Taxes are going up
what practice owners need to know
April 19, 2021
For the first time in 30 years, federal taxes are set to experience a major hike. The current proposal includes changes to income taxes, capital gains taxes, estate taxes, and itemized deductions, among other updates and revisions to the current tax code. In this article, we’ll focus on proposed tax changes that specifically impact doctors and practice owners.
impact on sellers
If you own a dental practice and are considering ownership transition options, the new tax proposal deserves considerable attention. Even if you’re not planning to sell in the near future, it’s important to note that the implications of the new tax proposal will last an indeterminate number of years if passed. It is for this reason that the significant financial impact of these changes will likely compel many practice owners to pull a practice sale forward into 2021. Timing is important, and you want to maximize the practice equity you’ve worked so hard to build.
The most notable part of the new proposal is a significant increase to the capital gains tax. Doctors who plan to sell their practices will find this tax increase greatly reduces the amount of after-tax proceeds they’re able to take home from a sale.
To better understand the implications of these proposed tax changes, it’s important to first understand the fundamentals of a practice sale. We’ll take this opportunity to review the process and lay the groundwork for your plan.
As a first step, you need to determine the value of your practice through a formal practice valuation. There are a variety of options available to accomplish this. For example, some doctors choose to work with dental practice brokers who serve as a third-party intermediary between the buyer and seller, while others work directly with a DSO, like Apex, to obtain a fair market valuation of their practice. Regardless of which option you choose, the goal and outcome are similar.
It’s important to note that there is no single, standardized method for valuing a dental practice. There are several different methodologies commonly used, such as net asset valuation, market-based valuation, and income-based valuation. Sometimes, it’s a combination of the three. Considerations like size, location, equipment, staff, payor mix, and other attributes factor into the valuation as well. Without getting too deep into each different methodology, the primary takeaway is that you as the business owner will walk away with an objective valuation of your practice and a better understanding of what your personal financial picture would look like moving forward.
When the valuation process is complete, the value of your practice is then allocated between tangible and intangible assets or fixed assets and goodwill, respectively. Both asset categories play a critical role in the valuation of a practice, and each is currently taxed differently. On average, the sale price of a practice consists of approximately 80% goodwill and 20% fixed assets, with goodwill being taxed as a capital gain and fixed assets being taxed as ordinary income through depreciation recapture.
Currently, the long-term capital gains tax rate is 20%, and the individual income tax rate is 37% (for the top income brackets of each). These two rates are combined into a blended rate to ultimately determine how much tax you will pay on the sale of your practice. Using the aforementioned 80/20 purchase price allocation between goodwill and fixed assets, the blended tax rate would be approximately 23.4%. Normally, that’s how much you would pay in taxes on the sale of your practice.
However, the new tax proposal would increase both the capital gains and the ordinary income tax to the same rate of 39.6%. Thus, no matter how you allocate the purchase price between goodwill and fixed assets, the effective tax rate on most large practice sales would be 39.6%. Most experts currently expect these tax changes to go into effect for the 2022 tax year.
It’s important to note that the capital gains tax increase applies to individuals with more than $1 million in annual taxable income. That might sound high to some, but it will likely come into play for most selling doctors because it includes the doctor’s normal take-home income from operating the practice plus the proceeds from the practice sale in that calendar year.
This substantial increase in taxes will greatly affect the net proceeds – or profit – realized from the sale of your dental practice. Let’s take a look at some simplified math using the tax rates mentioned above.
If your practice has a sale price of $1.5M, you would pay an estimated $351K in taxes if you were to sell your practice in 2021. However, based on the current proposal, your tax bill would increase to $594K if a transaction is consummated after the end of the year. As a result, your take-home profit would be $243,000 less. Meaning, you’ll end up paying 69% more in taxes and making 21% less in profit!
Here’s how this breaks down using all of the terminology discussed above:
As you can see, that’s a significant difference from one year to the next, and it is a difficult change to mitigate through tax planning or offset by future practice growth. For example, if you were to grow your practice next year by an impressive 20%, your after-tax proceeds from a sale would still be less in 2022 than if you were to close a transaction in 2021.
This drastic increase in taxes should provide some doctors with a sense of urgency to sell their practice sooner rather than later in order to maximize their profit from a sale. As with anything tax related, we always recommend consulting with your accountant to work through the different scenarios and determine the best course of action for you and your practice.
impact on doctors/owners
Doctors and practice owners who are not in the market to sell would also be affected by the proposed tax plan in a variety of ways, and it’s worth reviewing and understanding all of the potential upcoming changes.
In particular, doctors should pay close attention to the tax changes aimed at individuals earning $400K or more per year. As mentioned above, individual income taxes for high earners would increase from 37% to 39.6% under the proposal. This increase may sound relatively small, but it compounds quickly when you take into account other changes aimed at individuals earning $400K or more.
For example, the new plan will increase payroll taxes through the imposition of a 12.4% Social Security tax on all earned income exceeding $400,000 annually. Currently, employees and employers pay 6.2% respectively toward social security on the first $142,800 in wages. The new plan reassesses this tax once wages exceed $400,000. In other words, with 2021 tax laws, no Social Security tax is paid on wages between $142,800 to $399,999.
Keep in mind that the increased individual income tax and reassessed Social Security tax are in addition to other existing taxes such as Medicare which ranges from 2.9% to 3.8%. When you consider state taxes, the combined impact could result in some doctors paying a marginal tax rate of 60% or higher. As a result, dental practitioners need to be well aware of the $400,000 threshold and work with their accountant to ensure they are best positioned moving forward.
The new proposal also contains other changes aimed directly at higher earners. Those include but are not limited to:
- Capping the tax benefit of itemized deductions to 28% of value which means taxpayers with tax rates higher than 28% would face limited itemized deductions
- Phasing out the qualified business income deduction (Section 199A). This is relevant if your dental practice is structured as an S-Corporation.
If passed, the new tax proposal will impact doctors and practice owners whether or not they are planning to sell their practice in the near future. We strongly recommend educating yourself on the new tax plan, staying updated on its progress in Congress, and consulting with your accountant or CPA to best prepare for your financial future.
Net Asset Valuation – valuation based on a combination of tangible and intangible assets
Market-Based Valuation – valuation based on a combination of the collections of a practice and local market data of other dental practices
Income-Based Valuation – valuation based on pre-tax cash flow of a practice
Capital Gains Tax – a government tax on the profit from selling certain assets
Goodwill – intangible assets associated with a company or business
Fixed Assets – a tangible piece of property or equipment used by a business
Net Proceeds – after-tax profit from the sale of a business
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Choosing to sell your practice is a decision that shouldn't be taken lightly. At Apex Dental Partners, we work closely with you every step of the way to ensure you feel comfortable and confident you're making the best move for your future.