Tax Consequences of Selling Your Dental Practice

Many dental practice owners eventually seek to sell their practice, relying on this sale as a fundamental part of their retirement strategy. The sale of any business involves a lot of planning, negotiation, and overall strategy—and dental practices are no exception! As part of the process of selling any dental practice, business owners should consider the tax consequences that will result from the sale and how they can minimize their tax exposure. This guide seeks to highlight some of the major tax considerations anyone seeking to sell their dental practice should keep in mind throughout negotiations and the eventual sale of their practice.

Tax Consequences Based on the Current Business Structure

The first thing to consider is the current structure of the business. The entity status and structure of the business will affect how the sale will be taxed. Dental practices are typically structured as some form of a sole proprietorship or partnership. The sale of a dental practice structured as a sole proprietorship, partnership, limited liability company (LLC), or S Corporation will be taxed as income paid to the individual owner(s).

Therefore, the practice will be subject to that specific individual’s ordinary income or capital gains tax rates. On the other hand, if the dental practice is structured as a C Corporation, the business itself will be taxed on the sale of the business at the applicable corporate tax rate.

Allocation of Assets to the Purchase Price

For tax purposes, the most important part of the sale of any dental practice is the negotiation between buyer and seller for how the purchase price will be allocated among different assets. Dental practices have a variety of assets that are weighed when determining the final purchase price like client lists, equipment, value of the practice’s branding, accounts receivable, real property, etc.

Under IRS guidelines, the purchase price must be allocated among the assets that were transferred as part of the sale. This allocation determines whether the assets will be subject to capital gains or ordinary income tax rates. The allocation provides the seller with a tax basis for their newly acquired assets.

The IRS guidelines require assets be divided among seven different categories:

1. Class I – Cash and general deposit accounts, such as checking and savings accounts
2. Class II – Actively traded personal property, such as stocks
3. Class III – Accounts receivable and other assets marked to market for federal income tax purposes
4. Class IV – Inventory
5. Class V – Real estate and other fixed assets, such as furniture, fixtures, vehicles, land, and equipment
6. Class VI – All intangible assets except for goodwill or going concern. Examples include business books & records, licenses or permits, enfranchisements, interests in land, certain computer software, and so on
7. Class VII – Goodwill and going concern

The allocation of the purchase price among these different classes of assets affects both the seller’s tax liability and the buyer’s tax basis in the acquired assets. Sellers will be very sensitive to the allocation price to certain categories because it will determine how much tax liability the seller is subject to.

For example, the Class IV inventory category is subject to an ordinary income tax rate—a rate that can go up to 37% in 2022—while Class V real property and Class VI intangible property will be subject to the more favorable capital gains tax rates.

Thus, any allocation to these classes will be heavily negotiated. Sellers of a dental practice should thoroughly review how assets are distributed and negotiate the best allocation possible to avoid tax exposure. In the event that the buyer prefers an allocation that is not favorable to the seller, there may be an opportunity to ask for an increase in the purchase price upfront to account for the negative tax consequences of the allocation.

IRS Filing Requirements

The IRS requires that both the seller and purchaser of the business individually fill out Form 8594 Asset Acquisition Statement. The form reflects each party’s information and, importantly, details the allocation of the purchase price among all seven classes of assets. The form must be filed as an attachment to your income tax return in the year the sale date occurred. If the sale occurred in 2022, both the buyer and seller must fill out form 8594 and attach it to their respective federal tax returns for 2022.

Note that certain transfers of assets are exempt from filing Form 8594. For example, assets in a like-kind 1031 exchange do not have to file Form 8594. However, if a portion of the assets are not part of the like-kind exchange, Form 8594 is required.

Penalties for Failure to File

Filing the Form 8594 is required unless specific exceptions are met. If a taxpayer fails to file a Form 8594, they will be subject to a penalty or penalties. The penalties can vary greatly depending on the gravity of the failure, the time it took for the taxpayer to correct the error, and the taxpayer’s history of failing to file in previous years among other factors. If you are issued penalties for failing to file Form 8594, consult your tax counsel and other tax advisors for proper steps to mitigate against the penalties.

What Now?

The sale of a dental practice can be an exciting time in a business owner’s life, and the sale can result in both parties leaving the table satisfied with a great business deal. Lowering your exposure to tax liability from the sale of a dental practice can help sweeten the deal even further.

Ensure your business strategy is tax-advantaged. See how Corvee can help!