After-tax ROI for these two options are in table 6.
The rub is which after-tax ROI applies-the one in which all income earned in a given year by the incoming partner is subject to a 35% ordinary tax or the one in which a portion of that income is deferred to a later payment (here as year 7) at a lower 20% capital gains tax.
Part IV: Bridge
If the higher after-tax ROI (and extra $21,000 a year) is essential for the incoming partner to meet personal financial obligations, she should instruct the existing partnership that she wants an arrangement whereby she is taxed on ordinary income after debt servicing the promissory note. One thing we can take from tax law is that such a structure, with explicit clauses having to do with deductible expenses, can be created so as to achieve this result. The remaining issue as to whether the existing partnership will accept the consequence of paying ordinary tax on the new partner's debt service payments is another matter. Somebody is paying ordinary tax on income received in the partnership in a given year: the new partner, the existing partnership, or a single member of the existing partnership.
Take note: The only way the partnership can avoid paying ordinary income tax is to have the new partner buy out one of the existing partners so that the payments on the promissory note become a capital gain of the departing partner and not ordinary income of the partnership.
Part V: Conclusion
This article looked at the partnership decision reflecting on the cost of admittance of a new member against the added value of the existing partnership. It also determined the after-tax ROI for the proposed partner. Dependent on which tax basis is applied, there is a fall-off of 248 and 280 percentage points between a before-tax ROI and an after-tax ROI. The difference in the tax consequences of paying for the partnership as a capital investment or in paying for the partnership out of ordinary income creates different income or cash flow streams for the incoming partner, and certainly different ROIs.
Notes
1. Equivalent to the formula; 75% of total sales. Any dentist aware of my position on the economic valuation of dental practices realizes this is not a valuation I support or propose. Rather, it was agreed upon by the three existing partners and one prospective partner.
2. In table 2, a 6% sales growth model was employed, once again at the agreement between partners. The rosy picture emerging in year seven of a half-million gross distribution to each of the four partners created a little concern at the partnership meeting. Follow-up calculations were requested at 3% and 1.5% sales growth. These alternative payback tables, however, are not made part of this article.
3. The $2,000,000 number for the exit is a little exaggerated if we stick with the same method of analysis established so far. $9,021,782 of year 7 sales times 75% equals a sales price of $6,766,336. The sales price of $6,766,336 ÷ 4 partners = $1,691,584 for each partner. For the new partner, her return is based on $1,691,584 less $474,531 (being the down payment, promissory note, and interest), or $1,217,053. Anticipating the next section, a 20% capital gains tax and an additional 3.8% Affordable Care Act tax on investment income generates a tax on the new partner in year 7 of $289,659, leaving a net-of-tax capital gain of $927,394.
4. Ordinary income tax for a dentist can be as low as 28% and as high as 39.6%. There is also a self-employment tax of 15.3% and an additional tax of 0.9% on self-employment income as a result of the ACA. In 2014, capital gains tax legislation created four different layers of tax rates as well as an ACA surtax of 3.8%. See David John Marotta, "Capital Gains Tax Gets More Complicated," Forbes, May 2014.
Thomas A. Climo, PhD, writes and consults on the topic of Dental Economics, specializing in organizing practice management groups for solo practitioners and in the standardization of accounting for and valuation of dental practices. He can be reached at [email protected].
