In explaining a pretax transition, it is important to understand that there are really two types of dental practice transitions. The author explains.
In explaining a pretax transition, it is important to understand that there are really two types of dental practice transitions.
One is known as an after tax transition and the other is the pretax transition. Many buyers don’t realize how expensive it is for them to acquire the dental practice from a tax perspective. The acquirer typically thinks of the seller as having the tax issue upon the sale. The buyer doesn’t usually think of his or her tax consequence of a payment to the principal amount of the loan used for the transition price. In most cases, the buyer has a tax upon the payment of the amortized portion of the loan that is at the ordinary income tax rate from a federal, state and local standpoint. This means that, depending upon the state in which the transition occurs, the tax to the buyer may be up to 50% or more. This is because the type of income added to the buyer’s other income at ordinary tax rates boosts the tax bracket of the buyer.
Example of the tax cost to the buyer during a transition with an after tax approach
The cost is illustrated in this example. Suppose the purchase price of a transition is $500,000. If a buyer is advised properly as to his or her tax cost during an after tax approach, it will probably come as a shock to learn that the $500,000 transition price could end up costing $1 million. A simplistic understanding of this after tax approach revolves around the payment of the loan amount after income is reported by the buyer at ordinary income tax rates. In order to pay $500,000 against the loan principal, the buyer must earn $1 million so that $500,000 can be paid in federal, state and local taxes. This leaves the buyer the $500,000 to pay against the loan amount. This results in the buyer accumulating no money after earning $1 million. As described, the after tax approach is very expensive to the buyer.
An example of the pretax cost during a transition to the buyer
Using a pretax approach for a transition, a buyer pays the purchase price of the dental practice with minimal federal, state and local tax. This is how the pretax methodology occurs. The buyer uses the dental practice for the most significant allocation of the payment for the purchase price. If the items included in the allocation of the price for the dental practice are tax-oriented, they can be written of against the income of the dental practice. An example would be the use of a defined benefit plan such as a cash balance plan, to create a charge to the income of the dental practice. Equipment allocations in the purchase price at market value and any type of ordinary compensation to the seller become ordinary tax write-offs for the buyer and reduce the taxable income of the dental practice that passes through to the buyer’s reportable income. The unfunded liability created to decrease the value of the dental practice with the creation of the amount due for the retirement plan payment, assists as well with deductions against the worth of the practice. The liability created must be prior to or simultaneous with the acquisition since the debt owed by the practice would not be owed prior to its creation and sponsorship by the practice.
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What is the effect on the seller with a pre tax transition?
Remembering that a buyer alone can’t consummate a transition, what does the seller get out of a pretax transition? If a tax-deferred concept is used, such as a deferred compensation plan, a seller can use a calculation comparing a capital gain to the accumulation of funds in the retirement plan for comparison. With a capital gain under a best case scenario, suppose a sale took place at $500,000 and the entire transaction was considered a capital gain. If the gain was in a state with a high tax base such as New Jersey, the federal rate would be about 20% and the state rate would be about 8%. So a sale at $500,000 would have a tax cost of 28% and leave 72% for the seller. ($500,000 x 72%) leaves $360,000 for the seller. With a tax-deferred situation, almost the entire $500,000 is contributed to the retirement plan. The earnings are not taxable until withdrawn. With a minimum of three years at 4% or $20,000 per year, there would be $560,000 for the seller to begin drawing.
How is this pretax approach completed?
Contact a dental CPA for expertise in explaining and implementing this strategy.
Editor's Note: Image via Shutterstock