Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)
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Executive Summary
It is important for medical groups to decide in advance what to pay a member upon his or her departure from the group. These arrangements should be established as part of a consistent strategy that begins with associate employment, continues through member buy-in, and ends with appropriate payout provisions.
Mistake 1 Failing to Address Payout Provisions When Buy-ins Are Established
Too many medical groups wait to address an appropriate formula for paying out a departing physician until it is time for the departure. There are different reasons for this reluctance, including not wanting to “rock the boat” or assuming that a physician who enjoyed the good fortune of being with the group will not be so crass as to seek economic fairness upon departure. Regardless, this approach usually leads to strife and extra costs. It makes better sense to assess payout issues when addressing the buy-in formula. Almost all medical groups have readily demonstrable value. It is only fair to recognize that value among its owners. Otherwise, physicians would be penalized for having practiced in a group setting. It would be financially better to withdraw from the group, set up a solo practice, and then sell it for a value upon retirement.
Action Step Physicians should establish a fair and consistent payout approach before it is needed.
Mistake 2 Not Putting the Group’s Interests Foremost When Establishing Payout Arrangements
Fair payout arrangements should be premised, first and foremost, on protecting the ongoing group practice. The group’s welfare must be more important than maximizing the benefit to any individual physician. Excessive generosity will threaten the continuing well-being of the group, a sure pathway to trouble both for the continuing physicians and, often, for the departed physician whose installment payments may become threatened if the group becomes overextended.
Action Step Physicians should protect the group’s welfare when establishing payout arrangements.
Mistake 3 Establishing Different Payout Terms Based on the Reason for the Member’s Departure
Practices often believe they should vary the payout formula according to whether a physician’s departure is due to death, retirement, or disability, or if a physician retires “too young.” These approaches are often ill conceived. It is only fair to reward fully a departing partner who has participated in the group’s growth long enough to deserve a full payout, regardless of the reasons for the departure; after all, the physician is leaving behind essentially the same tangible and intangible values. An ongoing practice will almost always have the same patient loyalty and forecast for success, regardless of whether the departing physician dies, relocates, or retires.
Such variations usually intend to penalize “inappropriate” departures to discourage partners from withdrawing voluntarily. But a medical practice’s success is usually tied inherently to the collegial, if not synergistic, interdependence of its physician members. Someone who no longer wishes to be in the group but who stays because of economic coercion will provide a negative influence on the continuing group practice. (Exceptions, such as when a physician departs to compete with the group or harms the group with early notice, are discussed in Mistake 5.)
Action Step Physicians should establish a formula that ignores the motivations for departure.
Mistake 4 Funding a Payout with Life or Disability Insurance
Medical groups that obtain life and/or disability insurance on all or some of their members in amounts sufficient to fund buyout proceeds usually waste their money. It may be comforting to know that departures may have little economic effect on the remaining physicians, but this emotional comfort is often expensive and misplaced.
First, even when the insurance is funded collectively by the group, a departing member will wind up paying for an allocated portion of his or her own insurance, which then benefits the group. The accounts receivable generated by that physician remain with the group. Thus, the doctor subsidizes his or her own insurance and provides a gift back to the remaining colleagues of the receivables and other intangible values he or she generated. Second, the practice’s receipt of insurance proceeds may trigger the alternative minimum tax under federal tax law, making this arrangement far less attractive. If the physicians try to avoid the agreement with a “cross-purchase” arrangement (by which the shareholders individually purchase policies on each other), this is a complicated process at best, and unwieldy when the group has more than two or three physicians. Third, insurance funds a departure only under certain circumstances. A life insurance policy will not fund a payout due to disability, nor will a disability policy fund a death payout. Neither will fund a retirement. The group may have to fund a payout regardless of insurance, so why not just structure the payout to be affordable and eliminate the insurance?
On the other hand, sometimes a medical group has a physician whose drawing power, reputation, or influence is so great compared with that of the other physicians that the group is unsure whether it can survive that physician’s death or disability. In that case, insurance may be justified, to provide cash flow that would not necessarily be sustainable otherwise.
Action Step Physicians should avoid purchasing insurance to fund payouts, except in unusual circumstances.
Mistake 5 Ignoring the Goodwill Values Involved in a Group Practice Payout
As with a physician partner’s buy-in, all three types of assets that affect a medical practice’s worth should be addressed during the payout of a departing physician: the group’s hard assets, its accounts receivable, and its goodwill. Most groups embrace the first two categories, but some groups ignore or undervalue the practice’s goodwill. This approach is often unfair economically to the departing physician.
Most groups enjoy a fairly strong market for medical practice sales and significant value has been attributed to practice intangibles. Primary care practices are typically sold with goodwill values equal to 10% to 60% of annual revenue; specialties often command 10% to 80% goodwill values. Even hospital-based practices frequently have goodwill values of 5% to 25% or more. If a successful internal medicine practice can command a sale price equal to 40% to 50% of its annual pretax gross income, then logic suggests that it is unfair to deny at least some of those values to a departing physician.
