A $500,000 income tax exclusion
by Charles Blair, DDS and John McGill, MBA, CPA, JD
I am interested in leaving my personal residence to one of my children via my will following my death. Will my child be eligible for the $500,000 income tax exclusion on the gain from the sale of the personal residence if she is married?
As a general rule, all assets included in your estate at date of death receive a "stepped up" basis to their value, so that income taxes on all previous appreciation on the property is forgiven (not subject to federal or state income taxes). Any appreciation on the residence following your death would be subject to federal and state income taxes.
However, if your child began using your residence as her personal residence, then, once she had lived there for at least two years, any gain after your death also would be forgiven. Alternatively, if she held your residence and rented it out following your death, thereby converting it to rental property, she could effect a tax-free exchange of the property to avoid federal and state income taxes.
Last year, I purchased a practice from a retiring orthodontist who went out on disability. The agreed-upon purchase price was set at $220,000, but there was no allocation of the purchase price in the sales contract.
In filing Form 8594 with my 2000 tax return, my accountant recommended these allocations: covenant not to compete — $20,000; contracts receivables — $165,000; furniture, fixtures, and equipment — $35,000. The value of the furniture, fixtures, and equipment was based on the average of appraisals done by two dental supply companies. Furthermore, at the time of the sale, the face value of the contracts receivables was $210,000.
Unfortunately, the selling orthodontist is adamant about using an allocation of $180,000 to goodwill, $20,000 to contracts receivables, and $20,000 to equipment, in order to gain the maximum tax advantage. My accountant has advised me that the seller is not correct. What should I do, and what regulations apply?
Section 1060 of the Internal Revenue Code requires the purchase price be allocated according to the regulations provided thereunder, and be properly reported by both parties (seller and purchaser) on Form 8594 and attached to their respective tax returns. As a general rule, where the parties agree together on a purchase price allocation and include it in their sales contract, it will be respected by the IRS. In a case like yours where there is no agreement, the IRS is free to allocate the purchase price based on the fair market value of the respective assets.
The first step in the process is to allocate the purchase price to the fixed assets (furniture, fixtures, and equipment) based upon the values of these assets, which would be $35,000 (using the average of the two appraisals obtained). The remaining $185,000 would be allocated between and among the orthodontic contracts and covenant not to compete based upon their respective relative fair market values, with any remaining value allocated to goodwill.
In general, the value of orthodontic contracts would be nowhere near their face value, since these represent mere promises to pay in the future in exchange for services to be rendered. Since the doctor will incur substantial overhead costs and time in producing these contracts, the fair market value of an orthodontic contract is usually in the 20 to 40 percent range of its face value, says Roger K. Hill, a certified appraiser with The Blair, McGill, and Hill Group, L.L.C., (704) 424-5626.
The covenant not to compete would be valued next, based upon the difference in the value of the practice with and without the covenant not to compete. Since the retiring orthodontist was disabled, the value of the covenant not to compete would be quite low and probably would not exceed the $20,000 allocation suggested by your accountant. The remaining value would be allocated to goodwill.
Have your CPA review Section 1060 of the Internal Revenue Code and Regulations issued thereunder.
Dr. Blair is a nationally known consultant and lecturer, and is a member of the American Academy of Dental Practice Administration. McGill is a tax attorney and MBA. They are the editors of the Blair/McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes, and protect assets. The newsletter ($177 a year) and consulting information are available from Blair/McGill and Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217 or call (704) 424-9780.