Dentist practices are sold for many reasons: retirement, moving to another city, or even health problems. Regardless of the reason, it is very important to consider the tax consequences of the sale. Depending on the type of asset being sold, the seller may pay federal and state taxes of up to 40% of the profits. For example, the majority, if not the entire amount of equipment sold is likely to be taxed at the highest rates for both individual and corporate owners. This is because most dental appliances are written off in the year of purchase or are depreciated over a 5 to 7 year period. Therefore, there is usually little base on the equipment at the time of sale.
If a company owns real estate, the profits are taxed at the highest corporate rate. If a person owns real estate and leases it to a corporation or other legal entity, the tax on prior depreciation is 25% and gain over depreciation is 20%. Goodwill, patient records and accounts receivable are also assets normally included in the sale of a dental practice and will be taxed at a rate of 20%. Needless to say, the tax liability can be substantial as a result of direct sales.
Examples of direct sales from practice and resulting tax liability::
Equipment: $120,000 profit X 40% tax rate = $48,000
Accounts Receivable: $20,000 Profit X 20% tax rate = $4,000
Note: $90,000 profit X 20% tax rate = $18,000
Real Estate Profits $250,000 X 20% tax rate = $50,000
Goodwill profit $115,000 X 40% tax rate = $46,000
As you can see, the total tax liability of $166,000 on this hypothetical sale is staggering, but there are ways to defer this tax into the far future. This is called a Section 1031 tax-exempt exchange.
Deferring taxes through tax-free exchange
Section 1031 of the Internal Revenue Code has been around since the early 20th century. If you purchase a “like” property within six months of the practice sale, your taxes will be withheld, as long as various rules are met. There are two time periods involved. The first, called the identification period, requires the selling dentist to identify one to three replacement properties within 45 days. The second period involves the actual purchase of the property. It needs to happen within 6 months of the sale of the practice.
Exchanges can be totally or partially tax free. If you have sold your workout and bought another, it will qualify as a total exchange if you buy a more expensive workout. If it’s less than the assets sold, you’ll earn a partial exchange and some taxes will be due. Another example of a partial swap is where a practice is sold that includes real estate and a dentist then buys an apartment building for income property. If the cost of the building is greater than the real estate sold, no tax is payable on that portion. Tax will be payable on other assets sold.
Section 1031 tax-free exchanges are a great way to delay or in some cases eliminate tax obligations. It is very important to follow the rules for the letter. Therefore, it is advisable to seek guidance from an experienced attorney and/or CPA prior to implementation.