How is the sale of a dental practice taxed?
It depends first on what is sold. In an asset sale, which is how most dental practices change hands, the price is allocated among the assets under the residual method of Section 1060 and reported by both buyer and seller on Form 8594, and each asset produces its own kind of gain. Equipment and furniture produce ordinary income to the extent of the depreciation previously claimed (Section 1245 recapture) and Section 1231 gain above that when they have been held more than one year. Supplies produce ordinary income. Accounts receivable of a cash-basis practice are ordinary income when collected or when sold. Goodwill the dentist built in the practice is a capital asset in the seller's hands, so its gain is long-term capital gain if the practice has been held more than one year, while goodwill the seller previously bought and amortized carries Section 1245 recapture on the amortization. A covenant not to compete produces ordinary income to the seller. In a stock sale of the seller's corporation, the shareholder generally reports capital gain on the shares and the buyer takes the corporation with its existing tax basis, which is why buyers generally prefer asset deals and why a written allocation, binding on both parties under Section 1060 unless the IRS determines it is not appropriate, is negotiated rather than assumed. State dental practice acts generally restrict who may own a dental practice, so a DSO transaction usually acquires the non-clinical assets and pairs the sale with a management services agreement, while a dentist-owned professional entity continues to hold the clinical side.
What is personal goodwill in a dental practice sale and when does it hold up?
Personal goodwill is the value of the patient relationships and reputation that belong to the dentist individually rather than to the practice entity. When it exists, the dentist sells it directly to the buyer as a capital asset, and the proceeds do not pass through the corporation. The Tax Court recognized the distinction in Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998): personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract or covenant not to compete with the corporation. The same rule cuts the other way in a dental case. In Howard v. United States, an unpublished Ninth Circuit decision from 2011, a dentist who had signed an employment agreement and a covenant not to compete with his own professional corporation was held to have conveyed control of his patient relationships to that corporation, so the goodwill belonged to the corporation and the sale proceeds paid to him were taxed as a dividend rather than as his own capital gain. Personal goodwill therefore depends on the facts of each case: it can hold up when the dentist has never conveyed the patient relationships to the entity through an employment agreement or covenant not to compete, and when the practice's success rests on the dentist's own relationships rather than on the location or the brand. A separate personal goodwill agreement and a supporting valuation are how the position is documented, not what decides it; in Howard the court called self-serving language in a purchase agreement no substitute for a careful analysis of the realities of the transaction. It is most valuable when the seller's practice is a C corporation, because it moves that value out of the corporation's double-taxed asset sale. Relabeling a covenant not to compete as personal goodwill after the fact carries a heavy burden: in Muskat v. United States (1st Cir. 2009), a seller who had signed a noncompetition agreement and reported the payments as ordinary income could recharacterize them as goodwill only with strong proof that both parties intended them, at the time of the deal, as payment for personal goodwill, and he did not have it.
How is rollover equity in a DSO deal taxed?
Rollover equity is the part of the price the seller takes as an ownership interest in the buyer's holding company instead of cash, and whether tax on that part is deferred depends on the holding company's tax form. If the DSO holding company is taxed as a partnership, which is common with an LLC, a contribution of practice assets or entity interests in exchange for a partnership interest is generally tax-free under Section 721, but the cash paid alongside it is a sale, and Section 707(a)(2)(B) can treat the contribution and the cash together as a sale of the portion that was cashed out. If the holding company is a corporation, Section 351 defers gain only when the transferors, as a group, own at least 80% of the corporation's voting power and at least 80% of the shares of all its other classes of stock immediately after the exchange (Section 368(c)); a single dentist rolling equity into a large DSO does not meet that test alone, so deferral depends on the rollover being part of a larger qualifying exchange, and any cash or other property received is taxable up to the gain realized (Section 351(b)). Deferred gain is not forgiven: the seller's basis in the rollover equity carries over the low basis of what was contributed, so the gain is recognized when that equity is later sold or redeemed. Rollover equity also carries the risk that it is never liquid, which is a valuation and negotiation question before it is a tax question.
My practice is a C corporation. Why is an asset sale so expensive, and what are the options?
