Dentists, like others, enjoy surprises such as surprise birthday parties, anniversary parties, and other surprises that create happiness and good cheer for everyone. One surprise you can be sure that the associate dentist does not enjoy is when he or she discovers that every time a principal payment is made on a loan used to acquire a dental practice, a potential income tax becomes due.
When many dentists look to acquire a dental practice, the commonality among them is that they want to borrow money for the acquisition and pay off the loan as quickly as possible. Even though interest rates have increased over the past few years, they are still low compared to the 1990s and 1980s.
When conventional lenders are offering five-year loan terms at the lowest interest rate available and seven-year loans at low interest rates without regard to the last few years, many financial advisers to dentists suggest borrowing at these low rates. They explain that an enormous amount of interest will be saved and the loan will be paid off as quickly as possible.
Borrowing with a 10-year amortization term will be at a higher interest rate with a longer period to amortize the loan. Hypothetically, a loan for five years may be at an interest rate of 5%, while a loan for 10 years may have an interest rate of 5.50%. The difference of .5% will be paid for the entire 10 years. If $750,000 is borrowed for the practice acquisition, the interest paid over 10 years will be almost double at 5.5% compared to the interest paid over five years at 5%.
Did the buyer and the advisers forget something?
It seems like the buyer and his or her advisers forgot that every time a principal payment is made on a loan, there is also federal and state tax due as well. If the buyer is in the 35% tax bracket, assuming federal, state, and double Social Security tax, since the buyer is the owner and pays double Social Security tax and Medicare tax, the buyer will pay $52,500 per year in taxes or $262,500 over the five years of amortization if the $750,000 was amortized on a five-year term.
The tax payment over a 10-year term would be at a rate of $26,250 per year for the first five years. It would create a positive cash flow to the dentist of $26,250 per year for five years, or $131,250. There would be a small loss on interest payments over 10 years compared to a five-year amortization. The difference will more than take care of the change within federal and state income taxes for the dentist.
What does this mean for the dentist and the advisers? Do they understand the present value of money?
Over the first five years of the loan, there would be an excess amount of cash available for the dentist. What would the dentist do with these funds? What would his or her advisers suggest that the dentist do with these funds?
Is there an employer-sponsored qualified retirement plan for the dentist? If these excess funds were available to the dentist for the five-year period and it was used to fund an employer-sponsored qualified retirement plan, it would save the dentist an additional 35% of the amount saved. It would also be available for state-of-the-art equipment and anything else that the dentist needed for the dental practice or for himself or herself personally.
So, which is the better loan term? The dentist's financial adviser should have a lot to say about which loan term the dentist accepts. Understanding the present value of money is critical when making decisions about borrowing and the term of the loan and interest rate.
Retirement plans are all about the present value of money. The longer you can invest money without paying taxes, the more that money becomes worth. The further into the future you can go without paying a bill, the cheaper that bill becomes.
What else is similar regarding the present value of money and the deferral of taxes into the future?
Nearly every dentist has heard of retirement plans. These are typically employer-sponsored qualified tax-deferred trusts such as a 401(k), a profit-sharing plan, or a pension plan.
The concept is like the above description and would have the dentist's practice pay a determined amount now into a retirement plan. The dental practice receives a current tax deduction, and the funds sit in a retirement plan earning tax-deferred income until later, when the tax is paid. This example explains the concept of the present value of money: low or no taxes today, an investment fund that grows for years, and then a tax many years later when the value of the money in the retirement plan is high but the deferral is worth many times what the tax will be when it is paid.
The important thing is what the dentist does with the money that is not being paid in taxes today. The retirement plan should be invested in relatively safe investments that provide a reasonable rate of return so that funds grow nicely over the years before the tax becomes due a good amount of time later.
If the dentist has trouble understanding the concept, he or she should schedule a time to speak to a dental certified public accountant (CPA) about why this idea is so important for the security and well-being of the dentist and his or her family. If there is not a dental CPA employed by the practice, the financial adviser for the dentist should be contacted.
Bruce Bryen is a certified public accountant with over 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 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.
