By Adam Decker, CPA, CVA
There aren't many dental practices today that operate as C-corporations for federal income tax purposes, but they do exist. While some of these may have been formed recently with a specific purpose or reason that is still relevant today, most are remnants of old laws and rules. For instance, under the old rules (pre-1987) there were graduated tax rates for corporate level income until the personal service company (PSC) rules came along and imposed a flat 35% tax rate. In addition, under old law health insurance was only partially deductible by a self employed S-corporation owner or sole proprietor, where it was fully deductible by a C-corporation. These two tax benefits of a C-corporation no longer exist.
Those who operate as C-corporations likely haven't noticed much of a hit from being set up as such. Most often, a C-corporation pays the majority of its profits out in salary, reduces earnings to close to zero, and pays little or no dividends. Thus, the double tax issue of being a C-corporation is minimized. So what’s the big deal? Why should the C-corporation owner beware? The answer looms when it’s time to transition.
A C-corporation's capital gain income does not receive preferred capital gain tax rates that individuals (and thus pass-through LLCs or S-corporations) receive. As a result, capital gains recognized by a C-corporation are subject to the same 35% tax rate as all other income the company earns. On a sale, this can have a substantial impact on the net proceeds the owner recognizes, because often goodwill, which is capital property, is a large portion of a practice sale (and thus non-C-corporation sellers pay 15% on a portion of their gain, which many times is a substantial portion). In addition, in the year of the sale, it may be unreasonable to pay the entirety of the proceeds out in the form of a salary. As a result, the double taxation that had been minimized in previous years is now a problem.
Compare this potential result with that of a pass-through entity (or sole proprietor). The capital gain rate is currently 15% and there is no double taxation. Assume a practice sale results in total taxable gain (assume little equipment, etc., so it’s all capital gain) of $500,000. In a pass-through entity, this would be subject to 15% tax (plus applicable state/local), therefore a tax bill of $75,000. In the C-corporation, you could see a tax bill as high as $224,000 ($500,000 less 35% tax, net of $325,000 that is paid out in dividends subject to 15% tax of $48,750)!
Luckily, this isn't a foregone conclusion. With some strategic planning and preparation, some or all of this differential can be eliminated. One option is to convert a C-corporation to an S-corporation. While this may be an involved process that could accelerate some tax today, it may be worth the effort and cost. However, if a sale is likely within the next five or less years, this is probably not a reasonable option.
When a sale is likely within the next couple of years, another strategy is for the owner to personally sell his goodwill at the individual level, thus preserving the low capital gain treatment. However, this should be approached with caution and proper planning. There are a number of court cases that have disallowed this approach, costing sellers hundreds of thousands of dollars.
If you are a C-corporation, but aren't sure why and haven't questioned it, find out today. There may be a good reason or there may be a way out. Work with your dental CPA or tax advisor to understand the reasoning. Preparation today could mean substantial dollar savings and a lot less regret.
As co-founder of Veros Dental, Adam Decker, CPA, CVA, works with dentists to manage and bridge their business and personal financial picture. Veros Dental’s team provides comprehensive and insightful financial services for dentists from investment and practice strategy to tax compliance and bookkeeping. Contact Adam at [email protected] or see www.verosdental.com.
By Adam Decker, CPA, CVA