June 1, 2005
by David Harris & John McMillan
For a period following introduction of practice incorporation to a province, dental practice sales continue as in the past (i.e. sales of assets of dental practices, not shares of dental corporations). After a few years, dentists and their advisors adjust their thinking and share sales become the norm. This is the first installment of a two-part article that will deal with the topic of transacting shares of a dental corporation.
We begin by briefly reviewing the benefits of incorporating a dental practice. We will then discuss considerations for the valuation of an incorporated practice, and the tax and legal complexities of transacting shares. While share sales are invariably more complex then asset sales, there are often sufficient tax savings to the seller to make them worthwhile to both parties.
Review of benefits of incorporation
The first reason many businesses incorporate has nothing to do with tax. In general, corporations have “limited liability”–the owners are not responsible for obligations of their corporations (please note that there are numerous exceptions to this, including, for dentists, malpractice and professional misconduct1). Even with the exceptions, dentists can gain protection from certain types of creditors.
Incorporation also presents several tax opportunities. Most of these stem from a single phenomenon–setting up a corporation allows “fracturing” of a dentist’s tax regime into two pieces– corporate tax (approximately 20 percent and varies provincially) and a reduced personal rate (due to a “tax credit” provided when after-tax corporate funds are paid). The benefits are as follows:
In provinces where non-dentists are permitted to own shares of the corporation,2 income splitting with spouses and adult children can drastically lower a family’s average tax rate. In contrast with unincorporated practices, this is achieved through ownership and is not subject to a “reasonableness” test, including for example whether the family members are bona fide employees and the monetary value of their contributions. Tax rates for low-income family members can be more than 30 percentage points lower than the dentist’s.
To date, Ontario dentistry professional corporations have not been permitted to have non-dentist owners. However, in the May 11, 2005 provincial Budget, the Minister of Finance announced that this restriction would be eased, permitting family members to own non-voting shares. The target implementation date for this change is January, 2006.
Personal tax on income not currently needed by the family can be postponed by the corporation retaining and investing some profits instead of paying them to the dentist and family. Over an extended period, there can be a multimillion dollar benefit from investing 80-cent dollars (i.e. after 20 percent corporate tax) instead of 50-cent personal dollars.
Certain non-deductible expenses (e.g. life insurance) can be paid by a corporation (using 80-cent dollars) instead of with 50-cent personal dollars.
Having a corporation unlocks certain savings vehicles that are unavailable to unincorporated dentists. These include “Individual Pension Plans” and “Retirement Compensation Arrangements.” A discussion of IPP’s and RCA’s is beyond the scope of this article.
A “lifetime capital gain exemption” of $500,000 is available to anyone who sells shares of a qualified “small business corporation.”3
It is the fifth benefit that motivates dentists to sell the shares of companies owning practices instead of the assets themselves.
SHARE SALE vs. ASSET SALE
Lost tax shield
In an asset sale (and taxation is not markedly different between an incorporated practice selling its assets and an unincorporated dentist selling his or her assets), any amount received for an asset beyond the original cost of any asset is treated as a “capital gain” of which 50 percent is taxable. For any asset on which depreciation has been claimed, any amount received in excess of the “undepreciated capital cost” and up to the original cost is treated as “recaptured depreciation” and is fully taxed.
Consider a practice started by a dentist 10 years ago with goodwill now worth $300,000. For simplicity, assume that the only other asset of the practice is a Panoramic X-ray machine worth $20K. The Panoramic’s original cost was $25,000 from which $8,000 depreciation was claimed. Assume that the top tax rate in the dentist’s province is 50 percent.
On the sale of the assets of the practice for $320,000, the dentist would have a capital gain of $300,000 on the goodwill (since the dentist started the practice, the goodwill had no cost base) and recapture of $3,000 on the Panoramic (i.e. $20,000 minus undepreciated cost of $17,000). Because only half of the capital gain is taxable, this will result in the dentist paying tax on $153,000. Tax will therefore be $76,500.
Alternatively, if these assets belonged to a corporation, the shares of the corporation could be sold on a tax-free basis.
For the seller of a practice, this creates an obvious advantage. However, some of this benefit comes at the buyer’s expense. In this case, if the buyer purchased practice assets, goodwill will go into the buyer’s books at $300,000 and the Panoramic will go on the books at $20,000. The buyer will be able to get future tax deductions from claiming depreciation based on these amounts.
On the other hand, if the buyer purchases shares of a corporation, the depreciable values of the goodwill and panoramic owned by the corporation will stay as they are (i.e. nil for goodwill and $17,000 for the panoramic). Therefore, by buying shares instead of assets, the purchaser will lose future tax deductions. These deductions are sometimes referred to as “tax shield”.
There are a number of other differences between selling assets and selling shares of a corporation. The most important difference is that when selling shares of a company, ALL the assets of the company are sold, and ALL the liabilities of the company are assumed.
The assets include accounts receivable of the practice (which are not normally transferred in an asset sale) but also may include things like artwork, vehicles, cash and investments. Including the receivables in a purchase may transfer uncollectability risk to the buyer, although strategies exist for dealing with this. If certain assets are not intended to be transferred in the share sale, normally they are transferred out of the company at fair value, which may generate tax.
Additionally, in a share sale, some of the assets and debts change on a daily basis. It is often not possible to determine the final purchase price until sometime AFTER the closing date.
The main risk buying shares creates for the buyer is that you are assuming the history of the corporation and “invisible” liabilities may exist. Essentially, you are purchasing the corporation “warts and all”. For example, if following the purchase of a corporation, Canada Revenue Agency audits and determines that there is unpaid tax from the year before the sale, the buyer may find him or herself pursuing the seller to recover these amounts — a task that can present huge challenges. DPM
Part II of this article, in the next issue of DPM, will deal with how to address these various concerns, as well as the practical aspects of a sale.
1. Davies v. College of Pharmacists (2003), O.R.
2. This is usually done through a “family trust.” For a full discussion, see The Power of Trusts, DPM Winter 2004 by the authors.
3. This is a corporation where at the time of sale, at least 90% of the assets of the company are “used principally in an active business” and that for every day in the two years before the sale, at least 50% of assets met the same test. Examples of assets not used in the active business would be a stock portfolio, rental property o
r cash value of life insurance.
David Harris is a Registered Trust and Estate Practitioner providing tax planning and strategic consulting to dentists. He can be reached at firstname.lastname@example.org.
John McMillan is a Toronto business lawyer serving dental professionals. He can be reached at email@example.com