Looking for the Best Sale
Tax deferral on a laboratory sale or acquisition can net bigger gains.
By Bruce Bryen, CPA
Any savvy shopper knows that to find the best sale, one must carefully research the options and make sure to take advantage of cost-saving resources. The same could be said for those on the other end of the transaction who are looking to make the best sale. The traditional approach to selling or acquiring a laboratory business may not always be the most cost-effective or advantageous choice for the seller.
Considering the tax implications in a conventional sale or purchase can result in a lower net price for the laboratory buyer and more net money for the seller. When deciding whether to go with an after-tax method or a pre-tax approach, the laboratory owner must carefully consider the pros and cons of each.
Most sellers want as much of the sale price as possible allocated to capital gains because the rates are much lower than ordinary income tax rates. Besides the sale of the equipment, the largest allocation of value is likely to be designated to the laboratory’s goodwill. Its customer list, income stream, name in the community, and other intangibles will be allocated to goodwill in the sales agreement if the seller has his or her way. The value of the business will be determined and the debt subtracted to arrive at a net selling price.
If the assets of the laboratory are sold and value is allocated to those assets, the amount allotted to goodwill will be considered a capital gain. The buyer writes this allocation off over 15 years. So, for example, if the buyer used a 10-year bank note to pay for the acquisition, he will have to pay taxes on a certain amount each year.
If the purchase price were $300,000 and the entire purchase were allocated to goodwill in this example, the buyer could write off $20,000 per year ($300,000/15 years) for goodwill. If the bank note of $300,000 is for 10 years, then the buyer is paying principal payments of $30,000 per year ($300,000/10 years). For the term of the bank loan, the buyer has an annual write-off of $20,000 from the goodwill but must pay $30,000 on the bank note. The net write-off for 10 years is a negative of $10,000 ($20,000 write-off minus principal payment and no-write off of $30,000).
In states like New Jersey and New York that have a federal and state tax rate of about 50%, where the owner pays both halves of social security and Medicare, the first $20,000 of earnings would be used to pay $10,000 in taxes and the other $10,000 to pay the bank debt. This means that for the bank term of 10 years, the buyer will be reporting an additional $20,000 per year of income in order to pay the bank debt and the taxes on the non-deductible portion of that payment. During the 10 years of the bank loan, the buyer will have reported $200,000 of income—$100,000 that the buyer would have paid taxes on and $100,000 of the bank debt that would have no deduction against it. Interest is considered a deduction. This is an example of the traditional after-tax approach to the sale of a laboratory. The seller receives capital gains treatment, but the buyer needs to earn $20,000 per year for the first 10 years just to pay the bank debt and the tax on the portion that is not deductible.
In a pre-tax approach, the seller may employ the use of a qualified retirement plan so that the payments received would be tax-deferred. This type of scenario reduces the value of the business so that the purchase price is lower, net of the extra debt just incurred. The additional debt comes from creating a liability from the laboratory due to its retirement plan. This is sometimes called an unfunded retirement liability, and it is the responsibility of the laboratory to pay this liability so that it reduces the business value. Unlike the bank debt, the payments made by the buyer become tax deductible since they are now considered an operating expense. In this situation, the additional debt is payable indirectly to the owner of the laboratory via the qualified retirement plan. The seller must wait to receive the proceeds, but they are tax deferred and protected from creditors while in the retirement plan, plus the income earned is not taxable until withdrawn.
This approach works well when the seller can wait for the bulk of the money. The effect of the deferred collection will result in a larger amount of money for the seller because the earnings are tax-free so they accumulate faster than in a personal account, where they are immediately taxed. Of course, each person’s situation is different and an advisor should be consulted to discuss this approach. Compared to a lump sum capital gain, the disbursement from the qualified dental laboratory retirement plan is ordinary income. However, the tax on its withdrawal will be paid by income that has been earned while the funds are invested in the plan.
Bruce Bryen, CPA, is managing partner of Bryen & Bryen LLP, Certified Public Accountants in Marlton, New Jersey.