Thinking Ahead When Building an Insurance Agency Foundation

A nearly universal problem during the coronavirus pandemic has been running out of programs to binge watch on television. I hate to admit it, but that’s true for me, and it has resulted in my watching obscure architectural programs. In a recent episode, I watched a fascinating building being constructed with an unusual foundation, which though it was different, was uniquely suited for the building and the site. This led me to think about how important, and often overlooked, the foundation of an insurance agency is when first created.

The foundation of any business is its legal form of organization. In my experience, that form is chosen as a consequence of a very quick call between the founders and their CPA and not much else. While this generally works out, there are potential opportunities missed.

Most agencies are created with some kind of tax pass-through facility like a sub S corporation (S Corp) or Limited Liability Company (LLC). There may be a sole owner of the business, but frequently two or more people form a partnership to create an agency. In these circumstances, real care to anticipate future issues can save many operational and other problems down the road.

Avoiding Partnership Pitfalls

In a partnership, whether organized as a corporation, S Corp LLC, or the true partnership form of legal organization, ownership is generally held on the basis of capital contribution. While that may be entirely adequate, there are other forms of capital besides cash.

For example, one partner may be contributing significant intellectual property in the form of niche market expertise, depth of management experience or important carrier relationships. These non-cash contributions have real value, and accommodating them in the ownership structure not only recognizes their value but can potentially avoid future problems.

Another structural challenge in a multi-owner insurance agency is how to keep the ownership fair as the agency develops. An insurance agency’s largest asset is its book of business. If one or more shareholders produces a larger-than-average book of business, they may grow frustrated at some point if they feel their equity ownership is disproportionate to their production.

These kinds of issues are difficult to deal with in a corporate structure but are easily solved with an LLC, where equity can be divided among different asset classes. For example, an LLC can create separate divisions to own book(s) of business, furniture, fixtures and assets as well as cash to keep this production disparity fair.

Another potential problem in small, closely held, multi-owner companies arises when one or more of the owners feels they are doing more work than the other owners and not being fairly compensated. A simple way to deal with this issue structurally is to divide management responsibilities, use benchmarking tools to establish a relative cost for those management responsibilities and pay the responsible owner a salary based on those benchmarks.

Another issue to consider in a small business is how owners will take advantage of their unique tax-avoidance opportunities. Things like country club memberships, automobiles and other perks of ownership are both great benefits of being in business for yourself, but also potentially points of contention, disagreement and fracture with partners.

One way to deal with these issues, while keeping financial statements clean, is for each owner to hold his or her interest in a holding company and use that entity for ownership perks. This way, no disparity or jealousy will arise. Everyone will do as they please while being treated fairly.

When putting together any business entity, owners who think through all of these issues in advance will help ensure their business not only gets off to a great start but stays the course of time with little or no friction or disagreement.

Creating Unique Structures

My own agency is a good example of creating unique structures as the foundation for a business. Recognizing the potential for just these sorts of problems, my partners and I created an ownership structure using an LLC with three divisions.

The first division owned all company physical assets and all owners made an equal contribution to that division. The second division owned our property and casualty business. The third division owned our employee benefits division, which has a different value per dollar of revenue than the property and casualty business.

Later, as we added non-owner producers, we agreed to create a fourth division, and the equity and profits attributable from that division would be shared on the same basis as our core asset division, and we each made identical capital contributions to get it started. This unique structure solved for us some of the structural problems described above.

Another example is an agency my company assisted during its foundation, growth and sale. This agency took the unusual approach of paying all three owners equally throughout the agency’s life. One partner produced the lion’s share of the business, another created and managed operations, and the third positioned and sold the agency.

Some might think these entrepreneurs’ structure odd because in a typical agency, the producer partner would have been paid a large producer’s commission. But the partner’s business objective was to build an agency quickly and sell it for a best-in-class valuation. Their structure was created to support their business goals, and it worked very well for them.

Making a Change

What if your agency has been in business a long time but some of the problems I mention resonate uncomfortably with you? Change! It is more difficult to reorganize an existing business and repair the foundation than doing it at the beginning. But it can, and should, be done when necessary. Just like a building foundation that has cracked or sagged, you need to call in the specialists. This is where a really good tax advisor (not necessarily the firm that prepares your taxes) and attorney who specializes in business organization can be of tremendous value.

There are not only operational improvements that can come from reorganizing but often additional tax advantages. Getting the foundation for your business to support your business needs and objectives is a great project anytime during the life of the agency.

In creating a new agency, it’s important, and valuable, to carefully think through not just the tax considerations of ownership structure, but also how you want to operate the business and how you will want to deal with ownership challenges as they come up. Serious discussion among owners, or careful thought by the sole proprietor, along with sound advice from tax advisors and input from experienced owners who have been where you are going, are all great ways to make certain the business you are creating lasts.