Outside of the Box Strategies #4 – Turn Earned Income into a Capital Gain

Even though CRA is doing all that it can to prevent professionals from using all of the tax benefits that professional corporations can, or once could, use to minimize income tax, there are still a few strategies left for minimizing your income taxes. The Hill Kindy Out of the Box Strategy #4 allows you to turn some income into a capital gain. This is a strategy that works for dentists who are selling their practices and staying on as associates.

To understand how this strategy works you first need to understand how dental practices are, or should be, valued. Notwithstanding the variety of valuation methodologies that the various brokers use to determine practice value, there is really only one approach that is used by professional business valuators. For the professionals, value is a function of Net Profit, which is sometimes referred to as cash flow or EBITDA (Earnings Before Interest Tax Depreciation and Amortization). For the sake of this discussion, we are going to call it Net Profit. You will notice that Net Profit is profit after all expenses, including associates fees and paying the owner dentist for their work as though they too are associating. Understanding this last point is key to understanding our strategy.

Professionals determine value as a function of Net Profit to the extent that Net Profit should represent a return on value where that return is an “industry standard”. For example, in the dental industry, practice Net Profit is generally considered to equal about 20% of the value of a properly valued practice. In other words, an investment in a dental practice should yield a return on that investment of approximately 20%. A practice with a value of $1,000,000 should have Net Profit of about $200,000. If we know what the return should be (20%) and if we know what the Net Profit is, then with a little simple algebra we can calculate the value.

V = value
R = Rate of Return
E = Net Profit
M (Multiple)= 1/R

If: V*R=E
Then: E/R=V or E*M=V

Therefore if:
$1,000,000 X 20% = $200,000 then
$200,000 ÷ 20% = $1,000,000 or $200,00 X 5 (1/20%) = $1,000,000

The importance of this formula is that it establishes the relationship between Net Profit and Value. Therefore if:
$200,000 X 5 = $1,000,000, then obviously
$250,000 X 5 = $1,250,000

The greater the Net Profit the higher the value, and in our example by a value of 5 times. (In actual application, the Multiple used for dental practice value determination can very between 5 or 6 based on a number of different factors outside the scope of this article.)

Now let’s look at what happens when a dentist sells their practice and stays on as an associate. Just to make it easy let’s assume the following:

Assumptions:
1. Vendor sells and stays on as an associate for 5 years with consistent production.
2. Vendor has a tax rate of 50%.

                                         Scenario A        Scenario B
 Revenue
 Dental Gross                               720,000
 Hygiene Gross                              400,000
                                          1,120,000
 Less Lab                                    15,000
                                          1,105,000

Overhead at 50%                             552,500

Net Profit before Prof. Compensation        552,500            552,500

Prof. Compensation @ 40%                    282,000                n/a
 Prof. Compensation @ 20%                       n/a            141,000

Net Profit                                  270,500            411,500

Value at 5 Times Multiple                 1,352,500          2,057,500

 

Scenario “B” as opposed to Scenario “A”
  Decreased Annual Income (Prof. Comp.) for 5-year period       705,000
  Less Tax Savings                                              352,500
                                                                352,500

Increased Capital Gain on Sale                                  705,000
 Less Tax Cost                                                  176,250
                                                                528,750

Net Benefit to the Vendor                                       176,250

The net earned income result is an after-tax reduction of $352,500 ($70,500 per year) in associate compensation over the five-year period following the sale of the practice. This reduction in associate compensation however, is offset by an after-tax increase of $528,750 on the proceeds from the sale which will be received in year one. Simply put, by reducing the associate compensation (earned income) you can increase the purchase price of the practice (capital gain). The after-tax value of the increased capital gain is 1.5 times the after-tax cost of forfeiting one-half of the normal associate compensation. If the vendor plans to only work for three years after the sale, the calculations would be a little different but the theory is the same. If the multiple used in the initial valuation is different than 5 Times, again the calculations will be a little different but the theory remains the same. The greater the differential between the normal associate compensation of 40% and the reduced rate, the greater the benefit.

Conclusion: When it comes time to sell you practice you need to make sure that you have a lawyer, accountant and broker, all of whom can think outside the box to make sure that you reap every benefit possible.

Hill Kindy provides professional appraisals and practice sales all viewed from both inside and outside of the box. For help in planning and organizing your transition contact Derek Hill (dhill@hillkindy.com) or Cassandra Paolella (cpaolella@hillkindy.com).