If you ask a group of doctors the most important aspect of a practice transition, the majority will point to the purchase price. Too few doctors realize that the other terms of the sale have a dramatic financial impact on the final sales price. To achieve a successful transition, buyers and sellers must work out what assets are included in the price, the timing of the sale, the allocation of the purchase price between the various assets to be sold, and the structure of the sale.
One issue that can make or break a deal relates to the assets included in the purchase price. This issue is easier to address when the entire practice is sold since physical assets, such as dental and office equipment, furniture and supplies, and intangible assets such as personal goodwill, are typically included in the sale. However, accounts receivable are sometimes included in the sale and sometimes excluded from the sale. If doctors do not discuss this matter initially, both parties may subsequently disagree on the issue and cause the transition to fall apart.
Timing of the sale is more important than many doctors realize. If receivables are part of the sale, which is always the case for orthodontic practices, a seller is often inclined to complete the transition in the middle of the month, once most of the receivables for that month are collected. Normally, the buyer prefers to close on the first day of the month, before the receivables have been collected. The difference between these options can amount to thousands of dollars. Closing in the middle of the month likely means the buyer will work for several weeks with low collections from receivables.
As mentioned, it is important to identify the assets that will be sold (dental and office equipment, furniture and supplies, goodwill, etc.). Equally important is the allocation of the purchase price between each of these assets. The tax ramifications to buyer and seller are determined by the allocation. Sellers prefer to allocate more of the value to the assets that are taxed at the lowest tax rates. They typically seek an allocation leaning more toward intangible assets, such as personal goodwill, since these assets are taxed at the more favorable capital gains rates, currently a maximum of 20%. On the other hand, the sale of tangible assets, such as dental equipment, office equipment, and consumable supplies, is generally subject to ordinary income tax rates, currently a maximum of 39.6%.
Conversely, buyers seek an allocation that allows for the fastest depreciation deductions. Most tangible assets can be written off over five to seven years, compared to personal goodwill that takes 15 years to write off. Additionally, the tangible assets may qualify for even faster depreciation under the Section 179 expensing election. As a result, there is an inherent conflict between the buyer and seller since the assets taxed at the lowest rates have the longest write-off period and vice versa. Given the financial impact that allocation has on both sides of the transaction, this is one of the most important items to negotiate, and the allocation of the purchase price should be based on the actual fair market value of the individual assets.
Unfortunately, many doctors reach an agreement on price without sorting out all the terms and conditions. Then they approach an attorney or transitions consultant to finalize the deal, believing that the heavy lifting is done. However, in numerous cases there are many more issues to resolve that often lead to the derailment of a potential sale since both parties cannot agree on the terms. As a result, doctors should negotiate all terms and conditions up front to ensure both parties are satisfied with the transition.
Jonathan Martin provides transition planning through Roger K. Hill & Company, Inc., a member of the McGill & Hill Group, LLC. John K. McGill provides tax and business planning exclusively for the dental profession, and publishes The McGill Advisory newsletter through John K. McGill & Company, Inc., and is also a member of the McGill & Hill Group, LLC. For more information, visit www.mcgillhillgroup.com.