By Bruce Bryen, CPA, CVA
With the typical dental practice sale, the dentists and their advisors are scrambling for methods to substantially reduce their federal and state income taxes. Hopefully a dental practice valuation was prepared so that the seller can see the projected taxes that he or she will be responsible for with the transition that is being proposed.
For the buyer of the dental practice, the consultants that have been retained will reflect the tax on the acquisition side of the transaction as well. Between each party’s tax on the sale, it is certainly worthwhile exploring the possibilities of at least deferring the tax as long as possible. Those amounts that can be deferred from now until as far into the future as possible can become fortunes to those who understand these amounts that are involved both on the buyer’s side of the equation and the seller’s as well.
For those dentists who have advisors that have explained the time value of money, the reporting of the income in the future rather than now can become overwhelming. The present or future value concept explanation is not that complex. Simply put, if you take a dollar today and invest it at whatever rate is attainable, what will that dollar be worth at the end of the time frame that is selected? Of course, if the tax were to be paid on the transaction today, there would be no dollar to invest and watch grow anyway.
What do advisors to dentists normally point out as different ways to reduce tax liabilities on a transition? What are some pitfalls to the buyer or seller when certain approaches are taken?
Some common approaches that advisors to dentists may use to defer current taxes include the potential over statement of equipment valuation. This hastens the tax write-off of the equipment and thus gives the buyer more deductions faster than the normal write-off of the equipment. This hurts the seller who then must report the sale of the equipment at the higher value and then pay more of a tax now. Having the seller record the characterization of his or her goodwill offers the seller a break with the tax on that amount being at the capital gains rate as the funds are received. The buyer pays for that being written off for tax purposes over 15 years, which is a burden over each of those 15 years. Other examples of one side of the transaction hurting the other side from a tax perspective are many. There is almost no transition method that can allow the buyer and the seller of a dental practice to have an equal footing with respect to the taxes that each would be responsible for paying upon the cash being paid by the buyer to the seller. With a sale involving a larger transition than with a single practice, such as a dental service organization (DSO), an equity stake in the form of stock ownership and no tax is paid until that stock is converted to cash. The risk is that the DSO fails to achieve its goals so that the stock does not become worth much.
What method can be utilized to prevent a large tax today and to also have funds available with that particular method for tomorrow?
Many financial advisors suggest what is known as an installment sale to assist the seller and the buyer of the dental practice when a transition is being contemplated. The essence of that type of transaction is that the seller receives some money at the closing on which there is a tax. The balance of the sale price is paid by the buyer signing a note payable to the seller and making the payments over an agreed upon term with an interest factor included.
The seller pays tax on the amortization portion of the note and is taxed at a capital gains rate. The interest received is taxed at ordinary income tax rates to the seller. This method of payment leaves the seller at the mercy of the buyer and his or her ability to generate the cash flow necessary in order to make the payments. This method defers the taxes as it defers the receipt of the funds agreed upon by the parties to the transaction. It is an unsafe approach to the transaction for the seller but a terrific method for the buyer as there is little cash out of the buyer’s pocket as the note and its interest payment are being made.
This type of methodology is a rare occurrence when a dental practice is being sold as the seller’s advisors will undoubtedly reject the format because of its risk. These discussions lead us to one of the only safe methodologies for both the buyer and the seller to be safe and to defer the taxes for each for quite a long period of time. It allows the seller to watch the money grow and not pay a tax for years. It allows the buyer the most expeditious type of tax write-off possible while protecting the assets of the dental practice as the payments are being made.
What is the approach that astute advisors and the dentists would agree upon that hurts neither? What accomplishes the goal of a safe and sure method of reducing current taxes and continuing to watch the funds?
An employer-sponsored qualified retirement plan provides current tax deductions to the dental practice. A long-term approach to the concept of the retirement plan can offer the buyer and the seller of the dental practice the opportunity to defer taxes for years, based on the design of the retirement plan. Using an example of a sale price of $1,000,000, a buyer can have a qualified employer-sponsored retirement plan adopted by the dental practice and hypothetically pay $200,000 per year into the retirement plan. A tax deduction would be earned by the buyer’s dental practice for $200,000. The seller would see the deposit into the retirement account and ear marked for him or her. This would occur for 5 years until $1,000,000 was paid into the retirement plan. For a detailed analysis of this approach, the dental practice CPA should be consulted for the explanation.
Editor’s Note: Bruce Bryen is a certified public accountant with over 45 years of experience and is a part of Baratz & Associates CPAs. He is a regular contributor to Dentistry Today and more articles on finance and practice acquisitions can be found at dentistrytoday.com. Bryen specializes in deferred compensation, such as retirement planning design; income and estate tax planning; determination of the proper organizational business structure; asset protection and structuring loan packages for presentation to financial institutions. He is experienced in providing litigation support services to dentists with Valuation and Expert Witness testimony in matrimonial and partnership dispute cases. You may contact him at [email protected].