By: Doug Copple
Chief Financial Officer, CPA, CVA
 Many orthodontists may be aware of the some of the differences between an asset sale and a stock sale when purchasing a partial or complete ownership interest in an orthodontic practice. This article will attempt to assist both the buyer and seller in making a well-informed decision when entering into a purchase or sale transaction by pointing out many of the advantages and disadvantages of a typical asset and stock sale when the selling doctor wishes to sell 100% of his or her practice.
Generally, with an asset sale, the buyer creates a new corporation or other entity that purchases specified tangible and intangible assets of the seller’s practice, including dental and office equipment, dental and office supplies, orthodontic contracts, patient records, telephone numbers, equipment leases, and related practice and professional goodwill.
An asset sale is preferred by the buyer for two primary reasons: (1) protection from seller’s liabilities, and (2) stepped-up basis of assets purchased.
When the buyer purchases only assets from the seller, he or she is not required to purchase or assume the selling practice’s liabilities, including known and/or unknown, disclosed and/or undisclosed liabilities. Examples of these liabilities may include items such as unpaid amounts due to product vendors or service providers, unpaid taxes due to the local, state or federal government, lawsuit settlements for malpractice claims, and employee claims, among other items. In the event a liability arises subsequent to the sale, the seller, rather than the buyer will be obligated to satisfy any such liability that the buyer has not expressly agreed to assume in the purchase agreement.
In addition to protection against seller’s liabilities, the buyer is allowed to step up the basis of the assets based on the allocation of the purchase price. The new stepped up basis allows the buyer to depreciate or amortize these assets over a specified period as defined in the Internal Revenue Code and, therefore, receive a deduction for tax purposes. For example, the seller’s corporation may have dental and office equipment within the corporation with a book value of zero (i.e. fully depreciated). However, assuming that buyer purchases such assets for $100,000, the buyer’s basis in these assets is $100,000, which he or she is allowed to depreciate or deduct over a specified period of time. In addition, the amounts allocated to intangible assets such as goodwill, covenants not to compete, and patient files and records are amortized (deducted) over a 15 year period. Thus, the buyer can effectively write-off the entire purchase price over time, which is much more tax efficient compared to a stock sale, whereby the buyer is not allowed a deduction for the amount paid for corporate stock or LLC membership interests.
With an asset sale, the seller maintains control of his or her corporation subsequent to the transition and may elect to continue operating the corporation for various reasons, such as to provide orthodontic services through it to the buyer and other practices beyond the geographical limits of the restrictive covenant, to receive payments related to the sale (if seller financed) and/or to continue to fund his or her retirement plan.
The disadvantages of an asset sale to the buyer include more complex closing documents and initial creation of a new corporation. Because the buyer is creating a new corporation rather than simply taking over an existing corporation, the buyer must obtain new insurance provider numbers and contracts, formally rehire the seller’s staff, and set up payroll and other accounting functions. In addition, the closing documents include various conveyance documents that legally transfer or assign contracts and agreements from the seller to the buyer. For instance, assigning the facility lease (if applicable) may require approval from the landlord, and various other contractual arrangements (equipment and software leases and service contracts) may require approval from the lessor or service provider. Each of these agreements should be identified and addressed in the closing documents.
Disadvantages to the seller of an asset sale primarily relate to negative tax consequences. If a C-corporation sells corporately owned assets, such as furniture and equipment, supplies, accounts receivable and corporate intangibles (i.e. corporate goodwill), the corporation generally recognizes ordinary income on the gain, which is subject to two levels of tax: corporate tax on the gain and personal tax on the distribution. Although Subchapter S corporations are pass-through entities, and generally not subject to federal income taxes, they may be subject to corporate taxes on certain sales of corporate assets in accordance with Section 1374 of the Internal Revenue Code (the Built-In Gains Tax). However, much of the value of a specialty practice is attributable to the personal goodwill of the doctor, which is not considered a corporate asset, is not subject to corporate taxation and is currently taxed at favorable long-term capital gains rates of a maximum of 15% (the same rate as gains on the sale of corporate stock). Additionally, to the extent that the buyer does not agree to assume contracts that have a term remaining as of the closing date, such as an equipment lease for an item of equipment which the buyer does not need, the seller remains obligated to fulfill the remaining term of the contract, even though the seller may no longer be practicing.
