We get calls every week from dentists ready to sell their practices. But once we dig into the details and start navigating the finer points of the sale, it quickly becomes clear that many haven’t taken the key planning steps needed to minimize the tax hit when the deal closes.
This blog explores two of the most common tax planning areas we explore with clients before selling a practice through a dentistry professional corporation: asset purification and share structure. By addressing these early, dentists can maximize their capital gains exemption and get the most value from their sale—rather than leaving money on the table.
Good Versus Bad Assets and Why It Matters
One of the most common ways dentists miss out on significant tax savings is by holding too many “bad assets” inside their dentistry professional corporation (DPC) at the time of sale. What’s the difference? Basically, good assets are those things that generate active business income, while bad assets are those that are passive and generate non-active business income. Some examples of each type include:
Good Assets (Active Business Income)
- Your dental practice
- Equipment used in daily operations
Bad Assets (Passive Income)
- Excess cash
- Real estate
- Investments
- Insurance
If you want to take advantage of the lifetime capital gains exemption (LCGE) when you sell, you must qualify for it. And one of the qualification tests is the Asset Use test, which requires your DPC to have at least more good assets than bad for the 24 months leading up to the sale.
One non-active business asset we often encounter when working with dentists is third-party loans, such as a loan made from your DPC to a holding corporation. This is usually so that the holding corporation can use that loan to buy real estate, investments, securities, etc. This type of asset can be quite large and put your DPC offside the 50% good vs bad asset test.
Example
Your practice (owned by the DPC) is worth $500k, but your DPC also has $200k in excess cash in the corporation’s bank account and an outstanding loan of $400k.
- Total DPC Assets = $1.1 million
- Good Assets = $500k
- Bad Assets = $600k (cash + loan)
Since the good or active business assets only make up 45% of the total assets, you won’t qualify for capital gains exemption if you sell.
Too Many Bad Assets: What to Do?
So, if this is your situation, what can and should be done?
Corporate Purification
Hire an experienced dental accounting and legal team to remove the non-active business assets. There are many legal and accounting moves that need to be done to make this purification of non-active business assets proper, legal and defensible. You may need to either wait years after you’ve done the purification, or your accountant will need to make sure that your DPC has enough “safe income on hand” to effect the purification on a tax-deferred basis. It’s all complicated stuff, so again, please talk to a team of accountants and lawyers who are well-versed in these types of things!
Review Your Assets Regularly
Make sure to regularly monitor the value of your dental practice and compare it to the value of your non-active business assets. We have some dentist clients who monitor their asset balance annually and purify excess cash and remove other non-active business assets as needed.
Share Structures That Unlock Tax Savings — and Those That Don’t
Not all shares of a DPC are created equal—especially when it comes to qualifying for the tax savings through the LCGE. Only the correct type of shares, held by the right people, will qualify. If your DPC wasn’t structured properly at the outset, you could miss out on the opportunity to multiply the LCGE across family members.
An example of a poor share structure would be if only the dentist-owner held all the common or growth shares. In this case, if the practice sells for more than the dentist’s personal LCGE maximum, any amount above that may be subject to capital gains tax.
Example
Dental practice ABC Dental is valued at $1.1 million.
- Dr. Happy Dentistry Professional Corporation (Happy DPC) owns ABC Dental
- Dr. Happy (dentist-operator) owns all common shares of Dr. Happy Dentistry Professional Corporation
- The shares cost Dr. Happy $100k (when they first transferred their dental practice assets to Happy DPC and received back common shares at that tax cost).
Dr Happy sells their shares for $1.1 million to a third-party dentist.
- Dr Happy reports proceeds of $1.1 million and tax cost of $100k, resulting in $1 million capital gain.
- 50% of the capital gain ($500k) is taxable at the taxpayer’s marginal tax rate.
- Assuming Dr. Happy is paying the highest tax rate of 53%, they would pay approximately $250k in capital gains tax on that $500k!
As you can see from the example, this share structure would not put the selling dentist in the best financial position. Fortunately, if your share structure wasn’t set up correctly to begin with, there are ways to restructure in advance of a sale.
Wrong Share Structure: What To Do?
If your DPC share structure hasn’t been set up to maximize your tax savings, all is not lost. Dental accountants and lawyers can do something called an estate freeze. An estate freeze involves introducing family members as non-voting equity shareholders. This allows each shareholder to use their full lifetime capital gains exemption when the practice is sold, saving $250k each in capital gains taxes.
Again, this process involves many steps and can get complicated if you don’t have the right experience. Initially, we want to freeze the current value of the dental practice in the hands of the dentist. Then, we allocate new common shares to the dentist’s family members. Then, all future increases in value from the date of the estate freeze would go towards those new shares, and thus, the new shareholders would get to participate in the sale. Let’s review this with another example.
Example
Dental practice ABC Dental is valued at $1 million.
- Dr. Happy Dentistry Professional Corporation (Happy DPC) owns ABC Dental
- Dr. Happy (dentist) owns 100 common shares of Dr. Happy Dentistry Professional Corporation
Step 1: Value Freeze
- Dr. Happy freezes their shares of Happy DPC at $1 million by exchanging their common shares for 50 fixed-value shares, also worth $1 million.
- There are no immediate tax consequences because what they gave (their common shares) is worth the same as their new fixed-value shares.
- The entire $1 million value of ABC Dental at the time of the estate freeze is now accounted for in Dr. Happy’s new fixed-value shares. So, if we issue any new common shares, those shares won’t be worth anything yet.
Step 2: New Shareholders
- Happy DPC issues 50 new non-voting common shares to Dr. Happy’s two adult children.
After 30 months, Dr. Happy decides it’s time to sell ABC Dental by selling all shares of Happy DPC to a new dentist.
Step 3: Sell the Dental Practice
- All shares of Happy DPC are sold to a third-party dentist for $2 million, thus making the new dentist the owner of ABC Dental.
- The first $1 million of the purchase price goes to the fixed-value shares owned by the dentist. This portion is exempt from capital gains tax as it is still within Dr. Happy’s LCGE limit.
- The next $1 million goes to the 50 non-voting common shares. Each child’s portion is also within their LCGE limit and, therefore, has no capital gains tax.
By divvying the proceeds across multiple shareholders, the entire $2 million is free from capital gains tax, saving the family $500k!
So, introducing more shareholders with the proper share types can make a big difference in the tax cost. But be careful – timing is critical here as well. Those family members must own those shares for at least 24 months before a sale to qualify for the capital gains exemption.
Bottom Line
Selling your dental practice is a major milestone. And failing to plan correctly can cost you hundreds of thousands of dollars in unnecessary taxes. The good news? With smart, timely planning, those tax burdens can often be reduced or avoided entirely. Whether it’s restructuring your shares or cleaning up passive assets, the earlier you start, the more options you’ll have.
Consult with an experienced team of dental accountants and lawyers to properly set up your DPC and review it regularly. This way, when you are ready to sell, you get the most value from the sale— and walk away with more of it in your pocket.
Not sure where to start? DMC can help. Our team has helped hundreds of dentists structure and prepare their corporations for a successful, tax-smart sale. Contact us today to make sure your corporation is ready when the opportunity comes.
