Tips to Reduce the Tax Upon Transitioning the Dental Practice

ANDREY POPOV / STOCK.ADOBE.COM

When most dental practice owners and advisors think of a retirement plan, they are looking at the current and future year’s income tax and planning for the eventual transition of the dental practice once they retire. This is when the dentist’s expected annual income will decrease, and the deferred compensation accumulated without tax in the retirement fund will be used for the peaceful life the dentist and their partner expect to enjoy.

Of course, this is a wonderful plan for the current and future income tax and retirement plan savings and will put the tax bite on the lower level each year the dentist is working while building up an endowment for future economic benefits. When this time comes, the selling dentist and their advisor will almost always look for capital gains tax treatment to obtain the lowest current tax possible on the sale.

This always creates a problem for the buyer of the practice, as the capital gains tax to the seller almost creates an ordinary income tax for the buyer. This is because amortizing the allocation of the purchase price to a capital asset, such as goodwill, for the buyer is a 15-year write off term against their ordinary income, whereas the seller has a low tax rate via the capital gains tax treatment. If the buyer wants the practice badly enough, they pay the highest tax over a short term to obtain it.

These following paragraphs report a sophisticated approach to a transition that offer a unique way for the seller of the dental practice to defer taxes for a long time and enjoy more funds than the capital gains tax treatment affords. The tax comes from money that would not exist, except for this approach, and the tax after subtracting the money earned is less than the capital gains tax. It also assists with the allocation of the purchase price, so the buyer and the seller each gain substantial savings and an accumulation of funds.

How Can Taxes Be Lessened So the Buyer and Seller Each Benefit From the Transition?The advisors and dentists have created ideas by using the retirement plan to create a current tax savings boon for the dental practitioner. The transition framework of the dental practice can be designed, so the seller receives a better than capital gains treatment upon the closing based on the funds accumulated, which would not have been available had the capital gains tax been paid. The buyer also receives a definite improvement to their tax treatment once the transition occurs since more ordinary income tax write offs occur for the buyer. The plan to do this for the buyer and the seller of the dental practice is to use a similar mechanism for the transition as during the operating years of the dental practice.

It may be that the seller had a 401k/profit sharing plan in place during the career as a practicing dentist. In a typical sale, assuming the selling dentist is older, a new type of retirement plan would probably be used to substantially reduce the current tax on the sale. The type of retirement plan would most likely be a defined benefit plan where the gist of the formula for write offs is one where age is an important ingredient as to the amount of money. Unlike the 401k/profit sharing plan or a Simple IRA where statutory amounts are predetermined, the defined benefit plan works on a formula based on age, compensation, years of service, and other important ingredients to allow for higher contributions to the seller, who is older and has earned more than the other employees.

How Does This Occur?
An example of the mechanism of deferring and funding is as follows:

First, a defined benefit plan is adopted by the dental practice that is being transitioned. Based on the staff ages and compensation, it may be that an additional 401k/profit sharing plan is needed for the nonkey employees. Instead of paying the seller the sale price at closing, a contract is prepared along with the adoption of the defined benefit plan to pay the amount over a term but primarily into the defined benefit plan. As an example, if the sale price was $1,000,000 and the seller was in a high state income tax environment, the federal and state tax would be roughly 30%. That would create a tax of $300,000, leaving $700,000 upon the closing. Hypothetically, with the sophisticated adoption of the retirement plan and the contract for funding, approximately $200,000 plus interest would be paid into the defined benefit plan for 5 years and would escape any income tax until the funds were withdrawn. Effectively, the seller upon the transition with a capital gains treatment would have $700,000 to invest. With the sophisticated retirement plan sale adoption, there would be $200,000 per year plus earnings to invest for 5 years, then the balance of the remainder for however long the seller wished. Approximately $1,000,000 would be in the account after 5 years for investing compared with the $700,000 after the capital gains tax.

Additional Information Should Be Obtained to Insure Proper Reporting and Contract Format
This plan is very complex, but if it’s done right, it will save and earn the selling dentist thousands of dollars more than an outright sale using capital gains treatment for taxes. A sophisticated dental certified public accountant with experience in implementing this type of plan should be retained for this purpose. Not only does this benefit the seller but the buying dentist will also save even more than the seller based on the ability to write off large amounts of the purchase price quickly. Instead of the goodwill amortization of 15 years that would have occurred and cost the buyer substantial amounts, a hypothetical 5-year term, as described in the seller’s section, will allow the buyer the same 5-year term of write offs as the payments are being made.

If the advisor retained by the dental practice is in a fog about how this works, someone should be retained who understands how this occurs and should be able to explain it with a common sense approach, so the buyer and the seller have no doubts of its ability to save.