A dental practice is sold for a variety of reasons: retirement, moving to another city, or even because of health issues. Regardless of the reason, it is critical to consider the tax ramifications of the sale. Depending on the type of assets sold, the seller can pay federal and state taxes of up to 40% of the gain. For example, a majority, if not the entire amount of the equipment sold is likely to be taxable at the highest rates for both individual and corporate owners. This is because most dental equipment is written off in the year of purchase or depreciated over a 5 to 7 year period. Therefore, there is usually a minimal amount of basis in the equipment at the time of sale.
If a corporation owns real estate, the gain is taxed at the highest corporate rate. If an individual owns the real estate and leases it to the corporation or other legal entity, the tax on prior depreciation is 25% and the gain in excess of depreciation is 20%. Goodwill, patient records, and accounts receivable are also assets usually included in the sale of a dental practice and will be taxed at the 20% rate. Needless to say, the tax liability can be substantial resulting from an outright sale.
Example of an outright sale of a practice and resulting tax liability::
Equipment: $120,000 gain X 40% tax rate = $48,000
Receivables: $ 20,000 gain X 20% tax rate = $ 4.000
Records: $ 90,000 gain X 20% tax rate = $18,000
Real Estate $250,000 gain X 20% tax rate = $50,000
Goodwill $115,000 gain 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 is a way to defer these taxes until well into the future. It is called a Section 1031 tax free exchange.
Deferring taxes through a tax-free exchange
Section 1031 of the Internal Revenue Code has been in existence since the early part of the 20th century. If you purchase “like-kind” property within six months of the sale of the practice, your taxes will be deferred, as long as the various rules are satisfied. There are two time periods involved. The first one, 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. That needs to occur within 6 months after the sale of the practice.
Exchanges can be either total or partially tax-free. If you have sold your practice and are purchasing another one, it would qualify as a total exchange if you are purchasing a more expensive practice. If it is less than the sold assets, you it would result in a partial exchange and some taxes would be due. Another example of a partial exchange is one in which a practice is sold which includes real estate and the dentist subsequently purchases an apartment building for income property. If the building cost was greater than the real estate sold, no taxes would be due on that portion. Taxes would be due on the other assets sold.
Section 1031 tax-free exchanges are a great way to defer or in some cases eliminate tax liability. It is very important to follow the rules to the letter. Therefore, it is advisable to seek the guidance of an experienced attorney and/or CPA before implementation.