When you started your agency, you were probably focused on the basics of getting yourself established, setting up the office, and spending time with clients. You probably set up a separate business checking account to handle the incoming commissions and pay the bills. However, many owners may commingle personal expenses with the business early on when cash flow is tighter or throughout the life cycle of the agency.
Commingling your personal and business funds can have a negative impact on your tax situation, financial statements and agency valuation. This article explains why it can be a problem — and how you can solve it with properly segregated accounts.
Taxation Implications
When your personal and business transactions flow through the same account, it makes life harder for your bookkeeper, especially at tax time when they need to allocate expenses to proper categories and determine tax deductible expenses.
Trying to assign expenses retroactively creates extra work and increases the likelihood of errors, missed tax deductions, and improperly attributed expenses. Not only does this hurt your bottom line, but having commingled accounts and less-than-stellar bookkeeping can create a red flag with the Internal Revenue Service (IRS). This may result in a tax audit, tax penalties, and the inability to prove legitimate business write-offs.
Impact on Valuation
In addition to the legal and tax implications of mingled funds, having messy accounting can lead to an inaccurate valuation, potentially resulting in a significant drop in what a buyer will pay for your agency. It also impacts a lender’s ability to accurately evaluate your agency’s creditworthiness.
When considering an insurance agency sale or purchase, Seller Discretionary Earnings (SDE) is often used as a valuation metric. While EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is used for larger companies, SDE is designed for a single owner-operator or partnership.
Essentially, SDE is a calculation based on EBITDA plus the profit and perks paid or distributed out by the agency for your personal benefit. This formula includes net profit, owner compensation (salary, non-cash expenses (e.g. depreciation), non-recurring expenses, and perks paid out to agency ownership. Utilizing the SDE approach to valuation gives both you and a potential buyer insight into what your agency is worth.
Another aspect of keeping clean books and having an accurate agency valuation is your ability to access working capital or other financing. When going through the loan application and underwriting process, lenders use your agency financial statements as part of their assessment for creditworthiness. Having clean business-only financial statements readily available expedites the loan process instead of requiring extra effort to retroactively gather essential financial information.
Best Practices for Agency Accounts
With a minimal amount of effort, you can establish separate accounts for proper tracking of business income and expenses. Here is a recommended account structure that provides accuracy and efficiency:
1. Premium Trust Account (PTA): Although many policyholders pay premiums through auto-debits directly to the insurance company, others pay electronically to your agency or still prefer to bring their payments to your office. These payments should be deposited into an account dedicated to holding premiums until they are sent to your carrier(s).
2. Business Operating Account: Commissions and brokerage fees are deposited into this checking account to be used for payroll, rent, marketing. Leads, quarterly estimated taxes, vendor costs, office supplies, client appreciation costs, and other “everyday” expenses. (Optional: Some agencies keep a separate Tax Escrow account rather than using their Operating Account for upcoming tax payments.)
3. Business Reserve Account: This savings account should hold 3-6 months of business operating expenses, depending on your agency’s specific needs and cash flow patterns. This provides you with access to liquid assets for unexpected expenses or lags in commission payouts. Keeping cash in reserve inside the business, versus distributing it, helps prevent having to contribute personal funds back into the business in cyclical times.
4. Personal Checking or Savings Account: Instead of paying personal living expenses out of business accounts, pay yourself through proper payroll channels and/or an owner’s draw (also called a distribution) to cover personal expenses.
Setting Yourself Up for Success
Whether you’re just getting started as an insurance agency owner or you’ve been doing this for decades, a strategy of clear separation of finances puts you in a position of strength when it comes to taxes and business valuation.
If you have questions about the First Mid approach to specialized agency financing, please reach out to a member of our consultative team or call 1-877-894-2785.