October 1, 2021
by Michael Carabash, BA, LLB, JD, MBA, CDPM
Dental practice values are back up. Everyone’s hounding you to sell. Maybe you’re tired of the daily grind of running a dental practice – especially during COVID-19.
You find yourself drifting off. You’re on a pristine beach, at your cottage or on a golf course. You see yourself spending more time with family and friends, taking up new hobbies. Perhaps you even see yourself giving back (like volunteering on one of my annual dental mission trips).
Then the cold, hard, reality of tax planning for a sale hits. You wake up and realize you’re not prepared. But what you do or don’t do now will determine how much money you keep after you sell. And that will help make your dreams a reality (or not).
Thankfully, dentists are allowed to organize their sale to minimize their taxes. It’s called tax avoidance and it’s perfectly legal (not to be confused with tax evasion, which is quite illegal). Tax planning for a sale helps determine:
But tax planning before selling your practice isn’t simple or sexy. It’s hard to grasp and execute. Real estate agents, financial advisors and bankers can’t get involved (it’s above their pay grade). Transactional lawyers generally defer tax matters to accountants. And many accountants defer to tax lawyers.
But selling dentists need to appreciate some tax law fundamentals because, ultimately, the buck stops with them. They’re the ones that take the risk of the Canada Revenue Agency coming after them or the purchaser of their dental practice. If the selling dentist understands their options, the process and costs involved, the potential rewards (ie: lower taxes), and the risks involved (being audited and having to pay extra taxes, interest and penalties), then they can dictate how they want their sale transaction to unfold.
So let’s talk briefly about some key tax transactions that occur in the context of a practice sale. (This information is for educational purposes and is not legal advice.)
The Lifetime Capital Gains Exemption (“LCGE”) is a big driver of practice sales. It has the potential to allow each shareholder (e.g. a dentist and their family members) of a DPC to save up to $240k in capital gains taxes in their lifetime when they sell their shares of that corporation. More on that calculation later on.
That’s the really good news. The bad news is that qualifying for the LCGE can be difficult. And even if you qualify, you may still need to pay alternative minimum tax. And then there’s the federal government always looking at whittling down or possibly eliminating the LCGE to help raise taxes.
Qualifying for the LCGE involves a series of tests. Let’s get technical for a minute.
1. The dentist and their family members need to own the RIGHT type of shares. These are typically “common” shares and include both voting (for the dentist) and non-voting (for non-dentist spouses and children) common shares. These shares grow in value over time, along with the overall value of the DPC which owns the dental practice. Other types of shares, typically called “preferred” shares, may not qualify for the LCGE as they don’t represent equity and growth in the DPC or the Dental Practice: they were merely given to a shareholder for a nominal amount (e.g. 10 shares were issued to the shareholder for $10) mostly for income splitting purposes and the corporation can buy them back for the same amount.
2. Generally, those “common” shares need to be held by the shareholder for at least 24 months before being sold to a buyer. There’s an exception to this rule (more on that below) that would allow a dentist to incorporate a new DPC, transfer their dental practice assets to this new DPC in exchange for shares in the new DPC, and then turn around and sell those same shares to a buyer all in a very short period of time (e.g. days) while still qualifying for the LCGE.
3. For the 24 months leading up to the share sale, no more than fifty percent (50%) of the total fair market value of the DPC’s assets can be non-active business assets. Active business assets are things like your dental practice assets: dental equipment, furniture, fixtures, goodwill, supplies, leaseholds, computer hardware and software, etc. So non-active business assets are things other than this, like excess cash, investments, passive real estate, life insurance, and related party loans owing back to the DPC. The idea here is that the LCGE is available to shareholders of truly active (not passive) businesses, like a dentist owning shares of a DPC that owns and operates a dental practice.
As an aside, you should go and examine your DPC’s balance sheet (showing assets, liabilities and owner’s equity) and assets specifically. If, at any point during the 24 months leading up to a share sale, your DPC has a dental practice with a fair market value (not book value, mind you) worth $1-million but it also has over $1-million in non-active business assets, then that corporation won’t qualify under the LCGE rules! Here, either the non-active business assets need to be removed (e.g. to another corporation) or the active business assets need to be removed (for example, to a different DPC). More on these two scenarios below.
Finally, on the day of the share sale, no more than 10 percent (10%) of the total fair market value of the DPC’s assets can be non-active business assets. So you better have a squeaky clean DPC on the closing day!
Now that you have a better grasp of the LCGE tests, let’s discuss a few scenarios we deal with regularly to help dentists qualify.
As aforementioned, qualifying for the LCGE requires a dentist to own the right shares of a DPC for at least 24 months prior to a sale. But not all dentists are incorporated. And not all dentists can or want to wait 24 months before selling.
Thankfully, there’s an exception: if a dentist transfers all or substantially all of the assets he or she owns and uses in their dental practice to their DPC and receives shares in exchange, then he or she can then turn around and sell those shares shortly thereafter to a purchaser and still qualify for the LCGE.
This exception only applies to the individual (i.e. typically the dentist) who actually owns the dental practice assets; it wouldn’t apply to spouses or children unless they own those assets.
