Tax exposure is one of the biggest considerations when selling a business, such as a private practice. Below, we’ll discuss some key tax elements sellers should know when selling a private practice, including how to avoid common tax pitfalls.
The Capital Gains Tax
The capital gains tax is the most significant tax associated with selling a business or private practice. The capital gains tax is assessed when someone sells an asset, like a private practice, for more than its basis (what they paid for it).
For example, if you bought a private practice for $300,000, ran it for three years, and sold it for $500,000, the capital gain would be $200,000. That $200,000 capital gain would be subject to tax according to federal and state capital gains taxes, depending on your tax bracket.
Short-Term vs. Long-Term Capital Gains Tax
The capital gains tax varies depending on how long the investor or practice owner has held the asset. Long-term capital gains tax applies to profits from investments the owner has had for at least one year. Short-term capital gains tax applies to anything shorter.
Long-term capital gains have a lower tax rate than short-term gains and ordinary income to incentivize long-term investment and stability. Long-term capital gains are generally subject to a 0–20 percent tax rate, while short-term gains could be taxed up to 40 percent.
Federal and State Capital Gains Tax
As we mentioned, capital gains are taxable at both the federal and state level, but not every state levies the tax. Federal capital gains tax is the same for everyone, while states have their own tax rules. It’s obviously in the seller’s best interest to be intimately familiar with his/her state’s capital gains tax laws before selling to take full advantage of exemptions and deductions.
Some states—such as Texas, Nevada, and Florida—have no state capital gains tax. Conversely, other states—such as Oregon, Ohio, and Wisconsin—have some favorable breaks, allowing taxpayers to deduct their federal taxes from state taxable income. Washington state, for example, taxes capital gains at seven percent but has exemptions for certain assets—such as real estate, livestock, retirement savings, and timber.
Lowering the Impact of Capital Gains Tax When Selling a Business
While a seller can’t avoid the capital gains tax entirely when selling a private practice, a few strategies exist to limit its impact and avoid common tax pitfalls.
A simple solution for lowering the impact of the capital gains tax on a private practice sale is to do an installment sale. In an installment sale, the seller sells the practice in phases or installments rather than cashing out in one large sum.
Therefore, instead of paying the capital gains tax in one large sum, the tax liability is spread out over multiple installments that could last years. This strategy doesn’t diminish the capital gains tax but spreading it over several years can reduce its impact.
Selling to Employees
Another strategy many business owners follow to avoid the capital gains tax is selling the practice to the employees instead of an outside buyer. If the practice is a C corporation, the owner can sell to the staff through an Employee Stock Ownership Plan (ESOP).
An ESOP offers multiple advantages to sellers. For one, a seller doesn’t have to search for a buyer and negotiate and haggle over price as much. Sellers and employees can negotiate reasonably, and the owners get to sell to people they know. Then, the practice owners can take the cash earned from the sale and invest in an investment plan that defers the capital gains tax.
Timing of Sale
The timing of the sale of a private practice is critical, as it determines whether the resulting gains will be taxed under long-term or short-term rates. As we’ve discussed, short-term capital gains are for investments held less than a year and are taxed more heavily than long-term investment gains. Therefore, it’s in the seller’s best interests to wait until they’ve owned the practice for at least a year before selling.
Allocation of Sale Price
Another critical factor is the allocation of the sale price regarding the assets in an asset sale. The allocation of the sale price will determine the percentage of capital or ordinary income tax the seller and buyer pay on the transaction. So both parties must agree on what portion of the sale price is for tangible and intangible assets.
However, what is beneficial for the seller regarding their tax exposure is typically bad for the buyer, and vice versa. Therefore, this is an area where compromise and negotiation will be necessary. It’s in the seller’s tax interest to reduce the value of tangible assets as much as possible while amplifying the value of intangible assets like goodwill.
Opportunity Zone Reinvestment
Another method for deferring capital gains tax for business sellers is to utilize the Opportunity Zone reinvestment strategy. Until December 31, 2026, business owners can defer their capital gains taxes if they reinvest those proceeds into an Opportunity Zone within 180 days of profit accumulation.
Investing in a similar business or property is not a requirement to defer the gain. Rather than paying hundreds of thousands or millions of dollars in taxes, a seller can put that money into a Qualified Opportunity Fund. Ultimately, this investment will provide the seller with a significant return until 2026.
Asset vs. Entity Sale
Another important tax consideration for private practice sellers is whether to structure the transaction as an asset or entity sale. In an asset sale, the owner sells all or some of the assets. On the other hand, in an entity sale, the seller exchanges all assets as one entity—including any liabilities of the corporate entity.
Most entity sales are subject to the long-term capital gains tax rate, while most asset sales are subject to ordinary income tax rates. And as we discussed, tangible and intangible assets in an asset sale are taxed differently. In an entity sale, however, there’s just one tax hit for the entire practice.
Clearly, there’s a lot to consider when selling a private practice, including tax exposure. That’s why it’s always beneficial to enlist the help of professional, expert business brokers like Private Practice Transitions, who specialize in connecting interested sellers and buyers. If you need help selling your business, contact our helpful team today.