For the first time in 30 years, taxes are expected to increase significantly. This is particularly impactful to any doctor who is considering transitioning or selling his or her practice in the coming years. The new proposal includes a big increase to the capital gains tax, which for most doctors would dramatically reduce the amount of after-tax proceeds realized from a practice sale.
Are there ways to mitigate this impact after the increase takes effect? The short answer is yes, but given the magnitude of the proposed changes, it will take time and a significant amount of effort for most doctors. As a result, practice owners should consider whether moving forward with an ownership transition in 2021 (before the proposed tax changes take effect) is the more prudent financial planning decision.
Steps to take to reduce the impact of the changes
As I mentioned, moving a practice transition forward into the 2021 tax year may be your best option. But if this is not a possibility or it does not align with your career plans, here are three considerations to help offset the future impact of the proposed tax increases.
In general, your options for reducing tax exposure on a practice sale are extremely limited. Thus, these considerations focus on steps you can take to increase your practice’s overall valuation to help net the same after-tax proceeds on a future sale. It’s worth noting that these strategies are not quick fixes. They require hard work, dedication, and discipline to achieve great results.
Each of the considerations represents a valuation variable during the practice appraisal process, and your diligent efforts can influence all of them in the right direction. The first two variables, revenue (collections) and practice overhead, are part of an important financial metric known as EBITDA (earnings before interest, taxes, depreciation, and amortization), a proxy measurement of practice cash flow.
The third variable, your valuation multiple, is a factor applied to EBITDA over which you can also have direct influence. EBITDA is calculated by subtracting practice overhead (excluding interest, taxes, depreciation, and amortization) from total collections. It’s important to note that doctor compensation (i.e., your compensation for chairside work) is considered overhead and should also be subtracted. The multiple is then used to determine the final market value of your practice (figure 1)
The first way to increase your practice valuation and ultimately offset the impact of the proposed tax changes is by growing practice revenue. While it may seem obvious in concept, significantly increasing practice revenue in a time of economic uncertainty and increased competition across the dental industry is no easy feat, especially by the amount needed in this case.
For example, if you were to grow your practice next year by an impressive 20%, your after-tax proceeds from a sale would still likely be less in 2022 than if you were to close a transaction in 2021. Thus, while increasing revenue is an important mitigation strategy, it’s unlikely to be a silver bullet alone.
There are numerous ways to drive revenue growth, many of which go far beyond the scope of this article, but the quickest solutions are often the most straightforward. If you are not already setting and discussing practice goals with your team, I encourage you to do so. I consistently notice that the most successful practices are those where the entire team is oriented around a clear and definable goal. In addition, it is key to introduce or reevaluate staff incentive plans tied to those goals.
The valuation variable over which you have the greatest control is practice overhead. Since most practice owners personally pay the bills for their practices, this is a concept I’m sure many of you are familiar with. Knowing and understanding your overhead percentage can be a powerful tool in guiding your decision-making process. Unfortunately, too few doctors actively monitor and benchmark this number. I encourage you to make this part of your regular business management process.
In dentistry, some overhead expenses are relatively fixed, such as rent and staff compensation. However, other significant expenses, such as supplies, labs, and marketing, can be addressed in the near term, often without any impact to the quality of care you provide.
As technology has evolved, many domestic labs now offer comparable products at prices historically only found with overseas labs. Suppliers are more competitive than ever, and many doctors have found that buying a supplier’s house line of disposables allows them to reduce their supply budget without sacrificing on the products that matter most. In some cases, reducing expenses overnight will not be possible due to contractual obligations or other considerations, but starting those conversations with your vendors is a great first step.
Finally, when and where to invest or reinvest in your practice is an important decision. While I recommend making wise investments in the regular maintenance, upkeep, and modernization of your practice, I also caution against what I call “shiny object syndrome.” This is the temptation to invest in the latest dental equipment and technology without an integration plan in place.
Aside from the basic standard-of-care items (i.e., digital radiography, computers, and more), large technology purchases alone rarely lead to an increased practice valuation. It is what a doctor does with these items that generates the actual return on investment (ROI). For example, having a digital scanner or a CBCT will not necessarily increase the practice valuation. But if the integration of that technology leads to increased revenue or reduced overhead due to efficiencies, you will see a true ROI.
While practice collections and overhead are objective values derived from accounting, a valuation multiple is much more subjective because it takes into account both tangible and intangible assets associated with your practice. Considerations such as practice location, active patient base, and overall size all play a role in the determination of the multiple applied to EBITDA, which ultimately determines your practice value. Valuation multiples move over time based on market demand, industry dynamics, and macro factors. Since a practice’s value is ultimately whatever someone is willing to pay, valuation multiples may even vary among buyers based on the specific situation.
It’s important to conduct a holistic assessment of your practice and identify areas of improvement beyond boosting production and lowering overhead. Doing so often requires consistent reinvestment back into your practice, which ensures you remain competitive with your peers. A buyer will consider everything from office equipment to signage to curb appeal. Thus, if an ownership transition is on the horizon, I recommend pursuing improvements that present the greatest ROI from the perspective of a practice valuator.
An increase to the capital gains tax will directly affect doctors who are thinking about selling their practices. If you are considering an ownership transition in the coming years, you might find yourself in a better financial position to transition now versus waiting until after a tax increase takes effect. If you decide to wait, I recommend adopting a mitigation strategy focused on maximizing profitability to ensure you receive the highest valuation when the time comes. In either case, it’s critical to familiarize yourself with the upcoming tax changes and plan accordingly.
Editor's note: This article appeared in the July 2021 print edition of Dental Economics.
DAVID LOHMANN is the CEO of Apex Dental Partners, a leading dental support organization providing nonclinical, administrative support services to dentists focused on long-term relationships and high-quality care. Through its nonbranded model, Apex offers supported dentists an increased level of personal and professional flexibility, world-class business support, and a fun and patient-centric culture. Lohmann leads the company’s business development efforts and oversees clinical human resources. Learn more about Apex Dental Partners at ApexDP.com.