Dentists call us up every week about selling their dental practice. But when we start to go through the nitty-gritty of selling, we soon discover that they ARE NOT READY to sell because they haven’t done proper tax planning. Here are some classic examples.
DPC Has Too Much Bad Assets
If a dentist is looking to take advantage of the lifetime capital gains exemption and save a lot of $$$, what they don’t realize is that you must QUALIFY for it. It’s not automatic. And there are lots of tests that need to be met. One of the tests is that, for the 24 months leading up to the sale, the corporation must have at least MORE good assets vs. bad assets. Good assets are active business assets. Good assets include your dental practice. Bad assets are non-active business assets. Bad assets include things like too much cash, investments, real estate, insurance, securities, etc. Basically good assets are those things that are active and generate active business income; meanwhile: bad assets are those things that are passive and generate non-active business income like rental income, royalties, etc.
So basically we’re looking at total fair market value of the good assets vs. the bad assets. And if, for the 24 months leading up to the sale, the bad assets are worth MORE than the good assets, then the dentistry professional corporation won’t be considered a small business corporation and thus the shares owned by the dentist (and it’s the shares that are being sold to try to qualify for the lifetime capital gains exemption) WON’T QUALIFY for the lifetime capital gains exemption. So for example, if your practice (owned by the dentistry professional corporation) is worth $500k but your corporation also has $600k in excess cash sitting in the corporation’s bank account, then it won’t qualify! Why? Because of the total value of the assets of the dentistry professional corporation ($500k practice + $600k cash = $1.1-million) and the fact that the active business asset (i.e. the dental practice) only makes up 45% of the total assets ($500k / $1.1-million), then it WON’T QUALIFY for capital gains exemption.
Too Many Bad Assets: What to Do?
So what can and should be done? Hire an experienced accounting and dental team well-versed in these matters to purify (i.e. move out on hopefully a tax-deferred basis) the non-active business assets. There are many legal and accounting moves that need to be done to make this so-called “purification” of non-active business assets PROPER, LEGAL and defensible. For example, did you know that if you try to purify out cash TOO CLOSE to a sale of the corporation to a third party (i.e. a dentist buyer), then you may not qualify to have the cash moved out on a tax-deferred basis? There are complex rules and you may need to either wait YEARS after you’ve done the purification OR you need your accountant to make sure that your dentistry professional corporation has enough “SAFE INCOME ON HAND” to effect the purification on a tax-deferred basis (and then you won’t need to wait years to sell after you’ve purified). It’s all complicated stuff, so again: please consult with an experienced accountant and legal team.
Make sure to regularly monitor the value of your dental practice and compare it to the value of your non-active business assets. Yes, you’re allowed to have cash sitting in your bank account, but too much cash means that a part of it is no longer used for the active business of running a dental practice. And yes we do have some dentist clients who regularly monitor and purge/purify excess cash and remove other non-active business assets.
Another non-active business asset is a LOAN that your dentistry professional corporation has made to a holding corporation (usually so that the holding corporation can use that loan to buy real estate, investments, securities, etc.). Again: this is a type of asset which can be quite large and put your dentistry professional corporation offside the 50% good asset / 50% bad asset for the last 24 months leading up to a sale test. But yes you are allowed to re-organize your corporation to remove the loan entirely off the books (off the balance sheet of the dentistry professional corporation). And you can do this in a way that doesn’t trigger taxes – again, you need to be mindful of timing because if you don’t have enough “SAFE INCOME ON HAND” and you’re trying to do this move too close to a sale to a third party, you’ll end up trigger all sorts of penalty taxes. So talk to a team of accountants and lawyers who are well versed in these types of things!
DPC Doesn’t Have The Right Share Structure
We often find that dentists had not properly consulted with legal and accounting experts when creating their professional corporation and had simply given the common shares/growth shares/equity shares to the dentist owner/operator. But the problem here is that only the RIGHT shares qualify for the capital gains exemption and you want to give those RIGHT SHARES to the right people so that you can MULTIPLY the capital gains exemption. And yes you are allowed to have a spouse, adult child or parent (who are not dentists) own the non-voting common/growth/equity shares of your dentistry professional corporation. And yes you are allowed to give family members an equal split to try to multiply the lifetime capital gains exemption across the board (so everyone is using it).
