Get Tax Relief Upon the Sale of Your Laboratory
Considerations for both the buyer and the seller
Bruce Bryen, CPA, CVA
As a dental laboratory attains growth in reputation, revenue, and profitability, there comes a time when the owner feels ready for a sale to occur. Whether because the work is becoming too demanding, the ability to find personnel too difficult, or for any other reason, he or she feels that the height of the dental laboratory's value is close at hand. The first step should be a valuation of the laboratory's net worth. This is important because even though the laboratory owner has an excellent understanding of how to evaluate his or her own business performance, an outside evaluator will do so without any bias. Once the value is accepted by the owner, the steps to take place typically start with a CPA; an attorney who understands the specifics of the dental laboratories' world and their clientele, the dentists; and the engagement of a business broker.
Good and Bad News from the CPA
The owner wants to receive the highest price and the best terms possible for all of his or her long hours and money invested in the dental laboratory over the years when the transition occurs. The large capital investment in technology and equipment was a must for the laboratory to have maintained its competitiveness. It is important for the seller to understand that in the transition process, the CPA will play a very important role in assisting the owner. He or she will explain that what remains after all of the costs of the settlement with the buyer is what really counts for probably one of the largest receipts of funds in the dental laboratory owner's life. This, though, is really only one of the starting points in determining what remains because the biggest cost to the seller will probably be the total of the state and federal taxes that come from the proceeds. Another point to consider for the laboratory owner is that when negotiations are taking place among the advisors for the owner, a positive allocation of the purchase price for one party will result typically in a negative result for the other regarding the income tax allocation. An example would be a capital gain to the selling laboratory owner would result in a less favorable income tax treatment to the buyer. The attribute of goodwill for the seller, which is treated as a capital gain, results in the buyer receiving a less favorable tax treatment regarding his or her own taxes. Capital gains typically have the lowest tax rate available, so a seller would be happy. For the buyer, the acquisition of goodwill has a 15-year write-off period. This is a very long term for a buyer, especially if the transition loan is less than 15 years. Hypothetically, if a buyer is able to obtain a 10-year loan, it means that there are 10 years of loan payment and 15 years of tax write-off. Since the principal portion of the loan payment is not deductible to the buyer, the use of the goodwill write-off is a critical piece of tax planning for him or her.
Using some hypothetical dollar amounts from the above description, a clearer understanding may wake up the buyer to the realities of how important a tax allocation is for maintaining the most available funds from the closing. If the net gain after payment of commissions, professional fees, and other closing costs equals $500,000, the seller will hypothetically pay about 26% in federal and state taxes ($130,000), assuming that he or she lives where there is a state tax. That means that the seller will have 74% of the $500,000, or $370,000 for use in retirement, lifestyle expenditures, etc. For the buyer, if the purchase price was $600,000 hypothetically, because the seller's costs before tax included a 10% commission besides other settlement costs including legal, accounting, etc., and if the buyer borrows the $600,000 for 10 years, the buyer is paying about $60,000 per year in principal. If 100% of the purchase price is allocated to goodwill in this hypothetical example, that write-off over 15 years allows the buyer $40,000 per year of that goodwill for each of the next 15 years. For 10 years of the loan payment, the buyer has a write-off of $40,000 for the goodwill and must report $60,000 of principal each of those years for a taxable amount of $20,000 per year for 10 years ($60,000 principal payment that is not deductible minus $40,000 of goodwill that is). As the seller is getting his or her hypothetical gain, which is treated as a capital asset, and has a 28% overall tax rate, the buyer reports $20,000 as ordinary income from the dental practice and pays a tax rate equaling close to 56%, or approximately $11,200 per year. That percentage includes the doubling of self-employment tax of about 15%. The buyer is almost paying as much tax as the seller as one compares the seller's tax of approximately $130,000 to the buyer's tax of $112,000.
One may argue about the fact that the seller may have a low basis in his or her equipment and technology and may have no gain on that amount. The concept here is the hypothetical allocation and any allocation can be changed to benefit either party to the transaction. That is the whole point of this exercise.
There are many twists and turns along the way to the transition. The most important thing is to not lose sight of the goal, which is to have a successful transition of the dental laboratory and to be prepared for a different lifestyle if that is what the seller desires. If the owner wants to continue working in the field, there are ways to resolve the issue of the tax for both the buyer and the seller. Of course, a general hypothetical description does not fulfill the understanding of what approaches are available to change the result of the large tax burden. Specific information and creative ideas can come from the CPA for both the buyer and seller.
As an idea to discuss with the CPA, the concept of the use of a retirement plan for the deferral of tax for both the buyer and seller should be something to spend time contemplating. For the experienced CPA with expertise in this type of undertaking, the potential to defer more than $100,000 for each party based on a hypothetical sale of $600,000 and the above allocation is certainly worth considering. There is almost always a tax to be paid, but in understanding the concept of the use of the present value of a dollar, the CPA should be very helpful. To be more specific, if a seller agrees to continue for a while, he or she would hypothetically maintain almost the entire $500,000 to invest while the buyer would defer the $11,200 per year until retirement. The use of certain types of retirement plans and the adoption into the operating format of the dental laboratory is a must for the buyer and seller to seek advice about from those who understand this type of approach.
About the Author
Bruce Bryen, CPA, CVA, is the principal in the firm of Baratz CPA and Associates in Fort Washington, Pennsylvania.