The Dental Lawyer | Innovative Tax Strategies for Dental Practices Part 1: Taking a Reasonable Salary

It has been preached by many canons in the industry that a dental practice is a vehicle to bring a dentist from dental school to retirement.  A dental practice, however, can also be made into an incredibly efficient and alluring vehicle of another type.  A tax vehicle.  Here are some strategies every practice should entertain.  Keep in mind that while these are general tips, an accountant or tax attorney is almost always going to be able to provide your particular practice with the most tax efficient strategies for your particular practice.

      Taking a “reasonable salary” – For those practices which are taxed as a corporation taking a reasonable salary and retrieving additional funds as a dividend can allow the owner to save on FICA taxes (Social Security, Medicare), and other items which are “automatically” deducted from someone’s paycheck.  Here’s how it works. 

When an owner pays himself a salary he is required to pay certain federal and state taxes and fees (noted above).  For many of these taxes and fees, the employer actually gets hit twice as it is the employer’s responsibility to match the employee contribution.  For example, if the doctor has an employee who has $20 withheld from her paycheck for FICA taxes it is the employer’s responsibility to match that $20 with an employer contribution in the same amount.  This means that when the owner is being paid as an employee, the owner is actually seeing twice the amount of these taxes and fees being withheld as the owner is responsible for both the employee and employer portion. 

The way to avoid these taxes and fees would simply be to not take a salary at all and simply take one’s entire income as a dividend from the corporation.  The amount taken as a dividend would still be subject to income taxation, generally, at ordinary income tax rates (as is all money you would receive as a salary).  The benefit would be avoiding all of the withholding taxes which are “automatically” deducted from a normal paycheck.  This apparent loophole is known to the IRS, and as a result owners of corporations like dental practices are required to take a reasonable salary.

Whether or not the practice owner is taking reasonable salary is somewhat subjective, but the IRS and tax court will look at:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

(source IRS FS-2008-25, August 2008 Wage Compensation for S Corporation Officers)

The IRS is fairly strict and increasingly aggressive in making sure that individuals don’t dodge taxes by taking dividends instead of salary, so it’s important to play by the rules.  It is however still possible to arrive at a significant tax savings by taking some of the would-be profit of the corporation as a dividend.   Taking the above factors into consideration, the practice owner should set himself a reasonable salary for his location.  The rest should be taken as a dividend.  The amount taken as a dividend will rightfully avoid some taxation which would result if that amount was taken as a salary.

The Dental Lawyer | TSG Spring News Letter

Check out The Snyder Group's Spring 2012 Newsletter

The newsletter discusses:
1. The timing of dental transitions, and specifically that now is a good time.
2. The dangers of using "virtual escrows" as a means to accumulate funds for a partnership buy-in.
3.  Some tips on protecting the value of a practice in the event of death or disability (A subject I can go on for hours about)
4. Some basic questions you should ask to determine if your practice is get prepared to bring on an associate. (of course the best way to know is to put together a valuation with an Associate Feasibility Study).

A final note for today, I can't say enough good things about the people at The Snyder Group.  Tom, Charlie, Donna, Diane, Suzanne, Anita and anyone else who I'm leaving out, are tremendously courteous and extremely talented with regards to dental transitions!  I would highly recommend checking out their newsletters.

The Dental Lawyer | Top Ten Reasons Why Associateships Fail

Check out this video from Dr. Reggie VanderVeen  (a Henry Schein PTT Consultant and all around great guy) via the Michigan Dental Association, discussing the top reasons why Associateships fail.  I think a more appropriate title would be the "Top Ten Reasons Why Associateships Fail to Result in Successful Transitions." That's a little bit of a mouthful, but the point is that other than a few points in there, the video really is relevant to transitions and not the pure employer-employee relationship.

The Dental Lawyer | Entities and Practice Sales: Howard v. United States

In a previous post I mentioned that if there is any intention to sell a practice that said practice should not be taxed as a c-corp (note that when a corporation is formed you have the option, presuming you meet certain requirements, to be taxed as an s-corp or a c-corp).  This suggestion comes as a result of the 9^th Circuit’s decision in Howard v. United States, 448 Fed. Appx. 752; 2011 U.S. App. LEXIS 18092; 108 A.F.T.R.2d (RIA) 5993.  