Keep in mind that, if each person has a lifetime capital gains exemption that’s around $1-million, then when they go to sell their shares, the first $1-million is capital gains tax-free (mind you, there might still be refundable alternative minimum taxes they need to pay, but you can get that back by associating after the closing). So if you max-out and use up all of your lifetime capital gains exemption (because the practice sells for a lot of money), then each person saves about $250k in capital gains taxes. Here’s the quick math:
- Shares cost the dentist shareholder $100k (this was the cost of the dentist when they first got their shares; they transferred in their dental practice assets for $100k and received back common shares at that tax cost).
- Dentist shareholder sells those shares for $1.1-million to a third party dentist.
- Dentist reports proceeds of $1.1-million and tax cost of $100k, resulting in $1-million capital gain.
- 50% of the capital gain (i.e.g $500k of $1-million capital gain) is taxable at the taxpayer’s marginal tax rate.
- Assume dentist taxpayer is paying highest tax rate of 53% on the $500k.
- Dentist taxpayer would NORMALLY pay around $250k in capital gains tax UNLESS they qualify for the lifetime capital gains exemption, in which case they DO NOT PAY this $250k!!!!!
So now, if the purchase price for the dentistry professional corporation is $2-million and there’s only 1 shareholder – the dentist – who owns the proper common shares, then what? Well, that dentist would get their lifetime capital gains exemption on the first $1-million but then they’d pay capital gains tax on the next $1-million (e.g. $250k tax!). It would have been way better had the dentistry introduced a family member and given them non-voting common shares – which is perfectly legal – in equal proportion to themselves (so dentist gets 50 voting common shares and family member gets 50 non-voting common shares). And this way, when the practice is sold for $2-million, each shareholder gets to use their full lifetime capital gains exemption and save $500k in total or $250k each in capital gains taxes.
Wrong Share Structure: What To Do?
What if your dentistry professional corporation hasn’t been set up like this? Well, dental accountants and lawyers can do something called an “estate freeze” which allows us to freeze the current value of the dental practice (based on a letter of opinion or appraisal from a reputable company) in the hands of the dentist. And then from here we allocate NEW common shares to the dentist’s family members. Those family members would need to own those shares for at least 24 months before a sale to qualify for the capital gains exemption. But the idea here is that all future 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. Take this example:
- Dental practice is valued at $1-million.
- Dentist freezes their shares at $1-million (they exchange their common shares for fixed-value shares worth $1-million). There’s no immediate tax consequences because what they gave (their common shares) are worth the same thing as their new fixed value shares. This happens at the time of the estate freeze.
- All the value of the dental practice at the time of the estate freeze is tied up in those new fixed-value shares. So if we issue any new common shares to anyone, those shares aren’t worth anything AT THAT TIME (again, because all of the value of the shares is already accounted for in those fixed-value shares that the dentist is holding).
- So we issue new non-voting common shares to the dentist’s family members.
- The family members hold those shares for at least 24 months before they can sell (in order to qualify for the capital gains exemption).
- In 2+ years, the dental practice is valued at $2-million and the shareholders go to sell their shares.
- The first $1-million of purchase price goes to the fixed-value shares owned by the dentist. The next $1-million goes to the family member’s non-voting common shares. So we’ve not allocated future value from the date of the estate freeze to the family members’ non-voting common shares and thus taken advantage of multiplying the capital gains exemption.
Bottom Line
Make sure to consult with an experienced team of dental accountants and lawyers in order to properly set up your dentistry professional corporation and keep it clean (especially with respect to moving out bad assets prior to a sale). This way, when you do go to sell, you’re not stuck with a big tax bill OR having to suddenly postpone the sale FOR YEARS in order to save hundreds of thousands of dollars. Do the proper tax planning by getting proper advice from now!
