Not All Practice Valuations Are the Same
By Thomas L. Snyder, DMD, MBA, Director Henry Schein Professional Practice Transitions
Most of us understand the necessity of having a practice valuation prepared for financial and transition planning purposes, as well as for a potential practice sale or partnership buy/buy-out. The type of valuation prepared for these scenarios is called a “market value” practice valuation.
To prepare a market value, most valuators use three IRS commonly accepted approaches: Market, Income, and Asset Approach. Each valuator can choose from several valuation methods within each approach category to value a subject practice. In using three approaches, the subject practice is viewed through three different lenses, each requiring the application of various valuation formulae and databases to reach a conclusion of value. An average of the three methods is usually calculated to arrive at a market value.
Ultimately, a potential buyer will use a market value valuation as an aid in determining what a fair offer would be, based on an accurately prepared business valuation. Lenders often require a market value valuation to determine whether the transaction makes sense for their customer, the buyer.
There are, however, several other purposes for preparing a practice valuation that utilizes other valuation approaches and methods. These “special-purpose” valuations are either prepared to minimize the tax implications regarding a practice sale or co-ownership transaction, or for use in various litigation proceedings.
1. C Corporations and Personal Goodwill Valuation
This “special-purpose” valuation is used in conjunction with the sale of a practice having a C Corp business entity. Due to the double taxation nature of a C Corp, most tax advisers will allocate the majority of the valuation’s goodwill to “personal” (the doctor’s) goodwill. Thus “personal” goodwill is only taxed at the capital gains rate, as opposed to being subject to corporate tax first and then being taxed personally as well.
For years, the courts have upheld the personal goodwill allocation of a doctor/owner. Several years ago, however, there was a tax case in California that disallowed the personal goodwill allocation as the selling doctor had a C Corp with an employment agreement with himself as well as a restrictive covenant. Unfortunately, the doctor lost that court case. As a result, many CPAs and tax advisors are now concerned about the potential audit risk of their clients if a separate “personal” goodwill valuation is not prepared. Even though the doctor may not have an employment agreement with himself and his corporation, many advisers want to reduce any risk of an IRS auditor requesting a copy of a personal goodwill valuation. The purpose of this special valuation is to differentiate between the Doctor’s Personal Goodwill and the Enterprise (Company) Goodwill. As such, unique allocation models and formulae are used to arrive at the differentiation between Personal and Enterprise goodwill.
2. C Corp Conversions to S Corp Status
Many doctors have converted their C Corp to an S Corporation to avoid the double taxation issue. One frequently overlooked aspect of this conversion is the requirement for a “special purpose” valuation to be prepared if the timeframe for conversion at time of sale is less than ten years. The valuation should be prepared at the time of conversion to establish the appropriate tax basis. Failure to have this type of “special purpose” valuation may result in the doctor paying a higher amount of tax when the practice is sold.
3. Estate Sale and Gifting
In cases where a doctor has a relative who will become an owner in the practice, a “special purpose” valuation is required if the goal is to reduce goodwill value on the practice and minimize taxes. If any gifting to a relative is contemplated, this “special purpose” valuation is also required. A standard market value valuation will not be sufficient to support a gifting transaction in front of the IRS. It could be a costly mistake if there is an audit and a special valuation is absent, as additional taxes and penalties may be forthcoming.
4. Divorce and Partnership Dissolution and other Litigation Matters
Another final “special-purpose” valuation not only must follow standard valuation protocols, but these valuations must be prepared in accordance with local state law (which varies considerably from state-to-state). The valuators preparing these documents are also frequently called to justify and defend their valuation, either through deposition or under testimony and/or with personal appearances as a qualified expert witness in any litigation proceedings.
As you can see, there are several variations to the standard “market value” approach which brokers use to value a practice. These “special-purpose” valuations usually command higher fees due to their technical nature as well as the customization required to properly value the business for those “special business” purposes.
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