Goodwill and its importance to the dental practice owner

When thinking of the dental practice and its value to the owner, one of the most important aspects of the worth of the practice is the amount assigned to an intangible asset-goodwill. Besides the emphasis placed on goodwill and its appraisal as an item of significance, the differentiation between personal goodwill and the enterprise (dental practice) goodwill is an extremely critical point to consider. To define the amount of relevance allocated to each can be the difference between thousands of dollars to the owner when a transition occurs. This can be an associate acquisition or the outright sale to a hypothetical buyer after the practice is listed for sale and when the transaction eventually occurs. When planning the type of format for which the dental practice is organized, the entity decided upon has significance in terms of tax treatment that must be addressed. The allocation of the sale price in terms of asset importance regarding equipment, supplies, inventory, and other items on the settlement sheet is what the advisors to the dentist will strive for in the hope of encouraging the capital gain tax treatment for the seller of the dental practice. Personal goodwill should be the lead in the thought process.

Goodwill and the entity format of the dental practice

Besides all of the other considerations that a dental practice financial advisor or dental CPA may offer, the type of entity format is really one of the most critical. Here are some reasons and the type of business organization that affects the allocation of goodwill and what that assignment of the intangible means:

• The “c” corporation and its impact on goodwill will be the first to discuss. A “c” corporation is similar to a separate being. It has its own tax returns and it pays its own taxes. If there is an employment agreement with the owner, it means that the owner is part of the dental practice and the allocation of personal goodwill upon the sale of the dental practice is almost impossible to achieve. Upon a transition, the goodwill is a dental practice asset, meaning it is enterprise goodwill. The proceeds of the sale go to the “c” corporation and the owner and advisors must try to determine how to distribute the sale proceeds without paying double taxes that are so often the result of a dental practice established as a “c” corporation.

• The “s” corporation is what is known as a “flow-through,” entity. Since this type of organizational format has its activity “flow-through” to the owner, all of the allocations to it then pass through to the owner’s personal tax return and the owner pays the tax rather than the corporation. The income from the “s” corporation appears on the owner’s personal federal tax returns and the owner pays the tax, which is one federal tax. The “s” corporation does not pay a tax. This is significant because the type of tax the owner pays upon the allocation of goodwill is a capital gains tax, which is the cheapest tax that can be paid by the dentist upon a taxable transition.

• The other types of common business entities are the LLP, LLC or schedule c/ sole proprietorship. These are similar to the “s” corporation in that there is only one tax paid and the income “flows through,” to the owner’s personal tax return. The type of tax paid from a taxable sale from the allocation of the personal goodwill is a capital gains tax.

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Other types of business entities used to organize a dental practice

There are other types of business entities organized for dental practices such as hybrids of the above common dental practice formats and others. Whichever sort of business concept is used, it is important that an experienced advisor to dentists is retained to assist in the decision process. There is much at stake upon the eventual sale. This may occur years from the origination of the practice, so the allocation of personal goodwill may be overlooked when the time comes for the sale. A quick example in terms of dollars reflects what a mistake can mean to the owner who has worked his or her entire life and is now ready to retire comfortably after transitioning the dental practice.

An example of the dental practice transition using a hypothetical sale price

Using a hypothetical sale price of $500,000 and ignoring state taxes which are similar no matter what type of business entity is used, the federal tax on the allocation of personal goodwill would be approximately 20 percent of the sale price, or $100,000. If the sale price is $500,000 and there is no personal goodwill, the allocation is probably ordinary income. The owner would most likely have the following tax scenario: There would be double social security and Medicare on a portion of the sale price at $137,700 x 15.3 percent, or $21,068 in 2020. The portion of the Medicare tax of 1.45 percent x 2, as the owner, is unlimited so that after the $137,700 social security maximum taxable amount, the difference between that and the hypothetical $500,000, or $362,300 is taxed at the rate of 2.90 percent. That amount is ($362,300 x 2.9 percent) $10,507. There is one more self-employment tax based on the amount earned in excess of $250,000, assuming the taxpayer is filing a joint tax return. In this hypothetical case, the amount is an additional $112,300 x .9 percent or $1011. This all happens if there is no personal goodwill taxed at capital gains tax rates but at ordinary income rates. Besides federal income tax at approximately 35 percent, the owner upon the transition, owes an additional $21,068 plus $10,507 plus $1,011 ($32,586) and will be taxed on the gain at ordinary income tax rates and not at 20 percent, the capital gains rate. That taxable rate will be approximately 35 percent on the $500,000, or $175,000.

Analyzing the difference between a transition with personal goodwill and where there is no personal goodwill

Now one can see that the capital gains tax where the allocation of personal goodwill is available, results in a tax of approximately $100,000, or 20 percent of the $500,000. When there is no personal goodwill and based on the type of entity format, the tax can be as high as $32,586 for self-employment and Medicare taxes plus an additional 35 percent x $500,000, or $175,000 in ordinary income tax. The tax without an allocation for personal goodwill is $207,586.   It pays to consult with a dental CPA or financial advisor prior to deciding upon which business entity to use.