Incorporating Your Practice?

With the news in this year’s provincial budget that dental professionals may be allowed to incorporate in Ontario, I have been asked by many clients to comment on the practical issues related to selling a dental practice to a newly formed company. While I am not licensed to offer legal or accounting advice, I consulted with several leading experts in these matters and here pass on their advice.

First of all, it is important to understand that the legislation permitting incorporation has not been approved at time of writing. As well, it may not be approved at all, so do not attempt anything until this is legal. In the event it does become legal to incorporate, you are well advised to seek both legal and accounting advice prior to proceeding. Several experts have told me that the initial set up cost can be $5,000 to $10,000 and annual fees to maintain a corporation can be $1,500 to $2,500. These costs alone make it impractical for some to incorporate as they offset the possible tax savings you are trying to achieve.

Any dentist who has already formed a technical services company or hygiene corporation has likely achieved many of the benefits of incorporating and will find that it is not viable to incorporate again. One reason why incorporation is attractive in some provinces is that dentists can sell shares to family members. However, in Ontario, the only person who will be able to own the shares will be the dentist. This eliminates many of the benefits as it removes the ability to pay dividends to family members.

A few situations where it may be practical to incorporate include dentists who are owners of the real estate in which the practice is housed and those dentists who have associates. Speak with an accountant and lawyer to understand these issues better.

Dentists in Nova Scotia received permission to incorporate in 1994. Over 150 did so and Revenue Canada (now Canada Customs and Revenue Agency (CCRA)) reviewed every file. It was concluded that many dentists overstated the value of the assets transferred to the new company (goodwill in particular), which resulted in a deemed transaction (sale of goodwill) at a lower price. This reassessment of goodwill could trigger income taxes payable by the dentist even though no money actually changed hands. Penalties may also have been applied if the reassessment was significantly less than the amount used by the dentist. CCRA discovered that many dentists had used a simple letter from dental suppliers estimating fair market value – opinions that were disqualified completely. The suppliers are not at arms length and they have a direct conflict of interest as they sell other products to dentists. Additionally, CCRA more or less stated that the lack of detail in the letters, and the use of an overly simplistic formula of $X per chart, was not acceptable to substantiate goodwill value.

In order to defend themselves against these reviews, 19 dentists in the Maritimes requested that I perform an appraisal of their practice. My associate, ODA member Dr. Roger Ellis, and I faced the challenge of calculating the value of their goodwill as of 1994 even though it was five years later when we performed the office inspections. The methodology used to appraise in these circumstances, called forensic appraisal, is more complex and therefore more costly. The additional cost may have been prevented had a professional appraisal been done back in 1994.

CCRA had a substantial interest in proving that goodwill was worth a lower amount than what the dentists claimed because, in some instances, it could charge taxes on the amount the goodwill was over-estimated. Some of the more significant problems arose when dentists withdrew the money tax-free. I met with one young dentist, operating a modest family practice, who had a tax bill for over $100,000 with interest and penalties adding up every day.

In most instances, we appraised goodwill at a higher amount than CCRA’s valuators. In the event that CCRA concludes that enough errors were made in the incorporations in Nova Scotia, I’m certain it will be keeping a close watch on developments here in Ontario.

I am also led to believe that dentists in British Columbia and Alberta who operate Professional Corporations and/or Family Trusts may be contacted by CCRA about the appraisals they used if the Nova Scotia reviews are any indication.

This issue has the potential to be one of the largest debates about dental practice values we have ever seen. The resources to challenge the dental professionals who incorporate are readily available within CCRA offices across Canada and they would most certainly consult with their Nova Scotia offices to benefit from its experience. I am an adamant supporter of dentists and support any legal means of paying less tax. However, I caution you about acting too quickly and thus exposing yourself to the risk of a costly and time-consuming review.

Another issue related to incorporating is the ability to sell the shares of the company when you wish to sell the practice. This is opposed to the traditional sale of the tangible assets themselves in what is called an asset transaction. I have been selling shares in western Canada for some time and this has become the norm. The tax savings are significant for the seller, yet the consequences to the purchaser can be costly. While it is now customary for shares to be sold in some provinces, it took several years for the market to react to the taxation effects, especially for the purchasers, and prices went down for some time. Essentially, what happens is that the purchaser can buy your company yet he/she cannot depreciate the shares, which results in higher taxable income. Accountants call this a “lost tax shield” and they often advise the buyer to offer a price that is 10 to 20 per cent lower than the appraised value to reflect the lost amortization, depreciation, or capital cost allowance. It is important to remember that an asset sale does not trigger this price reduction. Furthermore, the capital structure of the company can have a big impact on the price of shares, such as the amount of retained earnings.

I caution you about incorporating if you plan on selling in the first one or two years after it becomes legal. The reason is that the purchasers may indeed buy your shares, yet they are certain to be discouraged by the reduced tax relief denied them when compared to other unincorporated practices. This will drive the value of incorporated practices down. Even though you pay less tax when selling those shares, you may end up in the same net after-tax position when it’s over. This reason alone may prevent dentists from paying the initial costs knowing the sale price will be reduced.

I predict that the market will become accustomed to share transactions after a few years and practice values will rebound but that will likely be the time that all the baby boomer dentists start selling their practices, which will increase the supply of practices for sale and reduce values due to oversupply.

If you plan on incorporating and subsequently selling your goodwill to this company to avoid future taxes, I strongly encourage you to retain a professional appraiser now and reduce the likelihood that you could face a costly review by CCRA later.

Ontario Dentist – September 2000