Editor’s note: I recently read a thread on an industry forum with this exact title – Taxes on Practice Sale. The doctor-owner wanted to know how much of his dental practice sale would be capital gains versus ordinary income. Sound straightforward? It’s not. The answer lies in the legal status and other factors unique to every practice.
To uncover the questions the doctor should have been asking, we tapped Brittany Burke of Centri Business Consulting. Before Centri, Brittany spent nearly a decade at KPMG. She now advises on healthcare M&A transactions day in and day out. When Brittany offered to share her perspective on how taxes impact practice sales, I said yes immediately.
In This Article
- Selling a Spa or Healthcare Practice – What to Know Before You Begin
- What is Purchase Price Allocation, aka an IRC Section 1060 Allocation?
- Why does Purchase Price Allocation Matter?
- How is Goodwill Taxed? / Is Goodwill Taxed at a Capital Gains Rate?
- Depreciation Recapture defined
- Why does depreciation recapture matter in medical practice sales?
- What is an F Reorganization?
- Why does an F Reorg matter?
- Summary
Selling a Spa or Healthcare Practice – What to Know Before You Begin
You may know that some of the income recognized on a practice sale is taxed as a capital gain and some is taxed as ordinary income. (The highest capital gains tax rate is currently 20%. The highest ordinary income tax rate is currently 37%). But you may not be sure how much of the proceeds from your practice sale goes into each.
Before we dive into capital gains and ordinary income, note that a practice sale is taxed based on how the practice is set up legally and what elections are made on how to tax the legal entity. The most common tax classifications of legal entities in the healthcare space include:
- disregarded entities (one owner),
- partnerships (two or more owners), and
- S-Corporations (“S-Corp”).
If the practice is set up as a C-Corporation, the practice sale will be taxed differently (something we will not be diving into in this article as it is not as common in the healthcare practice space).
- If a practice is a disregarded entity or a partnership, the owner or partners will be taxed directly.
- If a practice elects to be an S-Corp (note that there’s a multitude of rules that you must follow to maintain your S-Corp status which will be an important factor as we dive in), the tax flows through to the owners directly as well.
Whether your MedSpa or healthcare practice is classified as a disregarded entity, partnership, or an S-Corp, there are at least three tax terms you’ve likely never heard of that you’ll hear during your practice sale.
Purchase Price Allocation
What is purchase price allocation?
Purchase price allocation, also known in the tax world as an IRC Section 1060 allocation, is the process of assigning a price or value to individual assets, like equipment. Before the close of a practice sale, a preliminary purchase price allocation for all of the assets of the practice is performed but is often not finalized until after closing. The work is tedious – every laser, chair, and instrument gets assigned a value. Who performs the purchase price allocation is negotiated in the purchase agreement but both the buyer and seller ultimately need to agree on the final purchase price allocation and report it in each of their respective income tax returns.
After valuing all the existing individual assets on the balance sheet, the remaining value of the practice is allocated to intangibles or goodwill, which will make up the majority of the practice value in most cases. For example, we are currently selling a client’s dental practice for $7.5MM, but there is only $600K of value in existing assets on the balance sheet. $6.9MM of the value of the sale is goodwill.
Oftentimes, the price of all of a practice’s assets and equipment make up – at most – 20% of the practice value. In this case, it was much less.
Why does it matter?
You’re going to have equipment on your balance sheet and that’s going to be worth some amount of monetary value. But again, most of your value is going to be
- the brand that you created,
- your customer lists, and
- the name recognition in the area.
Those are the intangibles and “goodwill”.
How is Goodwill Taxed? Is Goodwill Taxed at a Capital Gains Rate?
Goodwill will be taxed as a capital gain to the seller. The gain on the other items is probably going to be taxed as ordinary income. This is the difference of being taxed at 20% vs. 37% (assuming the highest tax rates apply).
It is extremely important in medical practice sales to have accurate balance sheets and supporting schedules that report all of the assets included in the practice sale. These balance sheets are often used as a starting point for the purchase price allocation or IRC Section 1060 allocation. Worthless assets or assets not included in the sale of the practice should be carved out so that it is clear that no purchase price would be ascribed to these assets.
Assets that result in capital gain vs. ordinary income might sound straightforward, but things get sticky with nuances like …..depreciation recapture.
Depreciation Recapture
What is depreciation recapture?
As you use the tangible assets (not including real estate – those rules are different) in your practice – lasers, chairs, etc. – they depreciate, or lose value, over time. The IRS offers nuanced guidance on how you, as a practice owner, should capture that depreciation on your taxes each year. Generally speaking, depreciation allows practice owners to lower their ordinary taxable income, which results in a reduction to the tax basis in these assets.
