In pursuit of acquiring the dental practice that seems like the perfect fit, there are times when the buyer has not been in close enough communication with their adviser. The main issue is almost always the same: the potential tax due on acquisition and when that tax will come due. This figure can be inadvertently omitted from the adviser’s calculations.
Sometimes a purchaser cannot imagine how they could be taxed when buying a practice, so they are not aware of it. When that is the case, the consultant may be asked to set aside the tax discussion and concentrate instead on the projected growth following the purchase.
That is the wrong approach. This article examines the tax event itself, determines how a buyer of a dental practice would owe taxes, and explains when that tax becomes due.
The amount can be substantial, and buyers should not be surprised by it or feel they made a bad deal because of it. The important thing is understanding that this potential tax is coming, having time to plan for it, and determining whether any strategies are available to defer or reduce it.
Why would there be a potential tax to the buyer?
Bruce Bryen, CPA, CVA.
First, let’s be clear that the focus here is on the buyer’s side of the transaction, not the seller’s. Sellers (and their advisers) generally understand and anticipate the seller’s tax liability and have time to plan for deferral or elimination. There should be no surprises on that side.
The buyer’s tax arises from the amortization of the acquisition price. Interest on the loan is almost always deductible. However, principal payments come from two sources: income generated by the practice, which is subject to tax; or refinancing the debt, which is also subject to tax when that principal is eventually paid.
Strategies can be developed to defer that tax, but when amortization occurs, the tax becomes due unless other circumstances offset it.
Consider how this works with a residential mortgage. The interest is almost always deductible, but the payment against the loan balance is typically so small that most homeowners barely notice it is not deductible. With a 30-year or 20- to 25-year mortgage, the amortization in the early years is minimal.
A dental practice loan works differently. Using a five-year loan with straight level payments of 20% per year and a $1 million purchase price, $200,000 per year is subject to tax. Depending on the state, the buyer’s combined tax rate may reach as high as 55%, resulting in a tax obligation of up to $110,000 annually unless plans are made to reduce it.
What does a buyer do when confronted with this situation?
There should be no reason this tax exposure goes unidentified before closing. If it has been overlooked, however, there is still time to make adjustments. Several approaches can defer the tax or eliminate some or all of it in the near term.
One method is to accelerate the purchase of dental equipment if it is needed now rather than waiting until the equipment begins to fail. Dental equipment loans are not difficult to obtain, particularly through dental supply and equipment representatives. Rates and terms can be shopped by contacting local banks. The bank already handling the practice’s accounts is often a good starting point, since that lender has a relationship to protect. A dental certified public accountant -- a CPA with expertise in dental practice finance -- can also assist by leveraging their lending contacts.
Another approach is accelerating the purchase of inventory and supply items before the end of the fiscal year. Items that would be purchased in the first week of the new year anyway -- small tools, supplies, utilities, and rent -- can be bought in the current fiscal year instead. Each of these smaller amounts may add up to meaningful deductions. A line of credit from the bank can fund these purchases and be repaid after the new year begins.
Perhaps the most powerful strategy is adopting an appropriate employer-sponsored qualified retirement plan before year-end. A deduction can be taken in the current year, while the actual payment can be deferred until the tax return extension deadline. This approach can significantly reduce the net tax due in the year of acquisition.
Each of these methods, used individually or in combination, can substantially reduce the tax burden on a dental practice buyer, but only if the buyer and their advisers are aware of the issue and plan for it well in advance of the closing.
Bruce Bryen is a certified public accountant with more than 45 years of experience. He specializes in providing litigation support services to dentists, with valuation and expert witness testimony in matrimonial and partnership dispute cases. Bryen assists dentists with financial decisions about their practice, practice sales, evaluating whether to join a dental service organization, practice evaluation during divorce proceedings and questions about the future or financial health of dental practices. He is a part of Baratz & Associates PA in Marlton, N.J. and can be reached at [email protected].
The comments and observations expressed herein do not necessarily reflect the opinions of DrBicuspid.com, nor should they be construed as an endorsement or admonishment of any particular idea, vendor, or organization.