In Howard, a dentist sold his practice, a professional service corporation taxed as a c-corp (the “Corporation”), to a buyer.  When Corporation was formed owner’s attorney, rather thoroughly, put together an employment agreement with a covenant-not-to-compete along with the incorporating documents.  Dr. Howard entered into the employment agreement with the corporation, which said nothing about the ownership of goodwill.  In the Asset Purchase Agreement, Dr. Howard allocated $549,900 to personal goodwill and $16,000 to the a covenant not to compete with the buyer’s Corporation.  The remaining $47,100 was allocated to tangible assets. 

When the Howards filed their 2002 federal income tax return, they reported $320,358 as a long-term capital gain resulting from the sale of personal goodwill to the buyer.  The IRS, however, had other ideas, and after auditing Dr. Howard’s return, they re-characterized the goodwill as a corporate asset.  The implications of this cannot be understated.  If goodwill is treated as a personal asset, as Dr. Howard intended, the goodwill would be taxed once as a long term capital gain, a rate which is significantly lower than the high ordinary income rates which most dentists pay on their personal tax returns.  By being characterized as a corporate asset, the money allocated to goodwill would be taxed twice, once at the corporate level (that is, the corporation which was solely owned by Dr. Howard had to pay tax on the goodwill) and again when that money was distributed to Dr. Howard, as such a distribution would be treated as a dividend taxable to Dr. Howard personally. As a result, Howard was taxed twice at higher rates as opposed to once at a lower rate. 

The 9^th Circuit relied on Martin Ice Cream Co. v. Comm'r, 110 T.C. 189 at 207-08 (1998), Norwalk v. Comm'r, T.C. Memo 1998-279, 76 T.C.M. (CCH) 208 (1998), Macdonald v. Comm'r, 3 T.C. 720, 727 (1944), to reach the conclusion that when a C-corp has an employment agreement, with a restrictive covenant, entered into by the owner of the corporation, the corporation and not the individual owns personal goodwill.

Industry wide the advice given to avoid this double taxation conundrum is not to sell as a c-corp.  Read narrowly, one should only hit the double taxation problem if there is, (1) a Professional Service Corporation, (2) taxed as an c-corp, (3) where the doctor has an employment agreement with the corporation, and (4) where the employment agreement contains a covenant-not-to-compete. My feeling is, however, that this reading of the case is too narrow, and to avoid the issue dental practices should not be taxed as C-corps (there really are few benefits for most practices to be taxed as a c-corps anyways).

I would also add that I would not be surprised if in the coming years the IRS tries to use this precedent to expand the holding in Howard, to s-corps and partnerships.  As a result the best protection might be for OWNERS not to have employment agreements with their practices in any respect.  Owners, however, should make sure that any associate dentists they employ are bound by an employment agreement for a completely different set of reasons. 

 

The Dental Lawyer | Entities as Liability Shields

One issue that consistently surprises me is the number of dental practices which are run as sole proprietorships and without the liability shield of an entity.  (To be clear by “entity” I am talking about corporations, limited liability companies, limited partnerships, and other legally created business forms).  Entities provide a liability shield by protecting the owner’s personal assets from lawsuits.  What this means is that if Smith Dental Arts, P.C. signs a lease with Goliath National Landlord and then fails to meet its obligations under the lease, if Goliath sues the dental practice, only those assets which belong to the professional corporation are subject to any adverse judgment against the practice.  In that same situation if Dr. Smith had been practicing without being incorporated the landlord would be able to go after the personal assets of the doctor; meaning the doctors home, vehicles, and personal bank accounts. The value of forming an entity is that any obligations on the part of the practice stay separate and distinct from that of the personal assets of the person who owns the practice.    

The main limiting factor which dental and other medical professionals have to deal with when forming an entity is malpractice.  Malpractice is always personal, meaning that if Dr. Smith is sued for malpractice his personal assets are always at stake (this underscores the need for every dentist to have malpractice insurance, even if it’s not a legal requirement in your state).  Forming an entity will not limit the ability of a plaintiff to reach a dentist’s personal assets like it would for the contractor looking to recover on a breach or an individual who fell and injured himself on the practice’s property.  Another limiting factor is the “personal guaranty.”   Any contract or agreement entered into with a personal guaranty obligates the person offering the guaranty to satisfy agreement.  In other words, that person’s personal assets can subject to an adverse judgment.  