For example, let’s say you’re selling a spa. You bought a laser four years ago for $500,000. The IRS says that the depreciation on the life of the laser is five years (note that this is an example and not the actual tax depreciation rules).
So each year, you’ve been depreciating the value of the laser by $100,000. This year – year four – you’re going to have tax basis of $100,000 left on that laser. But this year, you’re selling your practice, and the party working through the purchase price allocation determines that the laser is worth $150,000. This means you now have a gain of $50,000. Because you already took depreciation of $400,000, which reduced your ordinary taxable income, the $50,000 gain will now be taxed as ordinary income.
Why does it matter?
You may think that the gain on the equipment in your practice would result in capital gain treatment and not ordinary income. However, because this equipment was depreciated (reducing ordinary taxable income in the past), a majority, if not all, of the gain recognized on these assets results in ordinary income to the seller.
F Reorg
What is an F Reorganization?
If, your practice is
- Organized as an S-Corp AND
- You’re looking to partner or sell to a buyer with a knowledgeable tax advisor
the buyer is likely going to want you to do what’s known as an F-Reorg (defined under Section 368(a)(1)(F) of the Internal Revenue Code) prior to the purchase.
During an F-Reorg, a new corporation is created, which will become the new parent S-Corp (“NewCo”). Historical S-Corp (“OldCo”) will be contributed to NewCo and become a disregarded entity for income tax purposes (there are a few steps that need to be taken to achieve this overall result and your lawyer and tax adviser can advise on these steps). The buyer will then acquire the LLC interests of OldCo, which results in the easy transfer of contracts, among other benefits.
Why does an F reorg matter?
Many MedSpa and healthcare practice owners struggle to maintain the multitude of rules to maintain their S-Corp statuses. If you don’t maintain your S-Corp status, you immediately become a C-Corp. When this happens, practice owners may not pay their taxes as a C-Corp because they didn’t know they lost their S-Corp status and became a C-Corp in the first place. From a liability perspective, an F-Reorg doesn’t eliminate all potential liabilities transferring to a buyer, but it mitigates a lot of them, especially on the income tax side. This also allows buyers to purchase stock or interests from a legal perspective but assets from a tax perspective, which results in a step-up in tax basis and future depreciation and amortization deductions for them as the buyer.
Whenever a client approaches me on the buy side, and asks, “What diligence procedures should I do?,” I first look to see if that practice is an S-Corp. If it is, I recommend an F-Reorg immediately, which reduces the diligence procedures on the income tax side, particularly the validity of the S-Corp election.
-Brittany Burke, Centri Consulting
Sellers should be open to the F-Reorg because there is typically language in the Purchase Agreement that they are legally required to indemnify the buyer if the buyer incurs any tax liability for pre-closing taxes of Target. Target not being a valid S-Corp at any point in time and owing taxes as a C-Corp would fall under this indemnification. The F-Reorg should keep that potential income tax liability with the seller and not transfer it to the buyer. It also ensures the buyer made a valid asset purchase for federal income tax purposes and is not at risk of losing the step-up in tax basis in assets purchased. However, the seller should note that by agreeing to the F-Reorg, they are now selling assets for federal income tax purposes and not stock. This may result in additional income taxes due by the seller vs. a straight stock sale. If this is the case, the seller (and their tax advisor) should calculate the incremental taxes due by the seller by structuring the transaction using the F-Reorg instead of a stock sale. This incremental amount should be requested by the seller as an additional purchase price from the buyer in the deal (i.e., a gross-up payment). Gross-up payments are very common in these types of deals, and MedSpas or healthcare practices, where the majority of value is in intangibles and goodwill, will likely only require a small gross-up payment, if any.
F-Reorgs are a process you should expect when selling a spa or healthcare practice. Lean on your lawyers and tax advisors to lead the process because timing each step matters. While an F-Reorg can sound overwhelming, it’s fairly common in medical practice sales.
Note: an F-Reorg should be standard practice for the professionals that you rely on. Your legal team can create the new entity for you and time all the other steps appropriately. Your tax advisor can assist in calculating what the appropriate gross-up payment should be.
In Summary
If you are selling a spa or healthcare practice you will likely deal with purchase price allocations, depreciation recapture, and F-Reorgs during a sale process, and almost certainly when selling to a private equity-backed group. Though complicated, surrounding yourself with a reputable team will be key to navigating each step. And note that you don’t have to wait until you’re ready to sell to contact an M&A advisor, tax strategist, or attorney. The most successful medical practice sales (the ones that sell at the top of the market) are preparing up to five years ahead of time, taking baby steps now to prepare for that eventual life-changing close.
