What potential capital gains changes mean for your dental practice sale: four scenarios

This article was originally published by ADA Practice Transitions (ADAPT).

The proposed spending bill currently making its way through legislation brings with it some big changes to capital gains tax rates. What does this bill mean for dental practice owners looking to sell?

For nearly the past decade, the top tax rate on capital gains has remained steady at 20%; however, the proposed $3.5 trillion spending bill currently making its way through Congress includes substantial changes to capital gains tax rates that would significantly affect the tax burden for someone selling their dental practice. That may influence whether and when they want to sell.

Selling a practice has always been a complex decision that generates many previously unthought-of questions for practice owners. One of the most important being:  What will the tax implications be from the sale?

The answer to that question has many different facets, but the most impactful would be capital gains tax in regard to selling capital assets or, in this case, a practice. Capital gains refers to the increase in value of a practice from the date purchased (or started) to the date sold. Prior to this proposed legislation, upon the sale of the asset, these gains become realized or taxable and are subsequently taxed at the preferential capital gain tax rates of 0%, 15% or 20% based on one’s respective income brackets.

The tables below summarize and compare the current law to the latest proposed changes in the House Ways and Means bill as it relates to some potential capital gains changes for individuals.

In addition, the current version of the proposed bill implements an expansion of the 3.8% net investment income tax. For single taxpayers with taxable incomes over $400,000 ($500,000 for joint filers), net investment income would include income derived in the ordinary course of a trade or business regardless of whether the taxpayer materially participates.

Four sample scenarios

The following scenarios show the effect of the proposed changes on the amount of capital gains tax from the pass through of capital gain to the owner associated with the sale of their practice:

Scenario 1 (no change to tax code):

DDS (Doctor), who files married filing jointly, sold his practice prior to the implementation of the proposed law and realized $1 million of capital gain.  He has no other income. What would be the capital gains tax?

Answer: DDS will be assessed a $162,800 capital gains tax liability associated with the sale calculated as follows:

($80,800 x 0%) + ($420,800 x 15%) + ($498,400 x 20%) = $162,800

Scenario 2:

Assume the same facts and circumstances as scenario 1 except DDS delayed the sale until after the  proposed law took effect  (potential date new rates become effective is Sept. 13, 2021). What would change?

• DDS will now be assessed a 25% tax liability on the excess gain over $450,000

Answer: The doctor will be assessed a $231,420 capital gains tax liability associated with the sale calculated as follows:

($77,200 x 0%) + ($372,800 x 15%) + ($550,000 x 25%) + ($1,000,000 x 3.8%) = $231,420

Scenario 3:

Let’s look back at Scenario 2 from above and assume, instead of having no other income, the selling DDS now has $600,000 of other income in addition to the $1 million capital gain from the sale of the practice. What would change?

Answer: DDS will be assessed a $288,000 capital gains tax liability associated with the sale calculated as follows:

($1,000,000 x 25%) + ($1,000,000 x 3.8% NIIT) = $288,000

As we can see in the above scenarios, based on simplified facts and circumstances,  the doctor would incur an additional $56,580 of tax liability  under the proposed increase of the top capital gains tax rate and their respective income thresholds alone.

Together, these seemingly small tax law adjustments have the potential to create large tax implications for doctors thinking about or currently selling their practice that should be taken into consideration.

It is worth noting the proposed increase in the top capital gains rate diverges from President Biden’s American Families Plan, which calls for capital gains to be taxed at ordinary rates to the extent adjusted gross income exceeds $1 million. The president’s proposal would effectively eliminate historical preferential capital gains rates for high-income taxpayers. Compounding this is the proposed increase in the top individual income tax rate to 39.6% from 37%. Should the proposed law change before enactment to align with the president’s proposal, we could see top federal rates of 43.4% on capital gains. In addition, let’s not forget when selling a business under current law, certain aspects of the sale get taxed as ordinary income including the recapture of accelerated depreciation and the portion of the purchase price allocated to accounts receivable.

Scenario 4:

Let’s look back at Scenario 3 and assume the same facts but that the law that is passed ultimately aligns with the president’s proposal (not in the Ways and Means Bill referenced above). What would change?

• DDS adjust gross income would be $1.6 million, exceeding the $1 million threshold and triggering their capital gain to be taxed at ordinary income rates

Answer: DDS will be assessed a $355,000 capital gains tax liability associated with the sale calculated as follows:

($400,000 x 20%) + ($600,000 x 39.6%) + ($1,000,000 x 3.8%) = $355,000

This liability is $192,200 larger than under current law and $67,000 larger than under the current proposed law changes. These results show significant increases and require careful income planning, in not only the current year, but also in future years to try to reduce or defer this tax liability.

We have touched on a few proposed changes related specifically to capital gains; however, there are additional factors to consider that can affect the sale and tax associated with selling your practice, such as:

• Effect of depreciation on one’s total capital gain
• Net investment income tax
• State income taxes
• Benefits versus risk of a deferring tax via an installment sale
• Benefits versus risk of waiting to sell
• Overall planning strategies

These capital gains tax rate changes, in their current state, are still proposals working their way through legislation. Therefore, there is a possibility the facts and figures presented will vary from those included in the final bill, but the most important change stemming from this bill would be the date these changes take effect. If passed as-is, these changes would be effective for any gains after Sept. 13, 2021.

If you are considering selling your practice, or are in the process of selling, closing the sale before enactment and hoping the  effective date of these changes is extended  is an ideal situation. Regardless, with all these changes and factors associated with selling a practice, consider discussing it with your tax advisor.

For more information on this topic, or to learn how Baker Tilly dental practice specialists can help, contact our team.