The purchase and sale of any business can be a daunting task. A transaction involving a medical practice is even further complicated by confusing and often impractical health care laws. While focused on business and contractual terms in the highly regulated health care industry, buyers and sellers often ignore important tax implications of practice sales. When not properly handled, these oversights create significant financial impact on practice buyers and sellers. Parties have competing interests when it comes to allocations, so understanding these particulars is essential. The purpose of this article is to provide an introduction related to the tax issues associated with the sale or purchase of a health care business.
These transactions involve many complex nuances, such as differentiating between goodwill of the health care provider and the practice entity. These nuances will be addressed in subsequent articles in our series.
Allocation of Purchase Price
One of the first provisions that buyers and sellers see in a practice sale agreement covers the allocation of purchase price. The IRS requires parties to a transaction to allocate purchase price among certain “classes” of assets. Classes of assets include the following:
- Value of stock, if the transaction is a stock sale
- Value of tangible assets (e.g. fixture and equipment), if the transaction is an asset sale
- Value of intangible assets (such as goodwill)
- Value of non-compete
IRS regulations state that if the buyer and seller of a business agree on the allocation of the purchase price, the IRS will respect the agreed upon allocation unless it is “not appropriate.”
Types of Transactions
In a stock sale, a practice’s assets and liabilities remain in the entity and continue to be carried in the same manner as before the transaction. Sellers generally prefer a stock sale because it allows them to completely step away from the practice and avoid responsibility for any future liabilities relating to the practice, although purchase agreements are often structured to shift liability responsibilities back to the seller for the operation of the practice during the period prior to closing. Buyers tend to disfavor stock sales due to the increased risk of taking on a seller’s liabilities. However, many practice buyers prefer stock sales because assuming third party payor contracts and Medicare numbers is often easier.
In contrast to a stock purchase, in an asset sale the buyer and the seller choose the assets of the practice to be sold to the buyer while the selling entity remains intact. The buyer typically purchases the majority of the seller’s assets such as equipment, patient lists and other items. An asset purchase also allows the buyer to better pick and choose those assets which it wishes to purchase (e.g., a particular piece of equipment) while excluding those liabilities which it does not wish to assume (e.g., an unfavorable contracts or pending litigation).
S-Corporations and C-Corporations
Differences in the income tax treatment of C-corporations and S-corporations should be considered at the onset of structuring a transaction. Since a C-corporation pays tax on its earnings, and its shareholders are taxed again when dividends are paid to shareholders, C-Corporations are subject to double taxation. S-corporations, however, are taxed only once. That is, the income is taxed only to the corporation’s shareholders. Thus, as discussed more fully in a future article, it is important to structure a practice sale in a manner that is sensitive to the tax “class” of the selling entity.
From the Buyer’s Perspective
From a tax perspective, asset sales typically benefit buyers. By allocating higher values for assets that depreciate quickly (such as equipment) and lower values for assets that depreciate slowly or not at all (such as goodwill), a buyer can reap tax benefits from the purchase price because depreciable assets can be written off in future fiscal years. Purchased equipment can often be deducted (up to a certain dollar amount) under Section 179 of the Internal Revenue Code, resulting in an immediate tax saving. To the extent equipment does not qualify under Section 179, it can still be depreciated over a period of only seven years or less (depending on the type of asset). Goodwill and the non-compete, on the other hand, must be amortized over 15 years. Thus, it is in the buyer’s best interest to maximize the purchase price allocated to tangible practice assets, and minimize the amount allocated to goodwill.
Of course, the value of tangible assets must be based upon fair market value in order to meet IRS and health care regulatory requirements.
From the Seller’s Perspective
A selling physician practice recognizes a taxable gain or loss based on the difference between the allocated sale price and the tax basis of the assets and liabilities. As noted above, if the selling practice is a C-corporation, an asset sale typically results in an increased tax burden.
By the time the assets of the practice are sold, much of the practice’s equipment has likely been fully depreciated for tax purposes. Therefore, any amount allocated to equipment that exceeds the book value of that equipment will be taxed at an ordinary income rate. Special attention should also be paid to the portion of the purchase price that is allocated to the non-compete, which is also taxed at an ordinary income rate Goodwill, on the other hand, is taxed at the much lower capital gains rate.
Michael A. Igel is part of the Johnson Pope Health Care Group