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Transferring ownership of an optometric practice

April 22, 2012

By James R. Armstrong, CPA, and Jodi Permenter, CPA

Finally made the decision to buy or sell a practice? Don’t enter into an agreement without giving consideration to exactly how this will be done. The structure of a transaction may affect the sales price the seller receives, the income tax liability on the sale, and future liabilities associated with the business.

Similarly, for those looking to establish or expand their practice through the purchase of a pre-existing entity, the structure of the sale will influence the bottom line for years to come. It may seem like a simple transaction, but the sale of a practice has far-reaching effects.

The methods of practice sale differ according to the type of business entity and the state in which it was formed. 

A sole proprietorship or other single-member entity can be transferred with a simple agreement between the buyer and seller. 

Entities with multiple members or partners may require the approval of the sale by the remaining partners. 

Partnerships and multi-member limited liability corporations (LLCs) can be further complicated because, depending on state law, the entity may automatically dissolve upon the withdrawal of a partner. 

In order to prevent problems when a partner does wish to retire or sell a portion of the partnership, it is important for partners to sign an agreement dictating how a sale of a partnership interest must be executed. 

Generally, a partnership agreement, operating agreement, or a buy-sell agreement should be included in the organizational documents of the entity.

There are two general ways to structure the sale of a business: a sale of assets or a sale of stock/ownership interest. 

While there are benefits and drawbacks to each, sellers generally prefer to execute a direct stock sale, while buyers find a direct asset sale more advantageous.  

It is important to understand the point of view of both parties in the sale, as it can have a large impact on selling price and negotiations, as well as the future cash-flow of the transaction.

A stock sale occurs when a buyer purchases an ownership interest in the company itself. 

This type of sale effectively and efficiently transfers all assets and liabilities of the business to the new owner. The titles of all assets belonging to the entity do not need to be transferred, which greatly expedites the sale process. 

In addition to reducing the paperwork, this method of sale also preserves the existing contracts the business maintains with other entities.  For example, contracts with suppliers, landlords, employees and customers will remain intact. Even line of credit (LOC) agreements with creditors will remain.

In the case of an asset sale, these contracts may have to be renegotiated with the buyer, as the buyer will form a completely new entity. Purchasing stock in an optometric practice is similar to purchasing stock in Google, Apple or any other corporation listed on a major stock exchange. When the stock is purchased, the corporate structure remains intact.

However, a total transfer of assets and liabilities in a stock sale has its drawbacks. The buyer will be responsible even for liabilities that were unknown at the time of the sale, such as product guarantees and employee or customer lawsuits that may not arise for many years after the sale. 

In most cases, the buyer has no recourse against the seller to collect payment for these liabilities. A well-drafted purchase agreement can provide some protection to the buyer, but it usually includes a time limit, a “floor” amount (also called a “basket”) and a “ceiling” amount. The clause will not be triggered until the undisclosed liabilities, cumulatively, exceed the “basket,” and any liability amount in excess of the “ceiling” will be the responsibility of the buyer. 

A stock sale is generally advantageous to the seller, with respect to tax liability, in the case of a gain on the sale.  Again, it may be helpful to think of the sale of an exchange-listed stock such as Google, where the seller would calculate the gain based on the sales price less the price paid for the stock, also known as the basis, and because the seller’s basis in a business may be nominal, most sales result in a capital gain. 

The good news is capital gains are taxed at a preferential rate compared to ordinary income. Currently, the capital gain rate is 0 percent to 15 percent, compared to ordinary income rates that range from 10 percent to 35 percent.
 While the seller receives fairly favorable treatment in a stock sale, the purchaser ordinarily gets the proverbial short end of the stick. Not only does the purchaser have potential liability as discussed above, but the tax aspects of the purchase are not most favorable. When purchasers buy the stock of a corporation, this becomes their basis in the stock, which is not deductible. 

In the Google example, a stockholder only gets to “deduct” the basis in the stock when the stock is sold.  This holds true in a practice purchase as well. If a buyer pays $300,000 for the stock of a practice, the buyer gets no tax benefit for this at the time of the purchase; it is simply the buyer’s basis in the stock of the practice. 

An asset sale occurs when a buyer purchases selected assets from the practice directly. The buyer will use the assets in a new or existing business. The seller will be left with the ownership interest in the business, although it may be worthless.

The tax benefit goes to the buyer in this type of sale structure. Rather than inheriting the existing depreciation schedule from the business, the buyer receives a “stepped up” basis in each of the assets.

