Unless you’ve been living under a rock for a few months, you’ve probably heard that Congress passed sweeping tax reform for 2018. The impacts of this legislation will be felt far and wide, but the general consensus is that the reform will be good for both companies and individuals. If that bears out to be true, the economic outlook for the United States should be very favorable for the years to come.
But, what does is mean for the dental industry and for DSOs in particular? Everybody’s got an opinion, so we asked some friends to share some feedback.
Here’s what they had to say…
What are the changes in the new law exactly?
The changes in the law impact a myriad of areas, but we’ll focus on three: rates, structure and interest expense.
- Corporate Rates: lowered from 35% to 21% for Personal Service Corporations (PSC’s) and C Corporations
- Individual Rates: lowered from 39% to 37% for the highest brackets
- Structure: a new deduction was created for pass through entities equal to 20% of “qualified business income”
- Interest Expense: the deduction for business interest is now limited to 30% of EBITDA (for companies with gross revenues greater than $25 million dollars) through 2021 and, beginning in 2022, the cap is lowered to 30% of the company’s EBIT
OK, but what does all of that really mean?
“For smaller DSOs, the new laws may create better tax benefits if the DSO is a pass-through entity. There is a new deduction for small pass-through businesses. This strategy will require the DSO to reexamine how it charges the management fee, as the new tax law will not benefit “services,” but appears to benefit licensing fees, rent, equipment leasing and other non-service related offering of DSOs. Doctors, dentists, lawyers and other professional services will not benefit from the new small business pass through deductions because of the exclusion of services. So, the deductions will not be available for the dental practice. Giving dentists ownership in the DSO may allow the DSO to shift the economics further to the DSO. Of course, the corporate practice of dentistry will have to be navigated when making changes to the management fee amount and characterization of fees.” Michael Byrd, CEO at ByrdAdatto
“The 20% deduction for pass through entities is not available for dental practices and potentially service businesses, i.e. management companies, if the owner’s individual taxable incomes exceed a range from $315,000 to $415,000. In those situations where the owners’ taxable incomes fall within the range above, it may behoove the PC to remain a pass through entity.” Steve Mizrach, CPA and Partner-in-Charge of Healthcare Services at Dorfman, Mizrach & Thaler, LLP
In terms of interest expense:
“One of the more significant provisions in the new tax law for private equity is the limitation on deducting interest expense. Private equity has been able to deduct interest expense on debt from pretax income for decades. This has encouraged private equity to rely on debt to acquire and grow companies, including DSOs.” John V. Arnold, Attorney at Waller, Lansden, Dortch & Davis
So, there seems to be some “lack of clarity” [in a tax reform bill - who knew?!] around this “20% qualified business income” provision…
“There have been some articles stating that DSO’s will be eligible for the 20% deduction as their business purpose is providing management services and leasing equipment to PC’s rather than providing dental services. We, along with other tax professionals, are awaiting the Joint Committee Report to be published. This Report is used to further explain Congress’s intent regarding the implementation of the new law which will provide greater clarity in determining which business models will qualify for the 20% deduction.” Steve Mizrach, CPA and Partner-in-Charge of Healthcare Services at Dorfman, Mizrach & Thaler, LLP
What’s the Outlook for the National Economy and the Impact at a Macro-Level?
“The investment backdrop for markets is still quite strong. The tax cuts have yet to work their way through the system in a meaningful way, and the global economy is experiencing synchronized growth for the first time in a long time. At home, 4th quarter GDP came in at 2.6%, not setting the world on fire by any means, but a solid number driven by a strong consumer. Interest rates are still low, though have risen to four-year highs over the past few weeks, and employment data is strong. US corporate balance sheets are in great shape, and the repatriation of overseas cash allows for reinvestment back in the companies to improve earnings or returning to shareholders in the form of higher dividends or share buybacks. There are still risks in the market and chief among them in our book is that, spurred by inflation, the Fed gets too aggressive with tightening which pushes the economy into recession.” Cliff Hodge, CFA, Portfolio Manager at FinTrust Investment Advisors
“Crystal Ball” time, guys. How will the impact of those changes play out in the years to come?