Rather than creating a new entity, a stock sale allows the buyer to purchase the selling doctor’s corporation by purchasing his or her corporate stock. Advantages to the buyer of purchasing corporate stock generally relate to the simplicity and speed of the transition. A new corporation is not necessarily created and the disadvantages of an asset sale as previously noted are alleviated. However, certain agreements with third parties may require consent from the landlord, service provider or creditor upon a significant change in ownership.
Disadvantages of a stock sale to the buyer include (1) assumption of all liabilities of the seller’s corporation, whether or not known, (2) non-deductibility of the purchase price (although the transaction can usually be structured such that a significant portion of the purchase price is tax deductible), and (3) inability to step up the basis in the corporate assets, though in certain limited situations a step-up may be possible under Section 338(h)(10) of the Internal Revenue Code.
As opposed to an asset sale, the buyer assumes all known and unknown liabilities of the existing corporation when he or she purchases the stock of the corporation. Although such liabilities do not become the personal liabilities of the buyer, the loss in the value of the stock purchased by the buyer from the seller as a result of such liabilities may cause economic harm to the buyer. The purchase documents can include personal indemnifications by the selling doctor that protect the buyer against liabilities arising after the closing date and caused by the selling doctor. However, these indemnifications are generally personally guaranteed by the selling doctor and may not provide the buyer with sufficient financial protection.
The amount paid for the corporate stock is also not deductible by the buyer for tax purposes (however, if agreed upon by the seller, the transaction can be structured such that a significant portion of the purchase price is repaid to the seller in a tax deductible manner). Although the purchase price becomes the buyer’s basis in the corporate stock, the purchase price is repaid with after-tax earnings, and it will most likely be a significant period of time before the buyer sells the corporate stock and recognizes the tax benefits of the higher stock basis. In fact, the buyer may never sell the corporate stock and could be limited on the annual loss related to the disposition of capital stock he or she can claim for tax purposes.
In addition, the buyer simply assumes the existing tax status and depreciation schedule of the corporate assets. Often, the assets within the corporation are fully depreciated, which precludes the buyer from receiving the benefit of future depreciation deductions. As previously noted, however, the buyer is allowed to step up the basis of the assets in an asset sale and depreciate the new cost basis over time.
Upon the sale of the corporate stock, the seller is taxed at favorable long-term capital gains rates (maximum 15% tax rate) on the proceeds that are in excess of his or her basis in the stock. With the maximum federal capital gains rate at 15% versus maximum ordinary income rates of 35%, the tax savings could be substantial, which, along with transferring any and all obligations of the practice to the buyer, is a primary benefit of a stock sale to the seller.
The previous sections attempted to outline basic differences (and is by no means exhaustive) in asset versus stock sales when a buyer purchases 100% of the selling doctor’s practice. Although sellers would prefer a stock sale, the majority of practice buy-outs are structured as asset sales due to the significant disadvantages of stock sales to the buyer. With an asset sale, the buyer receives the benefit of deducting the purchase price over time and avoids exposing himself to the selling doctor’s past liabilities. Although there are tax detriments when a corporation sells corporate assets (particularly C corporations), much of the purchase price can be allocated to the selling doctor’s personal goodwill, which receives favorable tax treatment and can significantly offset other tax disadvantages.
The choice of asset versus a stock sale is clear when a buyer purchases a 100% ownership interest in an orthodontic practice for the various reasons noted herein. This choice becomes more difficult when the junior and senior doctors desire to enter into a partnership arrangement or there is an extended buy-in and buy-out arrangement. In the next newsletter, we will focus on the various issues of a stock sale versus an asset sale in extended buy-outs and partnership arrangements.
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