Despite the restraints on the liability shield, the advantages of entity formation are still palpable. The doctor’s personal assets will be protected from any business dealings of the practice or any torts committed by the practice (outside of malpractice).  In addition there are tax benefits to forming an entity which will be discussed in a subsequent post. It is noteworthy that if there is any anticipation that the practice will be sold at some point, the entity formed should NOT be a C-corporation (again, more on this later).

The types of entities which can operate as dental practices vary from state-to-state. In New York P.C.’s (taxed either as S-Corps or C-Corps) and P.L.L.C.’s are the primary entities which can run as dental practices.  There are some additional entities which can also operate as a dental practices.  Check with an attorney in your state before forming and entity, and avoid the compulsion to try to do it yourself. 

The Lawer Blog | Depreciating Business Property

In an earlier blog post I mentioned that the optimum moment in which a practice should update its technology (assuming that the practice has not continually updated technology over its life span) is about 7 years prior to a potential sale.  Part of the reason why 7 years is suggested is so the doctor buying the new dental equipment can fully benefit from the depreciation deductions associated with the purchase of said equipment.  This point requires further explanation.

The Internal Revenue Code (relevant sections are 167, 168, 179, with a host of other publications and regulations) allows for businesses to take depreciation deductions on most business equipment purchased for use in the business. Generally, most tangible items which are used in the business, but not which are sold to customers or patients, are deductible.  For dental practices this means computers, lighting fixtures, digital x-ray sensors, furniture, chairs, vehicles, and operatory equipment all create depreciation deductions.  Inventories and land do not create deductions as the property creating the deductions must be used in a trade or business or be "property held for the production income".  However, the amount deductible in a given year is subject to calculation, and in part explains why 7 years prior to a sale is the ideal time to purchase new equipment.

There are two main methods used to determine the amount of a depreciation deduction in a given year: the “Straight Line Method” and “Double Declining Balance Method."  The Double Declining method is usually preferred because it allows the business to deduct greater amounts in a shorter time than the Straight Line Method; this translates to more deductions more quickly, which has obvious appeal.

Both methods adhere to certain rules and concepts promulgated by IRS publications which need to be understood before an explanation of each of the methods.  First, every piece of property has a "useful life" as determined by the treasury.  The useful lives are listed in Publication 946 and its exhibits and amendments.  For dentists, the useful life of a property is a fiction, and merely translates into the amount of years in which the property may be deducted. Thus an panoramic x-ray may have a "useful life" of 7 years under the regulations, but in reality the machine will probably work for 30 years.  The vast majority of equipment used in a dental office is depreciable over a period of 7 years, with the remainder usually depreciable over 5 years.  There are rare exceptions to this rule, but to recover the full value of depreciation deductions, the owner of the equipment should seek to own the equipment for the full useful life of the equipment.  The next important concept is tax basis, the purposes of depreciation deductions it's fair to say that the tax basis is the cost of the property to the business (provided an even-handed business transaction).  The basis is reduced every time a depreciation deduction is taken.  Finally, to understand two types of depreciation you must understand the "6 month convention". The 6 month convention, which is required under the tax code, requires a deduction to be taken at 50% of its normal amount 6 months into the first year of the property's use by the business, and again 6 months after the end of the useful life.  The effect is that a 5 year property will actually be deductible in 6 periods, a 7 year property in 8 periods.  This point is better illustrated by example.

The Double Declining Balance Method builds on the concepts of the Straight Line Method and was designed so business could more quickly recapture the depreciation, or in other words, so they could get deductions more quickly.  Using the same $500,000 example here is what the Double Declining Balance Method looks like:

 The above examples clearly show the utility of a Double Declining Balance Depreciation. By the end of year two, the Double Declining Balance method had provided $260,000 in deductions, where as the straight line method had provided only $150,000 in deductions.  As noted above, it's important to keep in mind that most dental equipment is depreciable over a 7 year period.  The numbers used in the examples above assume a 5 year period.  Also, the examples above use a lofty $500,000 piece of property, and in the dental world even the fanciest big ticket items are usually less than $100,000.  There are other depreciation rules to consider, and the rules are always changing so make sure you talk to a qualified accountant or attorney ( like those at Dental Transitions) before preparing your taxes.