Furthermore, if there are leasehold improvements or real estate being transferred into the DPC, then GST/HST could be triggered. Thankfully, there’s an election that can be used to not have to collect or remit GST/HST on the other types of assets being transferred (e.g. dental equipment, supplies, goodwill, computer hardware and software, furniture and fixtures); this election only applies if all, or substantially all, of the property necessary for the DPC to be capable of carrying on the dental practice or part of it is transferred to it.
The transfer will be done on a tax-deferred basis, such that no income tax is immediately payable by anyone. This is allowed because the fair market value of the dental practice assets being transferred into the DPC are identical to the value of the shares that are being issued to the dentist in exchange for those assets.
Finally, when the dentist does sell their new DPC shares, they calculate their capital gains tax based on the net sale proceeds minus the tax cost of those shares (called the “adjusted cost base” or “ACB”). For example, if a dentist transfers assets with a tax cost of $100k to a DPC, then the ACB of those shares that the dentist receives back will be $100k; if the dentist then receives $1-million in net proceeds from selling those same shares, then the dentist’s capital gains on the sale of those shares will be $900k ($1-million in net proceeds minus $100k in ACB for those shares). Half of these capital gains (i.e. $450k) will be fully taxable at the dentist’s personal marginal tax rate, which could be as high as 53% (top combined federal and Ontario tax bracket in 2021), resulting in a potential tax bill of around $240k!
That is, unless the dentist qualifies for the LCGE, in which case the first $892k (for calendar year 2021) of the $900k won’t be subject to any capital gains tax! Some exceptions apply, like if the dentist has previously used up some of their LCGE or if dentist has allowable business investment losses or cumulative net investment losses.
As aforementioned, to qualify for the LCGE, for the 24 months leading up to a share sale, no more than 50% of the total fair market value of the DPC’s assets can be non-active business assets.
If a DPC doesn’t meet this test, it can (among other strategies) transfer those non-active business assets out (called a “purification”) to another corporation. Purifications can differ, depending on the circumstances, but a simple example is as follows:
Typically, this type of purification wouldn’t trigger any immediate tax consequences because it’s an inter-corporate dividend between two Canadian controlled private corporations and not a sale of property (which would trigger capital gains). However, if this type of purification is done as part of a series of transactions or events that results in a share sale of the DPC to a buyer, then there’s an anti-avoidance rule (section 55(2)(b) of the Income Tax Act) that deems taxes to be payable! Why? Because, if it weren’t for the share sale, those non-active business assets would have been left in the DPC and that would have increased the value of the shares being sold (and thereby increased the capital gains taxes payable on the sale of those shares). Thus, section 55(2)(b) converts the previously tax-free intercorporate dividend into a sale of property of the DPC, thereby triggering taxable capital gains.
Thankfully, there is an exception to section 55(2)(b), but it’s complicated. It involves using the DPC’s “Safe Income on Hand” to purify some or all of the non-active business assets without having section 55(2)(b) apply and then sell the shares of the DPC. The underlying concept of Safe Income on Hand is that once the DPC’s income has been taxed, the DPC should be able to pass that income to another corporation on a tax‐deferred basis.
Another option could be to transfer only the active-business assets from the DPC to a different (and perhaps new) DPC. This would leave the non-active business assets in the old DPC, which would then typically change its name and restrictions after the purification so that it’s simply a holding company.
A simple example of this type of transfer involves the new DPC buying the active-business assets from the old DPC and paying for those assets by issuing shares. The ACB and the fair market value of these shares in new DPC would be equal to the tax cost and fair market value of the active-business assets being transferred. The new DPC would then buy back (i.e. redeem and cancel) its shares held by the old DPC and issue a promissory note (a legal IOU) to the old DPC for the same value as those shares. The end result is that the new DPC owns the active-business asset and owes money to the old DPC (now likely a numbered company) but can repay that debt over time.
This scenario works well when the dentist can wait a number of years before selling (because, you’ll recall, that dentist will need to own the shares of a DPC for at least 24 months to qualify for the LCGE). It also works well if the dentist’s family members weren’t given proper shares of the old DPC, but that can now be fixed with the new DPC’s share class structure; this would allow family members to ultimately participate in the sale and claim their own LCGE. Finally, this scenario works well where the dental practice earns and retains a lot of cash each year; that cash can be used to repay the promissory note to the old DPC over time; this differs from scenario #2 above, where the DPC might have to constantly purify non-active business assets to meet the LCGE asset tests.
Yes, you’ve heard it before: you need to plan 2 or more years out before a sale. As discussed in this article, a lot of it has to do with qualifying for the LCGE while avoiding section 55(2)(b) of the Income Tax Act. Other non-tax reasons to plan ahead include making sure your team members are on contract (which may take up to 2 years to implement) and making sure your lease has lots of years left and doesn’t have nasty demolition, relocation or early termination clauses.
Make sure you’re prepared so your dreams aren’t sidelined by taxes. Talk to lawyers and accountants well versed in tax law first before talking with anyone else about selling. Your sale will largely be a tax-driven transaction. If you want to speak about these or other sale-related topics, please contact the author for a complimentary phone call.
About the Author
Michael Carabash, BA, LLB, JD, MBA, CDPM is a founding partner of DMC LLP, Canada’s largest dental-only law firm that helps dentists sell and buy practices in Ontario. Michael leads DMC’s annual Caribbean dental mission trips (Grenada, Jamaica and Turks & Caicos). Michael can be reached at email@example.com or 647.680.9530.