“While it was disappointing for dental and healthcare professionals to miss out on the 20% deduction for qualified business income, as it will be considered a service based business, the new bill will certainly provide nice tax relief to our industry in the form of lower tax rates and higher thresholds. In addition, changes to bonus depreciation that allow for a direct write off of new and used fixed assets is going to be a great catalyst to M&A activity, and instantly improved the economics of asset purchases overnight.” Dr. Steven Villanueva Founder & CEO of MB2
“I suspect older, solo dentists will be emboldened to stay the course and squeeze as much juice as possible out of their practice prior to monetization. For small to mid-tier groups seeking liquidity or a partner to grow, I predict private equity activity will remain strong through 2018.” Mick Janness, Chief Development Officer at Dental Partners | Spring & Sprout
What about the impact on M&A activity in the dental space overall?
“As a result of this change, we anticipate that going forward many companies may look to preferred equity instead of debt in leveraged buyouts. In addition, limiting the interest expense deduction effectively increases the cost of capital, which could affect how much private equity is willing to pay for a DSO.” John V. Arnold, Attorney at Waller, Lansden, Dortch & Davis
“Most organizations that grow by making acquisitions, as most in the DSO world do, do so by using some combination of debt and cash to finance these events. Between the inability to deduct as much interest as before, as well as the likely increasing rise in interest rates and thereby cost of capital, buyers will certainly have to keep an eye on the valuations they are willing to pay for targets. In particular, especially for smaller DSO’s that are looking at lending sources outside of Senior Debt providers, the access to capital may become more limited or at the least they, in turn, will need to ensure they are maintaining a level of discipline with the pricing of targets. I don’t see it materially impacting the interest of DSOs looking to acquire either individual practices or groups, but it will certainly heighten the focus on pricing and valuation.” Greg Wappett, Director of Corporate Development at Gentle Dental Partners
And two more wrinkles to consider as it relates to structuring transactions…
“The new tax law repeals the carry back of any Net Operating Loss, which could affect transaction terms regarding the payment of additional purchase price for tax benefits arising from deductions related to the transaction that give rise to an NOL for the year of the closing. Sellers will no longer be able to carry back the NOL and obtain a refund of pre-closing taxes – meaning sellers may seek to negotiate to benefit of NOL carryforwards realized by the buyer post-closing. And the new tax law capping the maximum deduction for an NOL carryforward at 80% of the taxpayer’s taxable income, without taking into account the NOL itself, adds a potential additional wrinkle to these negotiations.” John V. Arnold, Attorney at Waller, Lansden, Dortch & Davis
“An asset sale usually contains a substantial allocation of the sales price to Goodwill, which is taxed at capital gains rates (20%). Thus there could be substantial tax savings in an asset sale by using a pass through entity (20%) instead of a C Corporation (39.8%), seeing as though C Corporations do not differentiate between ordinary income and capital gains.” Steve Mizrach, CPA and Partner-in-Charge of Healthcare Services at Dorfman, Mizrach & Thaler, LLP
Special thanks to all of our friends and industry experts for adding a bit of clarity around a very confusing topic. We appreciate all of their expertise and encourage you to reach out to any of them with specific questions.
If you’d like to discuss any other topics related to trends in our industry, please feel free to contact me at Perrin@TUSK-Partners.com. TUSK provides industry-leading resources for Group Dental Practices and DSOs. We help our clients START, GROW and SELL their Group Dental Practice or DSO. For more details, visit our website HERE or feel free to download our Overview of Services.
TUSK will be the featured presenter at the "DSO Foundations" Seminar in Charlotte, NC on June 1&2 where we will present "Tactics to START, GROW and SELL Your Group Practice". This seminar will be hosted by our friends at Patterson Dental Supply. You can find more information and register HERE. We hope to see you there as well!
To see where else we’ll be in the near future, please check our calendar for a listing of all seminars, conferences and presentations.