The Dental Lawyer | Antitrust Laws, Fee Schedule Disclosures and Non-Disclosure Agreements.

I didn’t intended for my first substantive posting to be about the antitrust issues surrounding the sharing of fee schedules, but as it happens, I was researching the issue, and I will share what I have learned. I should mention, that an excellent resource which gives a great foundation on anti-trust issues in dentistry is the Antitrust Laws in Dentistry: A primer of “Dos, Don’ts and How to’s” for Dentists and Dental Societies, Published by the American Dental Association written by Mark Rubin et. al., Associate General Counsel to the American Dental Association. This publication was incredibly useful at guiding my research and in framing this blog post. It is available here http://www.indental.org/uploads/antitrust_booklet.pdf if you are looking for a more in depth, but still easily comprehendible, discussion of some of the topics I have covered today.

The purpose for my research came about as a result of an article I’m writing about succession planning in dentistry. One piece of advice I give in the article is to put together an agreement with another practitioner whereby another dentist agrees to both, (1) taking custody of patient records and, (2) treating patients in accordance with the transferor’s fee schedule. (A blog posting discussing succession planning in larger detail is forthcoming). When I was discussing this tip with a dentist his reaction was that federal antitrust laws prevented dentists from disclosing fee schedules to one another. This caught me off guard, as I was certain that for the purposes of succession planning, which in dentistry largely amounts to ensuring ongoing patient care, the disclosure of fee schedules would be permissible.

The general purpose of Federal Antitrust laws are to ensure market competition and in doing so protect consumers from the evils which stem from a market controlled by cartels and monopolies. The legal standard for determining if a certain behavior is violative of federal antitrust laws, (specifically the Sherman Antitrust Act) is whether or not there is a “concerted action” which produces an “unreasonable restraint on competition”.

More or less, a “concerted action” is any action, formal or not, which taken by more than one party which results in the “unreasonable restraint on trade.” It is noteworthy that even a discussion among colleagues over cocktails may be a concerted action if discussion results several practitioners adjusting their fee schedules in a way which essentially fixes prices for a certain procedure or procedures. Obviously a formal agreement whereby prices are set at certain levels would also be a violation.

To determine if there is an unreasonable restraint on trade the courts employ a balancing test which weighs competitive and anti-competitive market forces which result from the concerted action. Generally the court will conduct an in-depth analysis to determine if the concerted action truly created conditions unfavorable for competition. There are also some actions which are recognized by the courts to create conditions unfavorable to competition (see price fixing), and those actions are analyzed more strictly against the accused, with certain presumptions made in favor of the accuser (usually the Federal Trade Commission, sometimes the Department of Justice). In cases of egregious price fixing, the government may prosecute antitrust cases both criminally and civilly. For most cases, the government’s remedy is civil damages and injunctive relief, or in other words, they take your money and force you to change your impermissible behavior.

Since it is relatively easy for dentists to fall into antitrust traps, and because the consequences are so severe, most simply do not discuss their fee schedules with outsiders or other practitioners. Still, the legal standards derived from federal antitrust law do not provide an absolute bar against disclosing fee schedules. So long as the result is not a restraint of trade, fee schedules can be discussed and disclosed.

Succession and estate planning are perfect examples of when and how fee schedules may be disclosed without violating federal antitrust law. If the purpose of the disclosure is to make sure that another dentist will honor a fee schedule in the event of the death or disability of another dentist, that disclosure is permissible. To fully protect one’s self, I would recommend a Non-Disclosure Agreement (NDA) which includes terms whereby the dentist receiving the fee schedule agrees not to, (1) disclose the transferor’s fee schedule and, (2) change their fee schedule based on the receipt of the fee schedule.