The purchase price is allocated to the assets based on their value, and the new basis is then depreciated over the remaining useful life of the assets. The depreciation deduction can be used to reduce the buyer’s tax liability for years to come.

However, the tax benefit for the buyer comes at the expense of the seller. Unlike a stock sale, the gain on the sale could be subject to a higher tax rate due to depreciation recapture. 

Because the business has been recognizing depreciation deductions for the assets against ordinary business income, the amount of gain that is attributable to this depreciation is taxable at the ordinary income tax rate. In addition, if the business being sold is structured as a C-Corporation, the transaction could result in double-taxation. The corporation will be responsible for paying tax on the gain from the sale of assets. The sellers will then have to pay individual income tax to liquidate their investment in the corporation.

An asset sale allows much more flexibility than a stock sale. Instead of purchasing all assets and liabilities, the buyer and seller can pick and choose the assets they want to purchase or sell, respectively. This can also be advantageous to the buyer, who can reduce the total selling price by only purchasing assets that are needed. However, it will greatly increase the amount of time required to negotiate and execute the sale. Usually this increased time investment is worthwhile to the buyer, who will be free of all unknown liabilities incurred by the entity.

For example, let’s say Dr. Mullen is ready to retire and his practice consists of one piece of equipment purchased for $75,000, which Dr. Mullen had fully depreciated in the prior year. The fair market value of the piece of equipment is $75,000. Dr. Mullen’s practice is a professional limited liability company (PLLC) that has made an S-election. Dr. Mullen started this practice from scratch and has zero basis in his ownership interest in the practice.  Dr. Mullen has negotiated a sale to Dr. Miles for $100,000. 

If the sale is structured as a stock sale:

  • Dr. Mullen will have a $100,000 capital gain, which is the sales price of $100,000 less his basis in the company stock of $0. Dr. Mullen will receive preferential capital gains rates on this sale and will most likely result in $15,000 in federal taxes.
  • Dr. Miles will have a $100,000 basis in the company stock and will get no deduction for this amount until he eventually sells the stock to another OD. Dr. Miles has potential liability for any claims against the company. Dr. Miles also will have no depreciation deduction in the future on the piece of equipment, as the company had already fully depreciated it in a prior year. Although Dr. Miles may not have any immediate tax benefits, when he chooses to sell his practice, his will be able to reduce the gain by the $100,000 basis he has in the practice. The first $100,000 of the selling price will not be subject to tax as it is a return of capital.

If the sale is structured as an asset sale – $75,000 for the piece of equipment and $25,000 for goodwill:

  • Dr. Mullen will have gain from the sale of the piece of equipment in the amount of $75,000. This is calculated as the fair value of the piece of equipment less the basis, which is zero because he had fully depreciated the asset in a prior year. This is subject to ordinary income tax rates that can range as high as 35 percent. If Dr. Mullen is in the highest bracket, he would owe in excess of $26,000 on this portion of the sale. Dr. Mullen would also have a capital gain of $25,000 for the sale of the patient list, known as goodwill. This would cost Dr. Mullen almost $4,000 in taxes, for a total of near $30,000, or approximately double that of a stock sale. 
  • Dr. Miles would have a $75,000 basis in the piece of equipment, which he could choose to fully depreciate under code section 179. He would also have a depreciable basis of $25,000 for goodwill that would be depreciable over 15 years. If Dr. Miles is also in the 35 percent tax bracket, the asset purchase will result in almost $27,000 of tax benefits in the first year, for a total tax savings of $35,000 over the next 15 years. If Dr. Miles eventually sold the practice, he will not have any remaining tax benefits. If the sale is structured as a stock sale, Dr. Miles will not have any basis in his practice to offset the income. In addition, if he also structures the sale as an asset sale, any gain may be subject to depreciation recapture.

It is easy to see the tax ramifications are vastly different under each of these scenarios. For this reason, an attorney and a tax adviser should be included in all negotiations, from the early stages to the final signature.

J.R. Armstrong, CPA, is a partner in the firm of May & Company, LLP.  Jodi Permenter, CPA, is a member of the professional staff of May & Company, LLP.  The firm consults with optometrists in 30 states, assisting with their tax planning and preparation, QuickBooks support, and business planning. May & Company was established in 1922 and has offices in Louisiana, Mississippi, and Alabama. J.R. Armstrong can be reached at 601-636-4762 or jarmstrong@maycpa.com.

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