An innovative approach to reducing the tax burden for the buyer and seller when a dental practice is sold that has used conventional financing for its acquisition.
By: Bruce Bryen
When the principal payments on the loan are paid by the buyer of a dental practice, they become subject to tax.
The seller knows that if the buyer uses a loan to acquire the dental practice, they will receive a capital gains treatment for the transaction and will pay a capital gains tax.
To give an example for the buyer in an instance similar to the purchase of the dental practice and the tax coming due, would be if the dentist acquires a house. If they use a mortgage to assist in the acquisition, the principal payment is not deductible and the interest payment is, similar to the dental practice.
Both of these payments come from the dentist’s income. The term of the mortgage is much longer than the term of the dental practice loan so the principal payment on the mortgage loan may not feel like much of a tax to the dentist.
This is especially true since almost all of the payment for the first few years is interest and therefore tax deductible. When the principal payment is paid on the dental practice loan because its term is much shorter than the mortgage loan its principal payment is much more. The tax will be much higher and it will appear sooner than the mortgage principal payment tax.
The advisors to the dentist will look for ways to reduce the tax to the buyer and not cause a tax to the seller. The only way to make this happen is for the buyer to have a payment that is deductible and not a principal payment on a loan. Is there a way to make this happen?
How a buyer can create a much lower tax for themselves when the acquisition of a dental practice has occurred
After a lot of input from the advisors to the buyer and the seller and an acceptance of the concept that principal payments hurt the buyer from a tax perspective, the seller wants to know how this idea assists the seller.
There would be no practice acquisition loan. The buyer would start by forming his or her own dental practice with whatever type of business structure that is desired. It can be an LLC, S corporation, C corporation, or any other type of business entity that is desired.
Once this has occurred, the next step is for the dental practice to adopt an employer-sponsored qualified defined benefit plan or a cash balance retirement plan for the dental practice and its employees, including the seller of the dental practice.
In the event that the seller is fifty years old or older, it is probable that the dental practice may have a tax-deductible contribution to the retirement account in excess of $150,000 per year. This amount would be allocated to the seller’s own retirement account. Compare that tax deductible amount to the $150,000 principal payment on a loan that was used for the acquisition of the dental practice.
Based on the state in which the dental practice resides, there can be a tax of 50% or more. When you double Social Security tax and medicare tax for the owner, federal and state income tax, there can easily be a $75,000 annual tax that would have been due that is now not due since the $150,000 is now deductible and is not part of the principal payment.
Hypothetically if the buyer took advantage of the retirement plan deduction for 7 years, $525,000 would have been saved. So why is this idea also good for the seller and what does the seller get out of it that would make him or her want to go ahead with the plan?
What does the seller get out of this? Is it better than selling and getting a capital gain and capital gain tax treatment?
From the seller’s perspective, he or she must receive an amount with safety that is a better return over the same number of years as what he or she would have gotten from the outright sale with a closing involving a lender to the buyer and a closing that will occur within the same time frame as the conventional bank closing.
If the retirement plan takes effect and is approved by the IRS, there is safety for the seller in that the dental practice will be guaranteeing the payment to the retirement plan, and will also be guaranteeing the lump sum available to the seller when he or she is ready to take the money out of the retirement plan. There are other advantages for the seller.
One is that the investment in his or her name is personal and not in the retirement account and is subject to being able to have creditors seize the account. The funds that are in the retirement account on behalf of the seller are immune from creditors as long as the funds are in the account. This may be appealing to someone interested in real estate investments where there may be an obligation to sign personally on large amounts of loans.
Let’s look at the seller’s position and compare it to the capital gain that he or she would have received from an outright sale with the buyer getting conventional financing.
With a conventional loan to the buyer and no basis for the seller, a hypothetical sale price of $1,000,000 would generate a tax of about $350,000 based on the state in which the dental practice resides.
At 3% it would make available $136,500 for a total of $786,500. With the retirement account, there would be $525,000 in it, and at 7.5% tax-free (earnings and appreciation in the retirement account are not taxable until withdrawn) for seven years, the $525,000 plus $275,625 in accumulated earnings would equal $800,625.
There would also be $475,000 minus a 50% tax of $237,500 or an additional $237,500 available to the added to the $800,625 to total $1,038,125. The retirement plan also is immune from creditors. The dentist can file a bankruptcy petition and the funds in his account in the retirement plan can not be touched.
Photo by Andrea Piacquadio
