*These are alternative tax deferral strategies. To read about our common tax deferral strategies, please click here.
Your practice sale will result in a significant current tax bill for the proceeds received in cash at closing unless you structure the transaction in a manner that allows you to delay most tax payments into the future. At some point, though, the government will collect its share. You may want to consider a deferral strategy in the following instances:
- If you think your personal tax rates will decline over time (this could be through a reduction in rates or through the reduction in your overall income level in retirement so that you’re taxed at a lower rate).
- If you are in a high-tax state and expect to move to a low-tax state soon, you maybe be able to save substantial state taxes with a deferral strategy.
- If you are comfortable not having direct access to the money to achieve the tax deferral strategy
Some sellers pursue the approaches (described below) in certain circumstances where a) the seller had specific reasons for delaying the tax payments and b) also had sufficient financial assets to allow the strategy to make sense. We see these strategies deployed in 5-10% of our transactions.
Overall Structures
To achieve a legitimate tax deferral on the sale of your veterinary practice, the approach typically involves working with an investment firm or trust company (with appropriate tax counsel) that will execute a two-step transaction with the buyer. The parties of the transactions are:
- Seller: The practice owner or ‘you.’
- Intermediate Buyer: A special purpose entity set up and owned by an investment firm, insurance company, or trust company (“Intermediate Buyer”) ‘buys’ the practice from you. In exchange, the seller receives a Note that will be paid off over time with specific repayment characteristics that are negotiated.
- Ultimate Buyer: The Intermediate Buyer immediately sells the business to the “ultimate buyer.” The ultimate buyer is the consolidator that you selected. The Ultimate Buyer pays the purchase price consideration (Cash) to the Intermediate Buyer, who invests the proceeds according to the agreements with the seller. The investment returns are used to pay the note between the Intermediate Buyer and the seller.
When we use the term notes, it refers to a loan or note payable between the seller and the Intermediate Buyer that has a specific principal and interest payments that are negotiated between the parties and are required to be paid to the lender (you or the seller). Principal payments are typically made to stretch the payments over several years or made as a balloon payment at the termination of the note, reducing the capital gains received in any one individual year to maximize the proceeds taxed at a lower rate (or deferring the total tax for an extended time frame). Capital Gains taxes are progressive, so the more gain received, the more that is taxed at the top rate of 20%. Note that the first $80,000 of capital gains is not subject to Federal Income Tax (married couple), and from $80,000 to $500,000 is taxed at 15%, and the rest is at 20%. With the Notes paid over a number of years, the seller recognizes gains each year at these lower rates – saving a lot of money.
By placing the Intermediate Buyer in-between the Seller and the Ultimate Buyer of the practice, it creates the ability to structure a deal that allows for tax deferral options. The Intermediate Buyer (not the seller) is receiving the proceeds into a legal entity that does not pay taxes on the proceeds (since the Intermediate Buyer does not realize any ‘gain’ on the sale relative to the purchase price they paid). There are several ‘flavors’ that this overall structure can take on, and it depends on your risk tolerance and timing for access to your proceeds. Some examples of the approach include:
- Treasury Funded Installment Sale: The Intermediate Buyer is a special purpose entity that pays for the practice from the seller with a Note. The Intermediate Buyer resells the business to the consolidator and uses the proceeds to buy Treasury Notes. The duration and interest rates on the Treasury Notes mimic the note that was issued by the Intermediate Buyer to the seller. Taxes are paid by the seller as interest, and the principal is paid over time on the notes from the Intermediate Buyer to the seller. The entity managing the Intermediate Buyer will take fees along the way for their services and for structuring the transaction.
- Collateralized or Monetized Installment Sale: This structure allows the seller to receive most of the proceeds at closing but defers tax payments. The Intermediate Buyer resells the business to the consolidator, where those proceeds are paid to Intermediate Buyer. The seller also takes out a credit facility (Note) with a third-party bank that provides the seller with immediate cash. The collateral for the seller’s credit facility is the money sitting with the Intermediate Buyer. Now, the seller has cash and a bank loan (usually interest only) that the Intermediate Buyer pays off at the termination of the loan. When principal payments are made by the Intermediate Buyer on the seller’s bank loan – taxes will need to be paid. The deductibility of the loan interest paid should be explored with a knowledgeable CPA in order for these transactions to have no taxable net income during the duration of the installment sale and note. There are significant fees associated with this structure, generally 5-7 percent of the transaction value, but installment sales yield cash at closing with deferred tax liabilities.
- Non Qualified Structured Settlements: This structure tries to provide a higher rate of return than Treasury Note Settlements. It attempts to generate higher returns through the Intermediate Company investing the money into an annuity product from an insurance company (fixed rate of return) or investing into a pool of assets that an investment firm will manage and take greater risk than in Treasuries or an annuity product. With the pool of assets, the seller determines their appetite for risk and selects a pool of assets that meets their risk profile. However, the seller is not receiving the investment returns in the pool. Instead, the seller receives a higher fixed return on the note that they receive from the Intermediate Buyer. The Intermediate Buyer, on the other hand, makes a spread between the actual return on the assets relative to the Note’s principal and interest payments. This structure can be combined with a partial Collateralized Installment Sale if the seller wants some cash up-front.
- Deferred Sales Trust: This structure is very similar to the Non Qualified Structured Settlements but with two key differences: the Intermediate Company is set up as a Trust, where the Trust is managed by an independent Trustee (a non-family member) that makes the investment decisions and takes on the risks associated. The note established between the Intermediate Company (a Trust) and the seller tends to have the most flexibility, as does the investment strategy pursued by the Intermediate Company. The Trustee is paid both in fees and by generating excess returns above the agreed-upon Note payments of principal and interest that are generated (which accrue to the benefit of the Trustee).
- Family Self-Directed Installment Sale: This structure is more complex since the seller’s family owns a minority stake in the Intermediate Buyer, and the family’s ownership and control increase over time. Investments inside the Intermediate Buyer (that the seller’s family partially owns) are tailored to the seller’s personal goals and financial return objectives. The key here is that the growth and success of the investments inside the Intermediate Buyer accrue to the seller or their family with substantial fees being paid to the firms structuring the deals.
In Summary
These tax deferral strategies are complex and, in the right situations, can provide both meaningful tax savings and appropriate returns. They are not meant for everyone. If you’re wondering if pursuing tax deferral strategies is the right choice for you, we recommend consulting your financial advisors or dropping us a note. We’d be happy to refer you to the appropriate advisor to discuss if any of these structures are appropriate for your situation.