Today, we are going to look at the tax breaks you receive after buying the assets of a business or practice.
For our example, we will look at the acquisition of dental practice worth $600,000, financed by a bank, and organized as an S-corporation.
The new practice owner received $200,000 of tax breaks the first year which reduced taxes paid by $70,000. “Stock deals” (where you buy stock of an existing corporation) use a separate set of rules so these benefits do not apply.
ALWAYS CHECK THE ALLOCATION: Accountants use the purchase price allocation in your valuation so be sure to make sure the values are reasonable. If not, you could be MISSING HUGE TAX SAVINGS.
The Gear Break (Equipment)
The valuation for the practice includes the estimated fair market value of each piece of equipment such as dental chairs, servers, office chairs, and equipment. The IRS allows the new practice owner to deduct the value in the first year (under section 179). That is huge benefit in year one!
In our example, the new practice owner can deduct $75,000 from their taxes for the equipment. In the 35% bracket, the new practice owner pays $26,250 less in income tax.
The Collections Break (Accounts Receivable)
This tax break is based on the valuation of account receivable done in the acquisition. The key point is VALUATION, not VALUE. If the earlier practice owner had $50,000 of accounts receivable VALUE but $10,000 is outstanding by 180 days, then the VALUATION discounts the $50,000 to a lower number. New practice owners cannot expect to collect the full value of accounts receivable that are older so there is a discount applied.
The IRS allows the new owner to deduct $60,000 of accounts receivable. In the 35% bracket, the new owner pays $21,000 less in income tax.
The Debt Break (Interest Expense)
Unlike most debt in our lives, the big loan used to pay for a business has a tax benefit of interest expense.
In our example, the interest on a $600,000 loan is around $25,000 in the first year. The new owner receives the $25,000 deduction which reduces income tax by $8,750 in the 35% tax bracket.
The “Leftover” Break (Goodwill)
Goodwill is the value remaining after you subtract equipment, supplies, and receivables from the purchase price. It is the value of the cash flow the selling doctor can generate using the equipment (i.e., a dental chair is worth more with patients attached to it)
Goodwill can be confusing so let me explain with a formula.
First, find the value of the practice based on the cash flows an owner will receive in the future. $600,000 in our example
Next, put a valuation on the equipment, accounts receivable, and supplies. $150,000 in our example.
Subtract the value in 2 from 1 to calculate goodwill
Goodwill=Purchase Price-Value of Equipment, Accounts Receivable, and Supplies
In our example, goodwill is $450,000 and this break must be allocated over 15 years. In the first year, the new owner receives $30,000 in tax break which reduces income tax by $10,500.
The Inventory Break (Supplies)
Every practice has a closet or drawer with stuff ordered from Amazon, Henry Schein, Grainger, or Office Depot. While these items are typically small and inexpensive, the inventory value is included in the practice valuation.
If the practice has $15,000 in supplies, the tax break is $5,250 at a 35% tax rate.
By lowering your taxes due, you will have more cash in the first year of ownership than in future years due to tax deductions. Year one of ownership is a perfect time to start building your savings!
In our example, the new practice owner paid $70,000 less in taxes because we took advantage of IRS tax rules.
Tax Break Total
Gear Break $26,250
Collections Break $21,000
Goodwill Break $10,500
Debt Break $8,750
Inventory Break $5,250
Total Reduction $71,750 in taxes paid
If you want to discuss your unique situation, schedule a FREE 15 MINUTE CALL to see how we can help you take advantage of the tax code.