Pretax and After Tax Transitions: A Comparison
Bruce Bryen, CPA, CVA | April 1, 2016
Selling a dental practice is one of the most important transactions in a dentist’s career. The taxes incurred by the buyer and seller can affect their living standards forever. I have spent hours explaining the taxes my clients (buyer or seller) will incur based on the allocation of the purchase price and the funds received. Let’s examine the buyer’s side of the acquisition.
The Buyer’s Cost Using an After Tax Transition
Learning what is taxable is a major step. After years of looking at a profit and loss statement for income awareness, many dentists are surprised to learn that debt reduction results in taxable income. I try to use the amortization of a home mortgage as an example where the interest is deductible and the principal is not. The explanation of where the funds come from to pay the principal is always an education for the dentist. The answer is that principal payments can only come from refinancing the mortgage or earning income to pay it. Money borrowed to pay for the transition is taxable as paid because its source of payment is income from the practice. With this understanding, clinicians see an example of an acquisition’s cost to the buyer, which includes almost doubling the tax.
For example, in order to earn the equivalent of a practice purchase price of $700,000, how much must a dentist earn if he or she lives in a state with a high tax rate? Federal taxes, as well as double the amount of social security taxes (buyer pays both employer and employee portions), state taxes, double the Medicare rate as an owner, and any local tax all add up to the effective tax rate. This equals a tax total of almost 50%, meaning that the buyer must earn almost $1,400,000 to pay the taxes and have $700,000 left to amortize the debt.
What Choice Does a Buyer Have?
A buyer can opt for a pretax transition. For this type of sale, the allocation is charged to the dental practice as an operating cost, resulting in minimal tax for the buyer. The item that allows this methodology is the use of deferred compensation to the seller. The most incentive laden plan for the seller is the adoption of a retirement plan where the tax can be deferred, the earnings not taxable until withdrawn, and the entire amount protected from creditors. Using an example where a seller is older than a buyer, the amounts deferred into the retirement account can be as much as 90% of the purchase price.
Does this Make Sense to the Seller?
In the case of a younger buyer and older seller, this situation will work well for the seller because if a seller received cash at closing for the above transaction at $700,000 and the entire transaction was allocated to a capital gain, the lowest tax would be a federal and state rate of about 35%. That means that the seller would be left with 65% of $700,000, or $455,000. If the dental practice adopted a cash balance retirement plan for the acquisition and the practice wrote off the cost of the contributions (up to 90% of the total based on the owner’s age, past compensation, etc.), over $600,000 would be available for the buyer to expense through the practice. The seller would have $600,000 plus the earnings on that amount until withdrawn. If the earnings were at 4% for 3 years, there would be $672,000 available for withdrawal at the end of this term. Compare that to the $455,000 with a cash transaction.
Where Do the Buyer and Seller Begin this Journey?
For the buyer and seller to work through the transition, they should start with an experienced dental CPA who can navigate their needs to create a win-win situation for each.
About the Author
Bruce Bryen is a certified public accountant with more than 40 years of experience. He is the principal in the firm of RKG Tax and Business Services, LLC, located in Fort Washington, Pennsylvania. Mr. Bryen specializes in retirement planning design, income and estate tax planning, determination of the proper organizational business structure, asset protection, and structuring loan packages for presentation to financial institutions. For more information, please visit www.rkgcpa.com.
