |
| Effective Tax Rate | 44.75% | 22.43% |
| Tax Savings | | $2,231,250 |
|
|
