At its most basic, the gross proceeds from your practice sale (pre-taxes) will get reduced by your tax bill (which usually falls anywhere between 20 to 35 percent of the cash received). Your tax percentage greatly depends on the state you live in and the advice you receive. How do certain common deal structures help you grow your capital on a pre-tax basis and delay the paying of taxes into future years? Let’s dive in.
Benefits of Tax Deferral
If you sell 100 percent of your business for cash, you pay the government their share before investing the rest (typically 65-80% of the gross proceeds) to fund your retirement or lifestyle. However, if you use some of the common tax deferral strategies as part of your transaction structure, you can grow a portion of the pre-tax proceeds for a few years before receiving the cash and paying taxes.
One benefit of delaying paying taxes into future years is that the federal capital gains rate is graduated: as you earn more, the gains rate increases. In 2023, if you are married or filing jointly, the first $89,250 of capital gains is not taxed; $89,250 to $553,850 is taxed at 15 percent; above $553,850 is taxed at 20 percent. In effect, if you defer your payments over multiple years, you’re able to take advantage of reduced capital gains rates in each year where you have the income. When evaluating deferring your taxes, the question you should ask yourself is this: Whatever tax deferral structure is utilized in a deal, is there a potentially better return on the capital that has been deferred?
Common Tax Deferral Options
Four common deal structure approaches result in tax deferrals. (i) Notes, (ii) receiving TopCo or Parent Company equity, (iii) retaining joint venture ownership in your hospital, and (iv) earnouts. In each of these instances, a portion of the purchase price isn’t paid at closing. Instead, it’s paid in future years, thus delaying your tax burden until the cash is received in those future years.
1. Notes:
Notes provide the most flexibility to you in controlling the timing of when you receive the cash. Most buyers are willing to offer delayed payments of the purchase price into future years and provide an interest payment on any notes issued (typically 4-7 percent interest). Occasionally, some sellers will offer Contingent Notes, where there is some minimal performance criteria (similar to an earnout). A seller can negotiate deferrals such as receiving a note for $500,000 per year for 3-5 years, which will reduce your capital gains taxes on that portion of the purchase price (assuming the tax code does not change).
2. TopCo or Parent Company Equity: This has become the most common feature in veterinary transactions over the past few years, with many buyers wanting sellers to ‘roll over’ some of their sales proceeds into ownership in the buyer’s business. Typically, 10-30 percent of the purchase price is received in TopCo equity, where no taxes are paid on this portion of the purchase price until the buyer sells or recapitalizes. From a tax deferral standpoint, the TopCo equity consideration is not taxed at the closing. However, the seller has no control over when the equity in the buyer is monetized through a recapitalization or sale. While this deal structure provides a tax deferral option, the seller loses an element of control when it comes to timing. Returns may vary based upon many factors but have historically been above market, and 20-35% of your equity investment is actually the tax that would have been paid on a cash sale (so you could have $75 of cash after-tax or $100 of TopCo equity).
3. Retained Joint Venture Ownership: This deal structure sees the seller retaining 15-40 percent ownership in their individual hospital(s) (different from TopCo equity where ownership is in the overall company). In a joint venture structure, the seller receives cash for about 60-85 percent of the business they sell. Taxes are paid on the cash received, and the retained practice equity is not taxed until it is sold in future years. A seller can sell their retained hospital ownership over a few years to take advantage of lower capital gains tax rates (for gains under $500,000), or they can sell all their ownship in one year. This structure provides the seller more control over their tax strategies with specific times to sell their retained interest (and potentially doing it over several years). One key differentiation – Owners of JV interests receive quarterly cash distributions of their share of the practice profits; TopCo equity owners do not (as it is reinvested to acquire more practices).
4. Earnouts: For certain practices, buyers will structure earnouts or contingent payments based on performance during the first twelve to twenty-four months. It’s imperative to know that these payments are part of the purchase price and therefore treated as capital gains. These payments are usually made one or two years after closing, so the payments are a tax deferral strategy. These are mostly applicable when practice is growing significantly and is a way to capture some additional sale price on future growth.
As you consider selling your practice, you should understand the financial implications of the transaction and how they affect your retirement plans. While evaluating your practice’s valuation is important, it’s also wise to understand how to best minimize your tax burden in order to maximize the cash you receive. We encourage and will assist all of our clients to get a tax estimate from their CPA so they can understand the tax implications of a transaction and plan accordingly. Discussing these tax strategies with your advisors – the Ackerman Group as well as your accountant and financial advisor – so that you’re well aware of your options will help you ensure you have the after-tax proceeds you need to live the lifestyle you want.