In addition, most departures that ignore goodwill result in a windfall profit to the continuing partners. Upon the member’s departure, the group will likely hire a replacement physician who is much less senior than the departed physician and who commands a much reduced compensation package. Yet the earnings of the group will likely be comparable to what the group earned before the member’s departure, precisely because of the practice’s goodwill value (which includes its ongoing vitality). While this windfall is greatest during the first year after the physician’s departure, it will continue while the replacement physician phases up to full-member entitlement.
Action Step Physicians should craft a payout formula that acknowledges their practice’s full value.
Mistake 6 Not Taking Advantage of Deferred Compensation Tax Rules
Payout arrangements should use “deferred compensation” to pay for accounts receivable and goodwill values to the departing physician. Deferred compensation is treated as “wages” to the departing physician (taxed as ordinary income) and is tax deductible by the group practice. However, because deferred compensation payments are paid for past services, there should be no FICA (Social Security) or related FUTA (federal unemployment) taxes for the group practice or the departing physician. This is because unfunded deferred compensation is subject to FICA and FUTA taxes in the later of the year the services are performed or when there is no “substantial risk of forfeiture” of the payment. When properly structured, deferred compensation is not subject to forfeiture (except, perhaps, for circumstances within the control of the departing member, such as competition). Thus, the deferred compensation was subject to FICA and FUTA taxes earlier, when the services were performed; but at that time the physician probably already paid the maximum FICA and FUTA taxes. Therefore, no further FICA or FUTA should be due.
For tax purposes, it usually makes sense to define the deferred compensation entitlement in terms of salary—eight months of the average monthly salary from the past three years, for example. (An acceptable alternative is to state the deferred compensation as a fixed percentage of the most recent year’s gross receipts.) If, instead, deferred compensation is stated as a percentage of accounts receivable and practice intangibles, the practice invites scrutiny by the Internal Revenue Service. The danger then is that the deferred compensation will be recharacterized as an asset repurchase by the group, thereby eliminating the tax deductibility of the payments.
Action Step Physicians should consider tax rules carefully when assessing whether to use deferred compensation for the payout formula.
Mistake 7 Failing to “Phase Up” Separation Pay Entitlements to Junior Partners
Payout arrangements should reflect the flipside of the group’s approach toward practice buy-ins. Typically, a physician phases up to full parity over some period of time to reflect the difference between the group’s overall vitality and the young partner’s individual contribution toward that vitality. The payout formula should reflect the same approach toward this “phase-in” to acknowledge that a junior partner leaves less value behind than does a senior partner (particularly the goodwill component).
Consistency suggests that the young physician’s equal right to payout should begin when the buy-in has been completed. However, many senior physicians are reluctant to provide a large payout to a young partner, regardless of economic valuation principles. Often, a group will phase up a young partner’s entitlement to a full payout more slowly than the buy-in term, so that the young partner may “pay his dues” through additional years of involvement. One example is a 10% to 20% phase-in each year, reaching full parity in 5 to10 years. The group must remember to reduce the senior physician’s portion as the junior member approaches parity. If the junior member’s payout entitlement is artificially reduced because of “paying the dues,” then the senior physicians receive a greater entitlement by default. As that discrepancy is reduced, the group must ensure that its payout formula reduces the senior physicians’ entitlement proportionately.
Action Step Physicians should assess how quickly a junior partner should achieve full entitlement to separation pay and make sure the senior physicians’ entitlements reflect this phase-in period.
Mistake 8 Miscalculating the Appropriate Amount of and Timing for Deferred Compensation
What amount of deferred compensation is appropriate depends on the group practice’s philosophy. First, if the departing physician was paid by productivity, should the physician receive an equal share of the practice’s payout values or a share tied to productivity? One argument suggests that the group owns its assets equally, and they should be shared equally with departing physicians. The alternative argument is that deferred compensation reflects the intangible values left behind by the physician, and those values relate to how hard that physician worked (i.e., the physician’s productivity). Either approach is fair if it reflects the group’s overall philosophy, including “share and share alike” or “eat what you kill.”
Second, how will the practice handle cash flow problems? The deferred compensation obligation may be significant in value, because it is tied to both receivables (future revenue tied to past services) and goodwill. The group therefore must consider how quickly it is willing to pay the deferred compensation. At a minimum, the group should not pay more during a payment period (monthly, quarterly, or semi-annually) than would have been reflected in the accounts receivable collected from that physician’s work, minus the payments made to the replacement physician. Indeed, it makes sense for the group to pay only a fraction of this amount on a current basis.
On the other hand, if the payments are spread over too long a period, the departing physician loses the present value of those funds. Would the group be willing to increase deferred compensation to recognize the time value of money, perhaps with an interest component to the payments? The difference in value is perhaps insignificant for deferred compensation paid over one or two years, but it is a very real component of the overall package when payments extend three to five years. Further, most group practices reject the concept of paying interest on deferred compensation. Again, the answer should reflect the group’s overall philosophy.
