3 Big Tax Mistakes To Avoid When Buying Or Selling A Practice
Inside Advice From A CPA
I left off my last blog by saying that most ODs do not realize the importance of assigning dollar values for equipment, inventory and goodwill when they negotiate the purchase and sale of a practice.
For expert advice, I collaborated on this blog with my tax resource, J.R. Armstrong, CPA of May & Company LLP, in Vicksburg, MS.
Dear Jerry,
This is a great topic to make your readers aware of as I have worked with many ODs who really don’t understand how much allocations can affect their tax liability in the purchase and sale of a practice.
A Typical Practice Sale
For purposes of discussion, let’s assume that Dr. Beyer has signed an agreement to purchase a $500,000 practice for 70% of gross, or $350,000.
Of that $350,000, the contract states that Beyer is paying Dr. Cellar $50,000 for inventory and $150,000 for equipment.
That leaves $150,000 ($350,000 - $200,000) to be accounted for when Dr. Beyer and Dr. Cellar file their 2009 tax returns.
The portion of the selling price not allocated to inventory or equipment — in this case $150,000, is what the IRS considers to be ‘Goodwill’.
Goodwill Receives Favorable Tax Treatment For The Seller
Even in friendly negotiations, the buyer and the seller have opposing objectives when assigning a value to Goodwill in the sale of a practice.
That’s because Goodwill is taxed as a ‘capital asset’ to the seller.
That is a good thing for the seller because he will receive favorable tax treatment (generally 15%) on the capital gains portion of income received for Goodwill in this sale.
In this case, the capital gains tax would be $22,500 ($150,000 x 15%).
By comparison, if that amount was treated as ordinary income, the tax would be somewhere between 25% and 40% ($150,000 x 40% = $60,000 in taxes).
The difference is significant.
Goodwill Is Not So Good For The Buyer
On the other hand, the tax treatment of Goodwill is not so favorable for the buyer.
That’s because he cannot simply deduct the $150,000 he paid for Goodwill in one year. The IRS requires Dr. Beyer to ‘amortize’ the amount allocated to Goodwill over 15 years.
That means he can only deduct $10,000 per year for the next 15 years.
Selling Inventory
One OD is typically not going to sell inventory to another OD for more than he paid for it.
However, that can become a point of negotiation if the buyer is trying to shift part of the purchase price from Goodwill to inventory for tax reasons.
In that case, the seller needs to understand that any gain on the sale of inventory will be taxed as ordinary income to him. We would assume that to be a tax rate of between 25% to 40%.
Selling Equipment
Any amount the seller allocates to the sale of equipment will be subject to a complex set of rules known as ‘recapture’.
Again, it is unlikely that you would sell used equipment for more than you actually paid for it.
But, should that occur for reasons of negotiation, the full amount of the gain on the sale of the equipment could be taxed as ordinary income under the recapture rules.
Deducting Inventory Expense
Unlike deductions for Goodwill, Dr. Beyer can deduct the full cost paid for inventory in the same year the frames and lenses are sold.
For example, if he dispenses all $50,000 worth of frames and lenses in 2009, he can deduct all of that on his next tax return.
Deducting Equipment Expense
Dr. Beyer can also depreciate the $150,000 allocated to equipment over 5 or 7 years.
Or, under Section 179, he can elect to expense up to $250,000 paid for equipment in 2009.
However, it may not be good tax planning to take the entire deduction in one year. That decision should be based on his total earnings and other deductions.
Buyer Versus Seller
The net effect of all this tax talk is that the savvy seller will want to allocate as much of the practice sales price as possible to Goodwill.
That should lower his taxes on the income he receives from the sale of the practice.
A sharp buyer, on the other hand, wants to allocate as little as possible to Goodwill and as much as possible to items that receive more favorable tax treatment — inventory and equipment.
It’s a delicate dance and there are no magic answers.
Just be sure to consult a knowledgeable CPA or attorney before committing yourself to a purchase price and allocations.
Best regards,
J.R. Armstrong, CPA
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Disclaimer: The information and opinions contained on this site are for discussion purposes only and are NOT intended to serve as legal, accounting or investment advice. ©2009 Jerry Hayes, OD. Not to be reproduced without written permission of the author.
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great advice. Clears the tax
great advice. Clears the tax implications