A few things are worth mentioning here. First, NDA’s can be put together inexpensively, and the type needed here should only take about an hour of an attorney’s time, so don’t let an attorney charge you too much for this. Second, if you’re paying for succession planning on a flat fee basis, the NDA should be part of the “package” and you should not be charged additionally for it. Finally, many protections can be built into any NDA, but the type needed here is basic and should not be allowed to devolve into and endless pit of negotiation and counterproposal…just get a agreement in place and make sure you’re dealing with a straight shooter.

It is also worth mentioning the state antitrust laws do exist and may be relevant, so your decision to disclose or not disclose your fee schedule should also take state law into consideration.

The bottom line is that there are ways to disclose a fee schedule but such a disclosures must be made carefully, with proper intentions, and without impermissible results.

Information I post in this blog is not intended to be legal advice and should not be relied on. Nothing contained in this blog shall create an attorney client relationship. If you’re a dentist and you have legal questions you should contact licensed attorney in your state.

The Dental Lawyer | Updating Technology and Practice Sales

Depending on the buyer, an office’s technology, or the lack thereof, can be a major draw or stumbling block in selling a practice. It is not an across the board rule that newer technology will make a practice more marketable. Generally practices with the newest technology run higher overhead, which reduces profitability and can make a practice less appealing to a buyer. On the other hand, the efficient purchase and incorporation of technology into the practice can increase profitability. The perfect example of this is the incorporation of a velscope (or similar oral cancer screening light) into the practice. After the purchase the doctor should make oral cancer screenings a mandatory portion of every visit (or every exam). The charge for the screening can be modest, say $15 per screening, and the equipment will pay for itself in short order. With one purchase, the practice has (1) increased its overall profitability, (2) protected itself from malpractice lawsuits which might come as a result of not spotting oral cancer, (3) increased the overall technology of the office, and (4) given itself a depreciation deduction. There are many other items of technology which can similarly be incorporated into a practice to boost the bottom line. Buyer beware, however, as purchase of every brand-new gizmo for your practice will more likely than not hurt rather than help your practice.

As alluded to above, when it comes to technology, the buyer matters. For the younger less experienced buyer newer technology is a key attraction. Generally these younger doctors want the technology they came out of dental school using. For a practice which has continuously updated its technology throughout the course of its life, technology is usually not an issue. For older buyers newer technology is rarely a sticking point. Dentists with existing practices who are seeking a satellite office or new location generally just want functional equipment and strong bottom line; having the newest technology is usually not a concern. These buyers, unfortunately, are less plentiful in the marketplace, and if one is seriously looking to prepare their practice for sale updating technology throughout the life of the practice important.

One important point not to be overlooked is that updating technology is something that should be done over the lifetime of the practice and not in the years immediately preceding a potential sale. Adding new technology should be done with the goal of improving patient care, efficiency, and profitability. Dumping money into new gadgets just for the hope of attracting a buyer accomplishes none of these goals, and will create a bloated expense report. For a practice that has not invested in technology throughout the course of its life the time to make such an investment would about 7 years prior to any potential sale. The hope here is that updated technology will increase profitability in the years which any potential buyer would consider relevant while also gaining the greatest possible depreciation deductions on business property. This will in a sense help the new technology pay for itself. Updating technology in the years immediately preceding a potential sale will have negative effects towards profitability due to the expense of purchasing the property without the time the realize the benefits of the new equipment. This later option also offers the purchaser inadequate time to recapture the depreciation on the new technology.

 One final point on technology. Not everything needs to be updated for a practice to be marketable to the younger buyer. In my opinion digital x-rays are a type of benchmark. If a practice has digital x-rays they are going to have a computer, and probably multiple computers, in the office. This raises the likely possibility that the practice is running some practice management software which probably can produce financial and demographic reports about the practice. Also with computers there is a good chance that the practice may incorporate intra-oral cameras and a variety of other digital dental diagnostic tools. The point is that digital radiography a point from which other items of technology flow . It certainly goes without saying that this isn’t always true, but as I said, for me it’s a benchmark. The bottom line is that if you want to taken seriously as regards the technology, digital radiography is the starting point. It is certainly worth mentioning however, that practice management software in many regards is fundamentally more important than any other technological improvement within a dental office. Attempting to sell an office without practice management software is difficult, and there is no way around it.  This software is another type of benchmark, and similar to digital radiography in that other technical improvements come after its incorporation.