Our last article was dedicated to the basics of tax considerations in the practice transition process. As a quick refresher, the total sale price of a dental practice is typically allocated in some part to goodwill, equipment, and supplies. Each of which carries with it its own tax consequences for both the buyer and the seller. In short, the seller will want to mitigate taxes on the sale proceeds they just received, whereas the buyer will want the shortest write-off possible for the business and property they just acquired.
While the above may seem obvious, occasionally some opportunities present themselves for even more creative tax planning and minimizing strategies.
A seller may want to pre-plan their transition to happen on January 1st of a new year (or first business day of the year). This will push any income (whether ordinary or capital gain) into a tax year with no other income. For example, a practice sold by a married owner that will result in $450,000 in capital gains and $75,000 in ordinary income from the sale, plus a $300,000 business profit in the same year would result in an approximate federal tax bill of $156,775 (19% effective tax rate). That same transition pushed to the following year without business income would result in a total federal tax bill of $123,049 between the two tax years (14.9% effective tax rate). This is an easy and straight-forward tax minimization strategy.
If a seller is not planning to execute your transition on the first of the year, he or she may be well served to use some of the sale proceeds to maximize funding of the practice retirement plan. This works especially well if you use a Cash Balance plan in conjunction with your practice 401(k)/Profit Sharing plan. A 401(k)/Profit Sharing plan will allow an owner age 50+ to deposit $64,500 into the plan pre-tax. If using a Cash Balance plan, that amount can easily be in excess of $150,000. Since deposits into these plans don’t have to be made until tax-filing, the cash from the sale of the practice can be used to make the deposits and result in considerable tax savings. This strategy should be formulated in the years leading up to a practice transition to best allow for any plan implementation or necessary amendments.
While some owner-doctors seek to get the entirety of their sales price upfront, not every seller needs or wants this. Consider a seller that is planning on staying with the practice after the sale as an associate for the new owner. If continuing to work, they may not need the sales proceeds to live on, so they can afford to take some or all of the sale price over time. In this situation, the buyer and seller have abundant flexibility in crafting deal terms.
One option available in a transition of this nature would be for the seller to finance the transaction, all or in-part. In this case, the buyer would make payments directly to the seller (instead of to a bank) over a specified term and at a specified interest rate. While this method does carry more risk to the seller than traditional bank financing, if the seller feels that the buyer is credit-worthy and charges a commensurate interest rate, it would allow the seller to stretch the tax on the sale of the business over time. In accounting nomenclature, this is referred to as an “Installment Sale.” In this case, the seller pays tax on purchase over time (some at capital gain rates, and some at ordinary income rates). Since an installment sale is a loan, it will carry interest which the seller will be taxed on at ordinary income rates.
Given the level of trust the seller must have in the buyer, it shouldn’t come as a surprise that a method like this is typically used when the buyer and seller have an exceptionally close relationship, like a son or daughter buying the practice from a parent.
Another potential option for a seller that is planning on working after the sale would be to balance the practice sale price with the associate’s salary. In other words, a seller is sometimes willing to take less for the practice up-front, if they will receive a generous salary as an associate in subsequent years. Conceptually, a practice listed for sale with an $800,000 price may actually sell for $600,000 if the seller will be paid $200,000 in salary over the next 2 years. It’s worth noting that this strategy would likely require a departure from the traditional percentage of production or collection compensation model in favor of a more conventional salary (fixed amount per year). Buyers may find the option appealing, as the salary would be immediately expensed (written off) in the year(s) paid. Even though the salary would be taxable to the associate (seller) at ordinary tax rates, that tax would be spread over the years it is paid. Furthermore, it allows for a point of negotiation if it is important to the seller to be able to work after the transition.
Taking this strategy one step further, if the new practice owner is agreeable to it, the associate may be paid as a sub-contractor. Instead of receiving compensation in the form of wages, the new owner will pay compensation in the form of fees to the seller (or their entity). Doing so will allow the seller to continue to deduct professional expenses just as they did when they owned the business. Additionally, they can couple this strategy with the Retirement Plan Funding tactic mentioned above to further offset income tax.
These are just a few ideas for strategies than can help manage taxes in a dental practice transition. The points listed above are the not applicable to all practice transitions and both a buyer and seller should consult their respective Dental CPAs to make sure any transition strategy serves their objectives. With that said, hopefully it’s clear by now that the more proactive and communicative both parties can be leading up to the formal transition, the more options for tax strategy they will have.
As a parting comment, I must caution all buyers and sellers to beware of the practice brokers that seek to apply a “cookie cutter” approach to deal structure. Which is to say they know one way to structure a deal that leaves little, to any room for creativity or flexibility. This is why it’s imperative to work with seasoned professionals, like ADS Dental Transition member firms. Collectively, we have decades of experience crafting successful practice transitions for both the buyers and sellers we have represented.
Ted Schumann, II, MBA, MSF, CFP®, AIF®
John Looby CPA – The DBS Companies