By Brian Hufford, CPA, CFP®
Many older dentists practice as C corporations because of the advantages that were available when they began practicing many years ago. These advantages became significant disadvantages as years passed, and many practices never addressed the need for change.
The most significant disadvantage of practicing as a C corporation is the potential for a double tax when selling a practice at retirement. The tax problem exists because the selling corporation must pay a corporate-level tax when selling the practice assets, and then the retiring dentist must pay tax again to get the cash out of the corporation. The result is the potential for a double tax.
A recent tax court case, the Howard case, further complicated the issue. In Howard, the dentist attempted to avoid the double tax by asserting that the majority of the purchase price should be allocated to personal goodwill attributable to the dentist and not be paid to the corporation. The dentist filed his return treating the personal goodwill as a capital gain asset outside the corporation.
The IRS was successful in asserting that since Howard had an employment and noncompetition agreement with his corporation, the goodwill was a corporate asset. The result was a double tax, first at the corporate level, and then at the individual level. This resulted in a tax horror story.
What are the tax planning options available when a retiring dentist practices as a C corporation in order to avoid the double tax?
The most obvious option would be to simply elect S corporation status to eliminate the corporate-level tax treatment. This would work quite well except for special treatment for C corporations that elect S corporation status. Under the tax code, gains from selling practice assets retain their double-tax status for a period of 10 years after the S corporation status is elected. This special tax treatment is referred to as a built-in gain for an S corporation.
In other words, even though S corporation status is elected by a C corporation, the S corporation must pay a corporate-level tax for a period of 10 years for the sale of certain practice assets. An S corporation election, immediately prior to the sale of the practice, will not work in this situation.
Why not simply sell the C corporation stock to the purchaser? This would be great for the seller, with full capital gains treatment.
The problem is that the purchaser would be unable to deduct the cost of any amount allocated to corporate stock, and most purchasers do not want to acquire any potential malpractice or other legal liability that may exist at the corporate level. The purchaser would prefer to buy assets.
Dentists concerned about having personal goodwill challenged by the IRS have been taking a different path. The problem is that, barring the sale of corporate stock or personal goodwill, the selling dentist is severely limited in realizing capital gains treatment for the sale of the practice.
The best path forward for many C corporation dentists has been to consider a deferred compensation arrangement. Under this arrangement, the corporation accrues and pays a large deductible deferred compensation amount, which offsets the corporate gain from the sale of practice assets. The doctor loses the capital gains treatment, since deferred compensation is taxed as ordinary income, but avoids the potential for double taxation.
The problem of double taxation does not typically exist for forms of entity other than C corporations. Deferred compensation treatment requires the support of excellent legal and tax advice, and is not beyond complexity or tax pitfalls of its own.
By far the best outcome might be achieved through offsetting the C corporation sales proceeds with large deductible defined benefit pension payments, another form of deferred compensation that is deductible and also not taxable immediately to the selling dentist.
By participating in some presale planning, the selling dentist can generate large pension deductions that could entirely offset the sales proceeds in the corporation. In most cases, this might be preferable — even to capital gains treatment — in that the selling dentist can invest the full amount of the sales proceeds in a tax-deferred environment while generating lifetime income from the pension.
In summary, if you practice as a C corporation and are contemplating the sale of your practice, you will need to undergo some intensive income tax planning to keep the hard-earned sales proceeds.
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].
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