Transitions, Tax Allocations, and Proper Documentation
Consider what's needed for the sale of a laboratory
Every business transition requires careful forethought and preparation, especially the sale of a dental laboratory. Buyers and sellers of this kind of business entity need specialized professional assistance for the tax and legal matters they'll encounter both before and after the sale.
Business Structure Matters
The type of business structure makes an enormous difference when preparing the agreements of sale and any ancillary contract such as employment, non-compete, and nonsolicitation agreements. The laboratory may have been structured as a type of business entity in which the profits and losses have been passing through to its owners on their personal tax returns. It would have been a proprietorship, an S corporation, an LLC, or an LLP, based on whether there were one or more owners. The organizational format may have been such that the laboratory reported its income on which it paid taxes as a separate entity referred to as a C corporation.
If we use goodwill in an example considering the structure of the enterprise was a C corporation, the question of the personal or enterprise goodwill becomes very important since the C corporation paid its own taxes as a separate entity and had its own goodwill. The individual owner or owners have their own personal goodwill, and the sale of that item affords capital gains treatment to the owners on their personal tax returns. Beware of employment contracts for the principals of the C corporation, which tie the owner to the corporation and would negate the argument for any personal goodwill. The difference in tax to the owners can be in the hundreds of thousands of dollars. The pass-through business structure allows the owners to report the income from the sale on their personal tax returns, and the goodwill allocation is not a major problem since the categorization would be that of a capital gain with the lowest tax rate accorded to it. Whether with the pass-through business structure or the owner reporting the goodwill directly, the income will all appear on the owner's tax return regardless, based on the nature of the enterprise.
What Does the Settlement Sheet Indicate?
When one is ready to sell his or her laboratory, it is important to have as much documentation as possible to substantiate the tax treatment suggested by the advisor to the laboratory and its owner. There are questions, however, about the understanding of how and what the financial and tax advisors communicate to give the owner of the laboratory the best income allocation available. This advice begins well before the buyer is obtained so that there's time to make the appropriate plans for the money received at closing and the taxes paid when the laboratory has been sold. Because the laboratory is a capital-intensive and technologically equipped business, the items that the buyer wants to allocate to equipment become a substantial matter of discussion between the advisors to the seller and buyer of the laboratory. In almost all business transitions, the better the federal tax treatment to the seller, the more adverse it is usually to the buyer. An example is the proportion treated as a physical asset such as the equipment at the laboratory. The seller has typically taken most if not all of the depreciation on the items allocated to equipment that the buyer is going to acquire. The laboratory must report what is allocated to the equipment on the settlement sheet in excess of its basis as income. The buyer desires the amount treated as equipment to be at its highest value since he or she can depreciate it all over again. A preliminary settlement sheet should be prepared by the advisors to the buyer and seller to see what appears in advance of the closing date for its review. Of course the agreement of sale should have the same allocation of assets on it with the value assigned to each being equal to that on the closing statement.
Ordinary Income and Capital Gains Tax Treatment on the Sale
The higher the amount that is allocated to the equipment at the closing, the more depreciation the buyer can take as a deduction and the more his or her income will be reduced for tax purposes as an immediate tax write-off. For the seller, the value recorded as equipment in the agreement and on the settlement sheet will become ordinary income to the extent that the value is in excess of its basis (cost minus depreciation) to him or her.
The seller should desire to have as much as possible of the sale price recorded as goodwill or attributed to the stock, membership interest of the company, or customer list and files. This affords a capital gain to the seller. This treatment for the seller of the laboratory increases the tax burden to the buyer in the early years after the transition. The entire concept of tax savings is based on the present value of how the tax savings are used. The more the tax reduction in the first years of the transaction, the more the funds will be available for business growth, debt reduction, or other uses such as lifestyle enhancement much more quickly than if the use of the funds available is delayed.
The Structure of the Enterprise for the Buyer and Seller of the Laboratory
With good advice and excellent advisors regarding tax structure, asset protection devices, and the use of funds, both buyer and seller will have the ability to gain the most use of those amounts that are agreed upon for the sale price. If the laboratory owner has been using the same structure for his or her business for years, it could be too late to overcome any obstacles if the agreements are ready and the financing is in place for the closing to occur. The buyer may then have more of an advantage if this is their first laboratory acquisition and they are willing to implement any business structure that the advisors suggest. The seller may have to be much more creative to obtain the best results. The agreements need to be drafted in such a way that the final documents appear in a consistent format on both tax returns and each presents what was intended. A CPA with experience in assisting laboratory owners will most likely be the advisor of choice for the buyer and the seller.
Tax Disclaimer: Inside Dental Technology and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
About the Author
Bruce Bryen, CPA, CVA, is Principal of RKG Tax & Business Services in Fort Washington, Pennsylvania.