When a client sells, or prepares to sell, a small business such as a dental, medical, veterinary or similar practice, stakes are high for the advisor, as well as the client.

You, as the advisor, have a unique opportunity to cement both your relationship with the client and your position as a high-value-added advisor.

Mostly, you have the opportunity – if you plan in advance – to capture assets under management. You can do this while enabling your client to keep much more of his or her hard-earned wealth, as compared to how much the typical dentist, doctor or vet keeps when the practice is sold.

What to Look For

Many dental, medical or veterinary practices are organized as S-corporations. S-corporations have some tax benefits while the dentist is in practice (such as avoidance of corporate tax), but can present tax problems or obstacles when the practice is sold.

In most cases, the best outcome upon the sale of a dental practice is long term capital gain tax treatment. In high-tax states, long term capital gain tax can easily result in a tax of 1/3rd or more of the gain. Most clients find it extremely painful to find that 1/3rd of their life’s work disappears. As an advisor, if you can show the seller how he or she can avoid the tax pain, you’ll be in a good position to keep that client forever.

Analyze the Assets

A typical dental, medical or veterinary practice will own (and sell) one or more of the following assets:

1.                 Equipment

2.                 Real estate and/or a lease

3.                 Client list

4.                 Goodwill

If the entire enterprise (such as S-corporation stock) is sold, the seller will typically be taxed on capital gain income.

However, few buyers will want to purchase S-corporation stock. Instead, they will prefer to purchase assets. Thus, the seller will typically still own the S-corporation, and the S-corporation itself will sell the assets.

Each of these assets may be taxed differently, both to the seller and the buyer.

Recapture

The sale of assets creates the potential for tax surprises in the form of depreciation recapture. For example, while a dentist was in practice, the practice will probably have purchased equipment (chairs, dental equipment, x-ray machinery, computer systems, and the like).

Almost certainly, those assets will have been depreciated. The catch is that when those assets are sold, the full amounts that were depreciated must be “recaptured” and taxed. The rate of recapture tax on most assets that are not real estate is the ordinary-income tax rate. This tax on recapture can come as a nasty surprise, and drive the total tax rate for the seller above even the already high capital gains tax rates.

In addition, if the practice owns real estate (if you are planning going forward, it will almost always make sense for the real estate to be owned outside of the practice), and that real estate is part of the sale, the accumulated depreciation will be subject to recapture tax. The rate on recapture tax is currently 25% on real estate, as compared to the 20% top federal tax rate on capital gains.

A Better Tax Outcome

If the practice is an S-corporation, and both the situation and your client’s goals line up, it may be possible to entirely avoid tax on the S-corporation’s sale of assets. The solution is to have the corporation use a tax-exempt Business Owner Trust inside the corporation.

If the corporation contributes less than “all or substantially all” of its assets to the tax-exempt Business Owner Trust, the trust can sell the assets tax-free. The trust, properly structured, will then be able to distribute income, or accumulate it tax deferred, for decades into the future.

If the practice, or certain assets, are owned individually, there is also the opportunity for the seller to take advantage of the tax-free nature of a Business Owner Trust.

Personal Goodwill

Many dental practices have a significant aspect of goodwill associated with the primary dentist’s name. In these cases, there may exist personal goodwill, which if owned outside of the S-corporation may present additional important planning opportunities. This will be the subject of another post.

To Learn More

Cases involving assets owned inside closely held corporations – such as dental practices — often present significant planning opportunities. The solutions will typically involve more than one facet. See here to learn more about tax-exempt Business Owner Trusts, or call 703 437 9720 and ask for Connor or Dave.