We all know that DEATH AND TAXES are the only two certainties in life. We also know that when you sell a dental practice, chances are you are going to have to pay income taxes on the sale. What may come as a surprise is that the amount of taxes due can vary widely depending on how the sale is structured. The transaction structure can also have varying tax effects for the buyer.
One transaction structure is to sell the corporate stock, LLC membership units, or partnership units to the buyer. This is great for sellers as they will usually accomplish long-term capital gain treatment. This is not so wonderful for buyers as they don’t get any tax benefit until they sell the practice at some point in the future. In addition, a buyer is also purchasing any contingent liabilities that may come with the practice.
The more common approach to dental practice sales is to structure the transaction as an asset and personal goodwill sale. With this structure, the seller typically achieves long-term capital gain treatment (currently 15%) on the goodwill sale, but typically pays ordinary income rates (up to 35%) on the asset sale.
The buyer in turn gets some tax benefit through the ability to immediately expense items such as supplies and certain assets up to a limit, and can depreciate/amortize the remaining asset purchase over varying periods from five to 15 years.
What becomes critical in these transactions is the allocation of the purchase price between tangible assets and goodwill. In this scenario, the dollars allocated to goodwill benefit the seller, but alter the tax deduction timing to the buyer because it takes 15 years to amortize the goodwill purchase.
Conversely, the more dollars allocated to assets speeds the tax deductions to the buyers. They can depreciate them over shorter periods (five to seven years), and this is detrimental to the sellers as they typically have to pay a higher tax rate.
What becomes clear is that the objective of buyer and seller regarding taxes can work in contrast to each other. Therefore, when negotiating a dental practice purchase or sale, the purchase price allocation should be discussed along with the price and should be included in the “Intent to Purchase” document that outlines the offer and acceptance.
The allocation of purchase price must be reasonable, and in most cases the IRS will not heavily scrutinize it as long as the buyer and seller report the same amounts on their tax returns. In most dental practice sales, a majority of the purchase price is allocated to goodwill. Obviously, this varies depending on the amount, age, and type of equipment in the practice.
One other item that can affect the tax consequences is how the purchase price is paid. In most practice sales today, the buyer borrows the money from a lender and pays the seller in cash at closing; however, there are still some transactions that are handled with a “deferred sale,” whereby the seller is paid out over time. This obviously has tax ramifications for both buyer and seller.
In many cases, the seller will continue to work for the practice as an associate following the sale. There have been cases where the seller’s compensation has been modified to essentially include part of the purchase price.
This arrangement can be detrimental to sellers as they are paying ordinary income tax rates on the funds received; however, the greatest risk with these arrangements is they are subject to IRS scrutiny because they do not represent the essence of the transaction.
The result is that taxes can have a dramatic effect on both the net purchase price paid by the buyer and net purchase price received by the seller. Therefore, taxes should definitely be a consideration when negotiating a transaction. Both buyer and seller should consult with their accountants and/or attorneys before agreeing to the terms of the sale.