Understanding the Importance of Goodwill to Both the Dentist and the Dental Practice

There is no way to overstate the value of goodwill to the dentist and to his or her dental practice. From the acquisition of an interest in a dental practice to the investment of a partner in the practice, all eyes should be on the goodwill and the value it creates to the dentist and the dental practice.

Goodwill is the most valuable asset in the dental practice. It may be created by each of the dentists who are partnership owners and the practice itself may have some of its own goodwill. Whenever a dental practice valuation is being prepared, those experts who understand the valuation process will always give recognition to between 50% and 75% of the value of the dental practice as being allocated to goodwill. From those percentages, there is a further allocation of the goodwill between the personal goodwill of the dental practice and the enterprise or dental practice value of the goodwill meaning that proportion is allocated to the dental practice itself and not to an individual dentist. These percentages when converted to dollars form the basis for the value of the dental practice since the equipment is available on the open market when new and used. The used value of equipment can be equated to the value of an automobile as the new automobile loses about 50% of its value during its first year on the road.

What other assets are part of the dental practice value?

When thinking of the other assets within a dental practice some of the items that come to mind are the equipment, staffing, phone number, patient lists and records and location of the office. Other than the equipment, all of the other assets are part of the composition of goodwill. When it is thought about, other than the equipment, just about every other asset in the dental practice can be allocated to either personal goodwill or to dental practice (enterprise goodwill). Equipment is available for lease or purchase from most dental supply and equipment sellers.

Goodwill is a primary item when the dental practice is being listed for sale and a negotiation is underway as to how much goodwill there really is in the dental practice. The income tax allocation for the sale of goodwill is a priority for the seller of the dental practice since that allocates the best income tax rate to the seller of the dental practice. The buyer of the practice will look to reduce the goodwill value since that hurts him or her when allocating the tax aspect of the sale.

When a divorce of the dentist is underway, goodwill is of a primary interest especially in a state where there are equitable distribution rules in effect. With the current wave of dental service organization (DSO) acquisitions, the goodwill is important to the DSO as the buyer since they want to show their hedge fund or venture capitalist who is advancing the money good earnings. The allocation of the goodwill forces the buyer to not write off for income tax purposes a large amount of money in the early years of the acquisition so that the purchase automatically looks better from an income standpoint than from a cash flow diagram.

Comparing the buyer and the seller and their income tax effect when goodwill is accurately recorded:

We’ll use an example of an allocation of goodwill as a realistic percentage of the sale price compared to an unrealistic approach. With an $800,000 sale price of a dental practice, about $600,000 can be reasonably charged to goodwill so the buyer and seller each report the $600,000 the same way, which they have to on their tax returns. For the seller, he or she records a capital gain of $600,000 and will probably pay a federal tax of about 20%, or $120,000. The seller must amortize the $600,000 over 15 years so he or she can only write off $40,000 per year rather than finding another way to write off the $600,000 over a much shorter term if it was not allocated to goodwill.

This saves the buyer about $20,000 per year in taxes (50% of the write off of $40,000). A divorce has similar consequences for the dentist. If the spouse receives $600,000 in the settlement, it is not taxable since it is a distribution of a marital asset. However, assuming that the dentist has to borrow the $600,000, when he or she pays it back, since the principal payment is not deductible, it costs the dentist another $600,000 over the term that he or she repays the loan since the assumption is that he or she is in the 50% tax bracket and to pay $600,000, the dentist must earn $1,200,000 since he or she pays a tax of 50% and would have 50% left to pay the principal.

Potential life style changes for the dentist:

When paying out that much money as described above, either from the acquisition price or during a divorce, it may hamper the ability of the dentist to continue paying retirement contributions to his or her dental practice retirement plan. This will cause the dentist to suffer in the short term while making the payments, as well as in the long term while taking distributions from a retirement plan that is much less than originally thought to be. It takes a smart dental practice CPA to assist the dentist so that he or she gets back on track and at least obtains an ability to fund some of his or her retirement plan. This is in addition to the recurring dental practice bills as well as the normal bills of a person who needs to pay rent or a mortgage and has car payments and other debt. It would be rare for a dentist to be able to make an economic comeback without some professional financial advisory services.

Goodwill is then both a good and bad thing, depending on where the dentist is in his or her career.