Practice transitions: My favorite tax strategies
Tax sticker shock is nowhere more evident in today's high-tax environment than with the sale of an interest in a dental practice. A check the size of an impressive lake property is reduced by taxes to a visit to Starbucks. Important presale tax planning is needed to actually keep the value realized from all those years of hard work.
BY Brian Hufford, CPA, CFP®
Tax sticker shock is nowhere more evident in today's high-tax environment than with the sale of an interest in a dental practice. A check the size of an impressive lake property is reduced by taxes to a visit to Starbucks. Important presale tax planning is needed to actually keep the value realized from all those years of hard work. Over the many years that I have worked with dentists, I have been amazed at how rarely effective and thorough tax planning is actually conducted. Perhaps this is because most tax-planning ideas are more tactical and newsletter-like, such as employing children in the practice. Larger strategic tax reduction planning is needed for a practice sale. It requires real planning and not simply implementing a one-time newsletter idea.
The dental practice asset is correctly viewed as a retirement asset. Some dentists realize the value of the practice one time with a walk-away sale and others realize the value incrementally through various associate-to-partner transition models. Regardless of the method of value realization, taxes are a serious threat to supplementing retirement savings from transition proceeds. There are many forms of deductible retirement plan arrangements: 401(k) plans and defined benefit plans can be paired with a practice sale to help dentists keep most of the transition proceeds. Let me offer some examples.
Baby boomer dentists are beginning to leave the profession in droves. Most exit dentistry with a walk-away sale. Many have not saved adequately to support the type of retirement they deserve. We have been using an effective strategy for baby boomer dentists by which we can nearly eliminate all income taxes with the right set of facts. Older dentists typically have a perfect set of attributes to implement a special type of defined benefit pension plan called a cash balance plan to almost entirely offset the practice sale proceeds. With defined benefit plans, the annual tax deduction limit is based upon lifetime benefit funding, not upon a percentage of annual income such as a 401(k) plan. In other words, the annual tax deduction is based upon a retirement benefit limitation, not on annual savings limitation. If a dentist has not funded this lifetime benefit, some preplanning in anticipation of a practice sale can generate a large income tax deduction when practice sale proceeds are realized.
The tax planning strategy that we use in this case unfolds as follows: A dentist is 62 years old and wishes to sell her practice within the next three to five years. Currently, this dentist has a 401(k) plan. We implement a small cash balance plan, paired with her existing 401(k) plan, to generate additional small tax deductions each year - perhaps in the $20,000 range or so. The staff costs in this cash balance plan are minimal, and the dentist benefits from additional tax deductions and retirement savings while this arrangement is in place. Due to the minimal funding each year that the plan is in place, and with the actuarial benefits that may be accrued, it is possible that, in the three to five years from inception of the cash balance plan, this dentist could obtain as much or more than a $500,000 pension deduction in the year of the practice sale by amending the plan to accrue the maximum benefit. We have used this strategy, in particular, for C Corporation dentists who may be subject to a double tax problem.
For younger dentists - say, in their 40s - who have rapidly growing practices and need to hire associates who will become partners, we have used a similar but slightly different strategy. The problem that these younger dentists have is that the proceeds for partnership sales will be received on top of their larger practice earnings because they are typically in their peak earning years. This creates a tremendous tax issue. To avoid a confiscatory tax outcome, we design a retirement plan structure that creates much larger deductions for the senior dental partner than for the new associate partner. This is likely a great fit for both since the younger associate dentist is not in a position to save large amounts for retirement at a young age. Dentists in their mid-to-late 40s, however, can generate retirement plan deductions in the $150,000 range or above.
In summary, retirement plans offer compelling income tax savings opportunities for transitioning dentists. They are not the only tax planning solution, but they certainly offer powerful tax savings potential.
Brian Hufford, CPA, CFP, is a wealth advisor and dental practice thought leader with Buckingham Advisors, a national, independent wealth and financial advisory firm with a specialty in helping dentists achieve their most important goals. To connect with Brian and Buckingham, visit BuckinghamAdvisor.com, call (866) 545-8816, or email HuffordInfo@buckinghamadvisor.com.