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ODs may lower personal tax bill by owning the practice’s building
First be sure transferring ownership makes good business sense for yourself and your practice.
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An increasingly popular tax-saving strategy involves transferring ownership of the optometry practice’s building or other property, equipment or assets to the practice’s principal or principals. For many optometry practices a sale-leaseback can mean liberating badly needed cash in exchange for executing a lease and paying rent. For other optometry professionals it is for protecting assets such as when a lawsuit is filed against the optometry practice or other issues arise. After a sale-leaseback transaction, the building would be at least partially protected in any legal actions.
For the building’s new owner, there are benefits that can help achieve a lower personal tax bill, income legitimately removed from the practice and, quite often, more financing options.
Before rushing to take advantage of this strategy however, optometric professionals should consider whether this is a good, viable strategy for them and their practice. Questions such as under what type of entity should the new ownership operate, who is going to pay the mortgage, who will reap the tax deductions and often overlooked questions such as what will happen if the practice changes hands or a principal exits require answers.
Mark E.
Battersby
Basic sale-leaseback transaction
Because a building and often the land on which it sits are a necessity for any practice or business, a sale-leaseback enables an optometry practice to reduce its investment in non-core practice assets, such as the land and building, while freeing up cash.
These sale-leasebacks, transactions in which an operating optometry practice sells real estate or other property it owns and occupies or uses to the operation’s owner, shareholders or investors and leases the space back on a long-term basis, are popular strategies for freeing up capital for expansion of many optometry practices.
Favorable leasing
One of the perks enjoyed by an optometry practice selling its building, now the office/clinic building’s tenant, is the ability to negotiate favorable lease terms. In a typical lease, the lessee might make rental payments while the lessor pays all of the property’s operating expenses. With a so-called “net” lease arrangement, the tenant pays rent and also pays all of the property’s operating expenses. Thus, the landlord receives a fixed rental payment, net of all property expenses.
However, most sale-leasebacks are structured as so-called “triple-net” leases with the tenant usually responsible for taxes, insurance and common area maintenance expenses. A long-term “hands-off” lease gives the tenant control over the property similar to when the tenant owned the property. The tenant can, of course, work with the building’s new owner to include options allowing for future expansion and possible sublease of the property.
As property owners, the interest expense and depreciation were the only tax deductions usually available to the optometry practice. On the other hand, a practice leasing its premises can write off the total lease payment as a tax expense. Thus, a sale-leaseback may have a greater tax advantage and produce a bigger tax deduction.
Unlike a mortgage, a sale-leaseback transaction can be structured to finance as much as 100% of a practice’s land and building’s appraised value. As a result, a sale-leaseback uses the practice’s investment in the real estate more efficiently as a financing tool.
Because a sale-leaseback is not technically a financing instrument there are no restrictive covenants. And fewer covenants give an optometric professional greater control when operating his or her practice.
Trust, LLC or corporation
The new owner of the optometry practice’s building can be a trust, corporation, a limited liability company (LLC) or even a partnership consisting of the optometrist and several associates or key employees. Because owning commercial real estate involves risks that are different from operating an optometry practice, establishing a LLC or other similar entity to own the building allows the two to be kept completely separate. The new owner can then lease the building back to the practice, as well as to other tenants if space permits.
A trust is a unique legal entity as well as a separate taxable entity. A trust usually involves an arrangement created either by a will upon the creator’s death or by a trust instrument that may take effect during the creator’s life. Under either arrangement, a trustee takes title to the property in order to conserve it for the trust’s beneficiaries. However, the trust will still be recognized as a separate taxable entity, even if the beneficiaries are the people who planned or created it, so long as its purpose was to give the trustee genuine responsibility for conserving and protecting the trust’s assets.
A so-called “business” or “commercial” trust is a trust created for carrying on a profit-making practice or business, usually using capital or property supplied by the trust’s beneficiaries. The trustee or other designated people, regardless of whether appointed or controlled by the trust’s beneficiaries, manage the undertaking. For federal tax purposes, this arrangement is treated as an “association,” which may be taxed as a corporation or as a partnership, while standing alone from the other types of trusts.
Net investment income tax
Regardless of the type of entity used to hold title to the newly acquired building, thanks to our unique tax laws, a dilemma exists. On the one hand, under provisions in the Health Care and Education Reconciliation Act of 2010 that came into play in 2013, many individuals now find themselves subject to a 3.8% net investment income (NII) tax.
NII includes not only rents, but interest, dividends, annuities and royalties. Although NII does not apply to income derived in the ordinary course of a trade or business, it does include income from a so-called “passive” activity, and the IRS decides whether an individual materially participates in business activities on a “regular, continuous and substantial basis.” If the IRS feels that an individual’s participation is not material, they cannot deduct losses to the same extent as someone who does materially participate in a professional practice or business.
Thus, regardless of the type of entity the new owners choose to own the building or other property, the NII adds an additional tax on the profits from that passive activity. In addition, losses are also denied or limited for passive operations.
Reversing or getting out
Many optometric professionals have successfully held their practice and the building that houses it as separate entities. Consider, however, an optometrist who is thinking about retiring in a few years or selling his or her interest in the practice. Many small practices are sold with seller financing, meaning the seller would get a portion of the price up front, and then the buyer would pay the bulk of the purchase price over the next few years.
Should the buyer fail at operating the practice, the seller/optometrist receives a double whammy: not only is the optometric professional not getting paid for the practice, the building just lost its only tenant. The building’s original owner is still required to make mortgage payments on the building, only now those payments come from his or her own pocket.
The good news is that there are strategies that minimize or defer taxes, resulting in a larger portion of those eventual sale proceeds going into the seller’s pocket at closing. Delaying the receipt of sale proceeds, converting from a regular “C” corporation to an “S” corporation or LLC, transferring stock to family members, structuring purchases to obtain a more favorable capital-gains treatment and using trusts to reduce estate taxes are all common strategies.
In most cases, any eventual sale will be influenced by two key factors: How the practice is legally set up and – in the case of an incorporated practice or LLC – whether it is the assets or the practice entity that are being sold. Sales by all sole practitioners and almost all partnerships are usually considered to be asset sales, as are the sales of many closely held corporations and LLCs.
With the current economic climate and unfriendliness of the credit markets, a sale-leaseback transaction provides an efficient and effective means for generating the capital usually needed for expansion of the optometry practice. The bottom line is that a sale-leaseback with a net lease can work for both buyers and sellers.
Buying the optometry practice’s real estate assets offers a number of clear benefits including:
- a predictable, long-term cash flow
- returns typically higher than bonds
- low management requirements
- rent increases and value appreciation that hedge against inflation
- some tax shelter from depreciation and other deductible expenses
- positive leverage, especially during this period of high capitalization rates and the low cost of debt, which can substantially increase the return on investment
Lurking on the horizon are possible changes to the current accounting treatment of sale-leasebacks. Although unlikely to impact the popularity of these transactions, they should be kept in mind. Obviously, every optometrist will require the services of a qualified accountant or attorney. A local appraiser can help establish a fair sales price. Above all, make sure the transaction makes good business sense.