The importance of the true fair market value of your practice

When selling a dental practice, the first milestone is generally reaching an agreement on the sales price.

Sep 24th, 2013

by Jonathan Martin, CPA, and John K. McGill, JD, CPA

When selling a dental practice, the first milestone is generally reaching an agreement on the sales price. However, doctors are actually selling various assets such as dental and office equipment (tangible assets), and personal goodwill (intangible assets). The biggest indicator of what a seller will receive after taxes from the transaction is not the gross sales proceeds, but rather how the sales price is allocated to the various assets being sold. From a seller's standpoint, an allocation resulting in the least amount of taxes owed will be more attractive. For example, sellers typically seek an allocation leaning more heavily toward intangible assets, such as personal goodwill, given that such assets are taxed at the more favorable capital gains rates, currently a maximum of 20%. On the other hand, the sale of tangible assets, such as dental equipment, office equipment, and consumable supplies, are generally subject to ordinary income tax rates, currently at a maximum tax rate of 39.6%.

On the other side of the table, a purchaser will seek an allocation that allows for the most expedient write-off of the assets purchased. Tangible assets can be written off much faster (five to seven years) than personal goodwill, which takes 15 years to write off. When you consider accelerated depreciation that can be applied to tangible assets, such as Section 179 depreciation, an allocation favoring tangible assets provides a better tax result for a purchaser. In other words, if something is more favorable for one doctor in the transaction, it is often less favorable for the other doctor. Given that assets that receive the most favorable tax treatment upon sale have the longest write-off period, and vice versa, it is obvious that this "push-pull" creates a fertile ground for negotiation.

According to the Internal Revenue Code (IRC) Section 1060, when allocating the purchase price, a method referred to as the residual method is used to dictate the order by which each asset must be allocated a portion of total price. Under this approach, accounts receivable is the first asset to be allocated value. However, when selling the entire practice, it is much easier to leave accounts receivable out of the sale. This is simply due to the disparity in perceived value between a buyer and seller.

When negotiating accounts receivable, a buyer is going to offer less than face value to purchase the receivables since there is always an amount that is uncollectible. The issue is trying to determine exactly how much will be uncollectible. Typically a buyer will err on the side of caution and estimate more, while a seller will assume less. In order to avoid this unnecessary negotiation, it is much easier for the seller to exclude accounts receivable from the sale. After the practice is sold, the buyer's staff will ultimately collect them on behalf of the seller and remit them to the seller upon receipt. In return for the collection services rendered, the buyer will retain a small percentage of the amounts collected. As stated above, this is for amounts collected on accounts receivable. This is not the case for orthodontic contracts receivable, which are included in the practice sale.

Given that accounts receivable are generally not part of the allocation, the purchase price must be allocated first to assets that receive the least favorable tax treatment upon sale -- tangible assets. As a result, it is not uncommon for sellers and their representatives to arbitrarily allocate a nominal amount to tangible assets, with the majority of the purchase price allocated to intangible assets. However, it is important to note that IRC Section 1060 indicates that the allocation to each asset class should be based on each asset's fair market value. This is especially important given the built-in conflict between buyer and seller. If one party intentionally manipulates the allocation by randomly allocating value to specific asset categories that are unilaterally favorable to them, it is reasonable to expect the same attempts will occur from the other side.

In order to avoid this issue and the potential endless negotiations that could follow, doctors should make sure the proposed sale price of the practice and the allocation of the assets are based on the actual fair market value of the practice and the individual assets of the practice. Guessing at one's practice value and arbitrarily allocating the purchase price will only motivate buying candidates to counter with equally unjustifiable offers that lessen the likelihood of a sale.

Jonathan Martin provides transition planning for practice sales, partnerships (buy-in/buy-out), practice mergers, associateships/compensation analysis, and financial forecasting (pro forma) through Roger K. Hill & Company, member of the McGill & Hill Group, LLC. John McGill provides tax and business planning exclusively for the dental profession and publishes The McGill Advisory newsletter through John K. McGill & Company, Inc., a member of the McGill & Hill Group, LLC. For more information, visit www.mcgillhillgroup.com.

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