Because the gain is taxed twice. In an asset sale by a C corporation, the corporation pays corporate income tax on the gain, and the shareholder pays tax again when the after-tax proceeds are distributed or the corporation is liquidated. Three things change the arithmetic. First, personal goodwill: value that belongs to the dentist individually, not to the corporation, is sold by the dentist directly and, when the facts support it, is taxed once as capital gain, which is why the personal goodwill cases, Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998), and Howard v. United States, an unpublished Ninth Circuit decision from 2011, matter most to sellers whose corporation would otherwise pay its own tax on the gain: a C corporation, or an S corporation still inside the Section 1374 recognition period described below. Second, a stock sale: the shareholder reports one level of capital gain, but the buyer inherits the corporation's tax basis and liabilities and prices the lost basis step-up and the assumed liabilities into what it will pay. Third, an S election before the sale: it removes the corporate-level tax on gain that arises after the conversion, but Section 1374 taxes the built-in gain that existed on the conversion date, at the highest corporate rate, if the asset is sold within the five-year recognition period that begins with the first S-corporation year, so the election helps only with time. Deciding among these requires a current valuation of the goodwill and a determination of whether any of it is personal, before the letter of intent is signed rather than after.
Can I spread the tax on a practice sale with an installment sale or an earnout?
Partly. Under Section 453, gain on a sale where at least one payment is received after the year of sale is reported under the installment method as payments arrive, which spreads the capital gain on goodwill over the years the buyer pays. It does not spread everything: depreciation recapture under Section 1245 must be recognized in the year of sale regardless of when the cash is received (Section 453(i)), and inventory-type property is excluded from the method. An earnout, meaning a price that depends on future collections or performance, is a contingent payment sale under Treasury Regulation 15a.453-1(c) and is reported under the installment method by recovering basis against the stated maximum price when the agreement states one, in equal annual amounts over the payment period when no maximum is stated but the period is fixed, or in equal annual amounts over fifteen years when neither is stated and the arrangement still qualifies as a sale rather than a royalty. Two costs come with deferral. Interest is charged on the deferred tax when installment obligations from sales above a statutory price threshold exceed a statutory aggregate amount at year end (Section 453A). And the seller carries the buyer's credit risk for as long as the note is outstanding, which in a DSO transaction is a question about the DSO's balance sheet. A seller can elect out of the installment method under Section 453(d) and report all of the gain in the year of sale, which is sometimes preferable when the seller expects higher tax rates in later years, has losses in the year of sale that would absorb the gain, or would otherwise owe the Section 453A interest charge.
What happens to accounts receivable, the covenant not to compete, and my post-sale employment agreement?
Each is taxed as what it is, and none of it is capital gain on goodwill. Accounts receivable of a cash-basis practice have never been taxed, so collecting them after closing produces ordinary income, and selling them to the buyer produces ordinary income as well, because receivables for services are excluded from capital-asset treatment (Section 1221(a)(4)). Payments for a covenant not to compete are ordinary income to the seller, while the buyer amortizes the covenant over fifteen years as a Section 197 intangible (Section 197(d)(1)(E)) and cannot write it off early even if the seller breaches or the term ends (Section 197(f)(1)(B)); the buyer therefore has little tax reason to load value onto the covenant, and the seller has a strong reason to keep it no larger than the restriction is actually worth, since an allocation that does not match economic reality can be reallocated by the IRS. Compensation under a post-sale employment or consulting agreement with the DSO is wages or self-employment income as it is earned. The practical consequence is that the allocation schedule on Form 8594, the covenant, the employment agreement, and any personal goodwill agreement are one negotiation, because a dollar moved from goodwill to the covenant changes the seller's tax from capital gain to ordinary income without changing the buyer's fifteen-year amortization, and a dollar moved from goodwill to future compensation does the same to the seller while giving the buyer a current deduction instead of a fifteen-year one.
General educational information about United States federal tax rules, current as of the review date above. Tax law changes and every situation turns on its own facts. This is not tax, legal, or financial advice and does not create a client relationship. Inflation-adjusted figures should be confirmed for the year in question before relying on them.
