By Dr. Jim Dahle, WCI FounderThe most expensive asset that many doctors, particularly dentists, will ever sell will be their practice. This sale may involve capital gains totaling hundreds of thousands or even millions of dollars. The capital gains taxes can be substantial, so it was no surprise to get a reader email like this one:
“I'm an 84-year-old dentist about to sell my practice. How can I avoid paying lots of taxes? Take payments over three years, use contract to borrow money to use day to day, and just pay interest?”
Wow, 84 years old! I'm impressed. Let's see what we can do to help.
How Capital Gains Taxes Work
If you own anything besides a collectible (gold, Beanie Babies, jewelry, art, classic cars), and sell it, you will owe capital gains taxes on the difference between your basis and your sale price. Basis includes what you paid for the investment plus any additions to the basis—such as improvements—plus taxes and fees associated with the purchase and minus any depreciation you have taken on equipment or property. You can also subtract any costs of selling the investment from the sale price before paying taxes.
If you have owned the investment for more than one year, you can pay taxes at the lower long-term capital gains rates. If you owned it for one year or less, you pay at the short-term capital gains rates, which are equivalent to your ordinary income tax rates. While this is not earned income and no payroll (Social Security and Medicare) taxes will be due, a big sale like this is likely to result in you paying the Obamacare tax known as Net Investment Income Tax (NIIT), which is an additional 3.8% if your income is over $200,000 ($250,000 Married Filing Jointly). So, you are likely to pay 18.8-23.8%, plus state income taxes, on any gains from the sale of your practice.
By the way, gains on collectibles are taxed at ordinary income tax rates with a maximum of 28%. NIIT is also due on those sales. But a medical or dental practice is not a collectible.
How to Pay Zero in Taxes
The lowest possible tax bill you can get in this situation is zero. That's not actually true. You won't get that tax bill; your heirs will. If you hold on to the practice until you die, your heirs will get a step up in basis and can then sell the practice and pay $0 in capital gains taxes. That's not very practical for most, but you are already 84 years old (the average life expectancy of an 84-year-old male is 6.4 years), so it should be considered. The main problem with this approach is that retired doctors want the money, not the practice. A secondary problem is that without a transition period of the owner-doctor working in the practice, the practice is not nearly as valuable as it would be with that period included. But these can be overcome in select cases. You could own the practice until the day you die and just employ associate dentists and enjoy an income stream from the profits for the rest of your life.
If you really needed more money, you could even borrow against the practice. While loans aren't interest-free, they are tax-free.
More information here:
Top 10 Ways to Lower Your Taxes and Lower Your Tax Bracket
Tax Policies: Enjoy Them But Also Reform the Right Ones
Pore Over Records for Additions to Basis
If you are going to sell the practice, you want to get that basis as high as you can. Pore over all of your records for anything that you can add to the basis. You're mostly looking for real estate improvements here. You should have the ability to add that cost to your basis, at least the amount that you haven't taken as depreciation. Your practice may be set up as two entities—the business and the real estate—and you may have to consider them both separately in this regard. While more complex, that approach also gives you more options, like just selling one or the other.
Remember That Not Everything Is Treated the Same
A business generally owns several different kinds of assets. Upon selling, the assets have to be classified into one of the following types with resulting different tax treatment:
- Capital assets: Capital loss or gain
- Depreciable property used in the business: Section 1231 loss or gain (if held > 1 year)
- Real property used in the business: Section 1231 loss or gain (if held > 1 year)
- Inventory: Ordinary income or loss
Keep in mind that it matters how the value of the business is split. The buyer will prefer one type of split, and the seller will prefer another. The negotiation may involve both the price and how the sale price is allocated between the various assets. If you get a favorable split, you may be willing to take a lower price. For example, “goodwill” (reputation of the business, the patients that are likely to stick with the practice, etc.) is a capital asset. The higher its value, the more of the sales price that the seller can take as a capital gain, paying a lower tax rate and potentially offsetting it with capital losses. However, the buyer can only amortize goodwill over 15 years. So, buyers prefer to allocate more of the value of the business to equipment than goodwill. Whether the sale is structured as an asset sale or stock sale also has variable tax and other consequences for both buyer and seller.
