With our upcoming “Selling a Dental Practice: What You Need to Know” seminar coming up next Tuesday, February 28th, this seems like a perfect time to shed a little light on this topic.
When considering selling their practices, most dentists consider the tax consequences. What they don’t always consider are the tax opportunities. This article addresses both.
Common Practice Sales
In the most common sale structure, a dentist sells her practice for a lump sum of money. Though we say the dentist is selling “the practice,” she is actually selling the assets of the business. These generally include equipment, dental and office supplies, and patient records. Often there is also a non-compete covenant as well.
For tax purposes, the sale price must be allocated among the various assets sold. If there’s money left over after allocating the price to the assets mentioned here, the remainder is considered goodwill and can be thought of as the value the seller has added to the practice over time. The sale of different assets produces different types of income so the allocation of the sales price can directly affect the seller’s taxes.
The sale of supplies generally generates ordinary income, which, depending on the seller’s tax bracket can be taxed as high as 50% when federal and state taxes are combined. The sale of patient records, the non-complete covenant, and the goodwill are all taxed at long-term capital gains rates which currently max out at about 30% when federal and state tax rates are combined. The sale of equipment has the potential to generate some capital gain income but often generates primarily ordinary income from the recapture of depreciation taken in prior years.
The seller’s preference, therefore, is to allocate as much of the purchase price as possible to patient records, the non-compete covenant, and goodwill, and as little as possible to equipment and supplies. Unfortunately, the buyer’s tax preferences will be in exact opposition to those of the seller. The buyer’s tax benefit comes from allocating more to equipment and supplies and less to the intangible assets. Even more unfortunate, the buyer and seller must both agree on the allocation of the purchase/sale price and report the results to the IRS.
In most sales, a compromise on the allocation of the purchase/sale price is reached somewhere in the middle, but that doesn’t have to be the case. When there are conflicting interests, there is hidden opportunity. Creative allocation of the price can be a great negotiation tool. The allocation could be altered, for example, in exchange for a higher or lower purchase price.
Creative thinking also exposes other tax opportunities when selling a practice. After paying taxes on the sale, most sellers will invest the remaining proceeds in hopes of getting that steady stream of income needed in retirement. Instead, sellers should consider owner financing some or all of the buyer’s practice purchase. In this scenario, the seller serves as the bank and allows the buyer to make payments over a number of years. Since the income from the sale is not received all at once, the seller usually stays in a lower tax bracket than she would be in if she took in hundreds of thousands of dollars all at once. She receives a steady stream of payments, plus interest, over a number of years, stays in lower tax brackets, defers most of the taxes in to future years, will likely pay fewer taxes overall, and, in the case of default, can take the practice back and sell it again.
Bankers love to make loans to dentists because their average default rate is about 1%. They are low risk customers. In a seller finance situation, the seller takes on the same risk a bank would. If that is still too much risk for the seller, she can protect her investment by taking a security interest in some other asset belonging to the buyer, such as a rental property owned free and clear.
Keeping the Building
Another important opportunity that should not be overlooked is available to sellers who own the building in which they practice. Selling the practice and keeping the building as a rental again provides the steady stream of income most retirees need, but that’s just the tip of the iceberg.
Over the years, the seller has been depreciating the building and claiming a deduction for this on her tax return. If she sells the building, taxes will be paid on any gain recognized. Part of the gain will likely be due to appreciation of the building over time. This gain will be taxed at the lower long-term capital gains rates. Any gain associated with depreciation taken in the past, will be taxed at higher ordinary income rates. A seller in this situation will likely feel penniless after paying her taxes from the year of sale.
But there is an alternative, and it reduces the taxable gain on the sale of the building to zero. If the seller keeps the building until her death, and then passes it to her heirs, all the depreciation she has taken over the years gets cleared, and they inherit the building at the fair market value at the date of her death. This means that they can sell the building the next day for its market value and pay no taxes at all, or they can rent it out for many more years, taking advantage of the depreciation deduction all over again. Amazing.
While I can’t think of a better tenant than a dental practice, if for some reason the selling dentist just doesn’t want to continue to own that particular building, she can also take advantage of the IRS Section 1031 like-kind exchange rules. These will allow her to trade this building for another income producing building while deferring the taxes down the road.
Just because most dentists sell their practice all at once for a lump sum of money, doesn’t mean it’s the best way. It’s certainly the easiest way, but with a little education and support from appropriate professionals, a creatively structured sale can reduce your taxes, give you a steady cash flow in retirement, increase your wealth, and provide a legacy to your children.
Ben Anders, CPA