Most dental practice advisers recommend using a capital gains methodology for practice transitions. This approach treats the sale as capital assets changing hands, allowing owners to report the transaction as a capital gain -- the lowest tax rate available compared to ordinary income treatment. The capital gains approach can reduce a seller's taxes by half or more compared to ordinary income methods, depending on the state.
Bruce Bryen, CPA, CVA.
However, there's another transition method that can reduce income taxes even further, making the seller's tax burden minimal, even compared to capital gains treatment. This method is more complex, but understanding it is worth the effort.
An experienced dental certified public accountant (CPA) who comprehends these complexities and can explain them clearly is essential. The dentist's attorney should listen carefully and support the dental CPA's guidance. It's also critical that the dental CPA has tax expertise and has attended many dental practice closings.
What is this approach?
The basic concept involves creating an expense and using it to write off money for tax purposes while keeping those funds secure. Instead of paying the seller for an asset and classifying the payment as a capital gain, payments are made to a defined benefit retirement plan on the seller's behalf. This requires considerable preparation to ensure everything is handled properly.
First, a qualified employer-sponsored defined benefit plan must be adopted on behalf of the dental practice. Based on employees' ages and compensation, most of the practice's deductible contribution will be paid to the retirement plan for the selling owner.
The dental CPA works with an actuary to design the plan accordingly. This payment becomes a practice expense. Since the selling owner isn't yet receiving the money, it's not taxable to them. The funds in the retirement plan are protected from creditors. Income and stock appreciation aren't taxable until distributed to the owner, at which point distributions are taxed at ordinary income rates.
A hypothetical example
Consider a practice with a $1 million gross sales price. If the owner, like most dentists, drew out profits over the years, the sale's basis would be zero for these purposes. The sale price minus brokerage commissions, legal fees, and taxes would leave the owner with about $625,000.
Assuming the owner's prior compensation was high, and they're in their 60s, the retirement plan contribution on their behalf would be about $200,000 annually for at least five years. At 4% interest, by Year 5, the retirement plan would hold over $1.1 million for the owner.
The money would be disbursed over the owner's remaining life expectancy, beginning at their normal retirement date. The owner could expect to receive about $200,000 annually for up to eight years, subject to their tax rate at that time.
The payout would be this high because the former owner would still earn tax-free income on amounts remaining in the retirement plan. This represents enormous savings for the seller and guarantees future income, allowing the dentist to spend their remaining years as they see fit with substantial guaranteed funds available.
Additional advantages
Under the best traditional sale methods, a dentist would start with about $625,000. Using a properly written qualified employer-sponsored retirement plan, the selling dentist would have about $1.1 million.
Other financial (and emotional) benefits include creditor protection while funds remain in the retirement account. This may prove helpful if the dentist borrowed considerable funds to invest in something like a shopping center or development promising large returns.
If the investment underperforms and the lender demands payment or threatens legal action, that lender can sue the dentist and attach personal assets, but not retirement plan assets. The ability to pass assets to heirs is also enhanced since retirement plan funds aren't involved in lawsuits, which skilled attorneys can delay for years.
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 can be reached at [email protected].
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