Finally, the group must protect itself against unforeseen problems. Even the most carefully calculated payout formula may create hardship when cash flow takes an unexpectedly bad turn. This is particularly important when multiple members depart within a short time, or when a very high-earning physician (with substantial deferred compensation) leaves the group. This danger can be addressed by proposing a cap on the total deferred compensation paid by the group during a fiscal year. Typically, such a cap is 5% to 10% of the practice’s gross income for the year. When structuring this formula, the group must decide whether this ceiling will defer unpaid compensation or eliminate it. One theory suggests that the practice’s cash flow problems demonstrate that the values left behind by the departed physician were less than the agreed formula had expected. The alternative argument is that any cash problems reflect an aberration and should not penalize the departing member. This argument is especially persuasive when the cash problems are due to subsequent circumstances.
Regardless, if this approach is taken, the deferral should be limited to one or two years. Any continued cash problems should then result in a reduction of the payment. But physicians should talk to their tax adviser, as this approach arguably affects the payment of FICA and FUTA taxes.
Action Step Physicians should assess timing and productivity issues when crafting a deferred compensation formula.
Mistake 9 Forgetting to Limit Separation Pay When the Physician’s Actions Hurt the Group
There are several circumstances in which this mistake can arise:
Reduction Because of Competition. When a withdrawing physician practices the same specialty within the group’s competitive market, the physician in effect takes back the goodwill value portion of his or her deferred payout. The group does not enjoy the value of that physician’s contribution to goodwill and should not pay for it. Indeed, a junior physician who leaves the group and competes may impose more harm than the physician’s contribution to goodwill can offset because the junior physician effectively removes more of the practice’s vitality than he or she contributed. It is thus important that payouts be reduced when a former member competes in any manner while the payments are being made. The group must value the reduction appropriately, since many courts will knock down a noncompete formula if it is perceived to punish the competing physician. A reduction tied to goodwill should be safe. But physicians should consult with competent health care counsel before implementing a reduction that includes any portions tied to accounts receivable or hard asset values.
Reduction for Sick Pay. A departing physician’s payout should be tied to values left behind by the physician. If a physician has drawn a salary before the departure, yet has been absent from work too often or for too long a period, the physician has already drawn down on those same values to fund his or her salary payments during the absences. It seems fair to reduce the deferred compensation by any sick pay received prior to retirement or death, unless the physician had returned to work long enough to generate sufficient additional revenues, thereby “replenishing the pot,” in effect.
Reduction for Insufficient Notice. A medical group needs time to minimize the losses from a physician’s departure, to reallocate workload, recruit additional physician assistance, and so forth. To discourage a member from resigning on short notice, physicians should consider adding a “penalty” provision to the deferred compensation arrangement. For example, if a six-month notice is normally required (absent death or disability), a physician who gives a four-month notice might have his or her deferred compensation reduced by one third. Under this approach, the departing physician retains freedom to decide whether to pay the penalty in exchange for a quicker departure.
Reduction for Upcoming or Prepaid Expenses. Groups sometimes pay expenses far in advance to achieve cost savings or for other reasons. If a group has just paid a year’s worth of malpractice insurance, a departing physician should be responsible for paying for that portion of the insurance that may accrue to the physician’s benefit in the future. This is unnecessary if a portion of the payment can be refunded.
A related issue affects insurance “tail premiums.” Malpractice coverage that is claims-based often requires a substantial tail premium to cover claims asserted after the physician’s departure. The risk covered by this insurance accrues both to the departing physician and to the remaining group practice. The group’s documents should make clear who is responsible to pay the tail premium. A common solution is to split the costs, since both parties benefit from the coverage.
Reduction for Future Liabilities. Finally, physicians should assess whether to seek recompense from a departed physician for any liabilities that affect the group because of the physician. Examples include a Medicare challenge for alleged billing errors made by the departed physician, or a malpractice claim potentially in excess of insurance limits. One solution may be to seek recompense in some amount for as long as the physician is still receiving deferred compensation, but then to reduce or forgo payback after the payout has concluded. Regardless, this decision should reflect the group’s overall philosophy and should be carefully drafted by competent counsel.
Action Step Physicians should identify those actions by the departing member that may affect the payout entitlement.
Mistake 10 Forgetting to Consider State Law When Crafting Separation Pay
State laws often affect separation pay issues. Some states, for example, prohibit garnishing an employee’s “wages,” which may be defined to include deferred compensation. This would affect any of the penalty provisions or reductions discussed in this section. Or, the state’s tax rules may vary from the federal rules and affect the tax ramifications of deferred compensation. Therefore, the group’s attorney should carefully consider separation pay provisions to assure compliance with state as well as federal law.
Action Step Physicians should consider state law when crafting a payout formula.
Conclusion
The overriding theme when crafting separation pay is mutual fairness. From the medical group’s perspective, this means that separation pay should be consistent with the group’s philosophy and should never be allowed to harm the ongoing vitality of the practice. This goal usually can be accomplished while still paying fair compensation to the departing physician.
Disclaimer: Materials in this presentation have been prepared by the Health Law Center for general informational purposes only. This information does not constitute legal advice. You should not act, or refrain from acting, based on any information in this presentation. Neither our presentation of such information nor your receipt of it creates nor will create an attorney-client relationship.
Written by:
Neil B. Caesar, Esq., and Kelly R. Pickens, Esq.
Peer reviewed by:
Thomas Baker, Esq.