Installment Sales
You may not wish to receive all of the income from the business at one time. Perhaps if you spread it out over a few years, you can pay at the 15% capital gains rate instead of the 20% capital gains rate. You might even get out of some NIIT. Of course, an installment usually means the buyer will also pay some interest, which is taxed at ordinary income tax rates. They might also destroy the practice, die, or retire before paying for the business, which may cause you to never receive full payment for it.
More information here:
Tips for Buying and Selling a Practice
How to Evaluate a Medical Practice Buy-In
Take Back a Note
Typically, a practice buyer will get a business loan to buy your practice from you. However, there's no reason that you cannot be the provider of part or all of that business loan, especially if they're having trouble getting one. You could “take back a note” of 3-30 years for all or part of the purchase price. Much like an installment sale, part of the payments will be principal (and you'll owe capital gains taxes on the “gain part” of that principal) and part will be interest (on which you will pay ordinary income taxes). Like car dealerships, you may make more on the interest in the long run than you do on the sale of the asset itself!
Tax-Loss Harvesting
Faithful White Coat Investor readers know that capital losses acquired through tax-loss harvesting can be used to offset capital gains and up to $3,000 per year in ordinary income. Any unused losses are carried forward indefinitely. If you have been booking losses in your taxable brokerage account throughout your career, they may add up to hundreds of thousands or even millions of dollars. Those losses can all be applied to the capital gains from the sale of your practice. They can also be used when selling a home that has appreciated more than $250,000 ($500,000 married). Note that when using capital losses to offset Section 1231 gains, the depreciation recapture cannot be offset by capital losses, and it is taxed at ordinary income tax rates with a maximum of 25%. But any gain above and beyond that can be offset by capital losses.
The sale of a practice can be a bittersweet day. Like a boat, the two happiest days of ownership are the day you buy it and the day you sell it. The money from that sale may become a huge chunk of your nest egg and may fund many glorious years of retirement. If you properly plan for it, you can minimize the tax bite from Uncle Sam and keep more of it yourself to fund that retirement, leave to heirs, or support your favorite charities.
What do you think? Have you sold a practice? What did you do to minimize the taxes?
Hi Jim- good news, the seller is not likely to owe NIIT as he was active in the business being sold. See point D on item 10 from this page at the IRS: https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax. -Thomas
I am getting to the age where I might want to retire. In my earlier career, I worked tons of clinical hours taking care of patients. Then I started hiring other doctors and I ended up building a large, successful multi-specialty group practice.
I am now facing a decision about my next financial move. I am on a glide-path to less clinical work each year. And I am mentoring the younger generation of doctors, having placed talented physicians in leadership positions, who are increasingly running the practice on a day to day basis over time. So my leadership responsibilities are being handed off more each year.
I am thinking I might simply continue cutting back while continuing to earn a 7-figure salary from profits each year. All of the docs are making very good incomes and bonuses, so everyone is quite happy, with minimal turnover. Selling the practice I built feels complicated and unnecessary given my ability to continue to draw income while having the freedom to travel extensively and spend time with my 3 new grandchildren.
I met with our business attorney and I am thinking to grant a small amount of equity ownership to a handful of the key physician leaders. We already share millions of dollars in profits each year broadly in the form of bonuses to the physicians and surgeons. What am I missing with this plan?
Why not just sell to them over time?
One area often overlooked by many is using charitable trusts and structures to minimize taxes and even in some cases eliminate taxes, I sold a company, albeit not a medical practices years ago and used a charitable remainder trust (CRT) to minimize my taxes. Twenty years later I am still receiving distributions from the trust at a 7.3% payout of principal and interest. I put a portion of the business in a CRT when I sold, and the proceeds for that portion was sold in the trust without capital gains tax. Setting up a portfolio the assets are not taxed, only my distributions. It is one of my best retirement planning tools. The proceeds from the CRT will go to a family foundation I established, so my children can be more involved with the community etc. Finally, those assets are creditor protected too.
My point here is there are tax strategies that are approved by the IRS that can minimize taxes.