Oct 27, 2016
Negotiate the Asset Allocation When Buying a Dental Practice
Written By: Brian Hanks
When trying to negotiate buying a dental practice, it’s important to find ways to negotiate beyond just the price. A good negotiation is one where you can avoid simply haggling over one number. In last week’s post, we discussed how a buyer can get real dollars in their pocket by negotiating the purchase of the accounts receivable. Today we’ll discuss another great way to find real value when you negotiate buying a dental practice – the asset allocation.
What is the Asset Allocation on a Dental Practice Transition?
Asset allocation is an accounting term. Asset allocation is a fancy way to say how much value the accountants in the deal are assigning to the different items being purchased.
“But I’m only buying one thing,” you may say, “a dental practice!”
Not true, says the IRS.
When you buy a pair of shoes in the store you really are only buying one “thing.” It’s a one-for-one exchange. Money for a sweet pair of kicks.
When you buy a business, however, you’re paying for multiple different types of assets. You’re buying supplies, equipment, goodwill, and other types of assets.
There are different accounting and tax rules around those different types of assets. If you’re savvy, you’ll look at the asset allocation as an opportunity to negotiate a win/win for you and the seller.
Depreciation is Why Asset Allocation Matters
The primary reason the asset allocation matters is the IRS allows different depreciation time periods for different asset types. Depreciation is easy to understand with a quick example. Pretend you stumbled upon a genie right after graduating dental school. One of the wishes the genie offered you is for your first job as a dentist to pay you for the next 5 years of work all in advance.
(Ignore for a minute your stunningly inept ability to think of better wishes and go with this example…)
There you are, the morning of your first day as a real dentist, gigantic check in hand and feeling good. You’ve got a pile of money and haven’t had to work for it yet. Honest person you are, you are still going to show up to work and work just as hard as if the owner was just paying you as you go.
But what about the owner? Does she get to say she had a gigantic expense in year 1 and avoid taxes that year?
The IRS would apply depreciation rules to my completely ridiculous example and only allow the owner to count 1/5 of that gigantic check of yours for each of the next five years. After all, the gigantic paid-in-advance check is for your next 5 year’s work.
The same principle applies to any asset you purchase as a business owner that has a value of more than $600 and a useful life of more than a year. For example, when you buy a computer, you’re probably going to use it for more than 1 year, and as such there are rules about how much of the computer’s price you get to expense on each year’s tax return.
Depreciation is the rule that allocates value to a tangible asset over its useful life. It’s an attempt by the IRS to match the expense of an item to the revenue that the asset helps you earn.
Typically, the depreciation rules break the assets of a dental practice into the three main buckets seen in the images below.
How does this affect the seller? The seller doesn’t care about depreciation, so why not try and just load everything into the categories most helpful to you as the buyer? Let’s stick everything in Dental and Office Supplies and Dental Equipment!
Not so fast.
On the other side of the transaction, the IRS has different rules for the seller for the tax treatment of different assets sold.
How the Seller Gets Taxed when Buying a Dental Practice
The IRS has two ways to tax sales of assets where the seller makes money – ordinary income and long-term capital gains. Let’s look at ordinary income first. This is the type of tax most people are familiar with. The ordinary income tax rates start at 10% and go up to a whopping 39.6%!
The second way the IRS taxes gains on asset sales is called capital gains. The basic theory behind capital gains is the IRS wants to reward people who invested in resources productive for society, like a business, with a lower overall tax rate on any gains from those investments.
The difference between the two is substantial, anywhere from 0% for low-income taxpayers to 20% for those in the top tax bracket.
If you are a seller, the obvious takeaway from this difference is that you want as much of your income to fall in an asset category where the IRS will tax it as capital gains, and not ordinary income. Doing this could save you as much as 20% on whatever money you can move from an ordinary income category to a capital gains category. Huge savings!
The Amounts are Negotiable
An important point to consider is as long as the buyer and seller are both consistent in how they treat the values in the different categories (they are both required to report these numbers to the IRS independently), the actual amounts allocated to the different assets is negotiable.
What does the law say? According to the IRS, the technical way to allocate the purchase price among the different assets is to allocate the Fair Market Value to the identifiable assets (patient records, equipment, supplies, etc.), then the remainder, if any, is allocated to Goodwill.
Many buyers assume the values assigned to the different categories are predetermined and set in stone. However, the definition of “Fair Market Value” is the price an independent buyer and seller can agree upon. So basically as long as you and the seller agree on the price allocated to the assets, that price is correct.
How to Negotiate Asset Allocation when Buying a Dental Practice
So what’s the point? As the buyer, you’re looking for opportunities to negotiate with the seller on more than just the asking price. Ideally, there are lots of different areas where your interests overlap or, at least, aren’t directly opposed to one another. We now have three categories with significant dollars behind them where the buyer and seller can move levers to find the option that works best for everyone and leaves everyone happy – price, accounts receivable, and asset allocation.
For example, Dr. Seller could feel very strongly she wants a full-price offer on the practice she’s worked hard to build over the last 25 years. Dr. Seller is going to be on the golf course a lot with her dentist friends and wants to be able to say she got a full price offer for her practice.
Dr. Buyer could ask if she would be willing come down in the percentage of the sale in the goodwill category and increase the amount allocated to equipment to allow her to depreciate the total cost of the sale more quickly.
Alternatively, Dr. Seller might be very sensitive about the large tax bill coming when he sells his practice. “No problem,” says Dr. Buyer, “if you can come down in price a bit, I would be willing to increase the asset allocation of goodwill to allow you to have more of the sale taxed as long-term capital gains.”
I’ve seen this happen frequently. Everyone walks away feeling like their needs are addressed and ultimately more satisfied with the deal.
Other Things to Negotiate When Buying a Dental Practice
Purchase price, accounts receivable and asset allocation are not the only items you can negotiate when buying a dental practice. They’re the main items with real dollars behind them. But what if you need a little more ammunition as the buyer? What if you need a little extra push to get a seller on board with a plan that works well for you?
Other common areas of negotiation include:
- Start Date
- Letter to active patients
- How to handle current employees
- Right of first refusal on the purchase of the building
- Restrictive Covenant
If there’s one eternal truth I’ve seen when helping buyers purchase a dental practice, it’s this: The more knowledge and more options there are, the higher the chance of pulling together a deal.
Ultimately, most buyers and sellers want the same thing. They want to successfully transition the business into new, responsible hands that will take great care of the staff and patients. They want to be rewarded for all the hard work they’ve done to that point – the seller with a gigantic check and the buyer with a steady income stream from a healthy business.
You’re more likely to get a win/win with a seller if you know what you can negotiate. Price is always negotiable. Purchasing the accounts receivable is a good negotiating point too. A great third option with real dollars behind it is the asset allocation. Know a few of the basics and work with your dental accounting firm to advise you on how you can profitably negotiate with the seller and create a situation where everyone wins.
Know someone about to buy a practice? Share this article with them! Or, have them reach out directly to me via email: email@example.com to help them through the process.
Read more below about dental transitions because you want to negotiate a great deal!
Four Things Your Attorney Should Do for You When Buying a Dental Practice
A Letter of Intent Should Include This When Buying a Dental Practice
Why You Should Buy a Dental Practice BEFORE Your Student Loans are Paid Off