The dental attorneys at Nardone Limited are experienced in representing both buying and selling doctors in dental practice purchases and sales. In a dental practice sale, the buying doctor will generally insist that the purchase agreement contain a covenant not to compete, so that the buying doctor can protect his investment in the practice. A non-compete covenant prohibits the selling doctor from competing with the buying doctor within a specified distance from the practice location for a specified period of time. In our prior article titled Dental Practice Sales: Competing Interests Regarding Purchase Price Allocations, we discussed that once the parties have established a purchase price for the dental practice assets, they must also negotiate how to allocate the purchase price between different asset categories, each with its own tax treatment by the IRS. The covenant not to compete is one asset category that historically caused tension between the buying and selling doctor when it comes to allocating the purchase price.
Historical Tension Between
Buying and Selling Doctor
Prior to the addition of Internal Revenue Code § 197 in 1993, consideration paid by the buyer for goodwill could not be amortized; whereas, consideration paid for a non-compete covenant was amortized over the life of the contract. Thus, the buying doctor typically advocated for a larger allocation to the covenant not to compete. With respect to the selling doctor, consideration received by the selling doctor for goodwill received capital gains treatment, while consideration received for a non-compete covenant received ordinary income treatment. Thus, historically, at times when the marginal tax rate applicable to ordinary income was substantially higher than the marginal tax rate applicable to capital gains—as is currently the case—the selling doctor typically wanted a larger allocation to goodwill. The diverging interests between the buyer and seller often created conflict in negotiating the purchase price allocation.
Elimination of Historical Tension
The introduction of Internal Revenue Code § 197, however, eliminated much of the historical tension between buyer and seller, as goodwill is now fully amortizable by the buyer. For the selling doctor, nothing changed, as consideration for goodwill still receives capital gains treatment, and consideration for a non-compete covenant still receives ordinary income treatment. One would assume that the buyer would now be indifferent with respect to allocations between goodwill and a covenant not to compete, since they both have the same 15-year amortization period. But, that is not always the case.
Because the 15-year amortization period applicable to non-compete covenants under Internal Revenue Code § 197 typically exceeds the actual term of the covenant, the buying doctor will sometimes request that the selling doctor enter into, and allocate a portion of the purchase price to, a management or consulting agreement, which in theory allows the buying doctor to deduct payments under the agreement as they are made, or amortize them over the contract term. In other words, this is common tactic to circumvent the 15-year amortization period applicable to non-compete covenants and allow for a shorter amortization period. But, the IRS will closely scrutinize those types of management or consulting agreements, and, to the extent the payments are made in excess of reasonable compensation for services provided by the selling doctor, the IRS will treat the payment as being made for a covenant not to compete amortizable over 15 years. Thus, the Seller should be cautious when a buying doctor requests an allocation to a management or consulting agreement.
Although the historical tension between the buying and selling doctor has not been completely eliminated—due to the concept of a shorter amortization period for a management or consulting agreement—most buying doctors are generally indifferent to the allocation between goodwill and non-compete covenants, as the amount allocated to a management or consulting agreement, if any, is usually small.
Contact Nardone Limited
The dental attorneys at Nardone Limited have vast experience representing buying and selling doctors in dental practice sales and can properly advise you regarding the allocation of the purchase price under an asset purchase agreement, including competing interests between the parties. If you need guidance regarding your dental practice sale, contact Nardone Limited.