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
A professional practice usually has three components of value: net tangible assets (e.g., cash, equipment, and furniture less its trade payables); collectible accounts receivable; and goodwill. Whether fashioning buy-ins for new physician-owners or buyouts for the existing owners, the issues are the same, and the agreements should properly reflect each component of value in the most tax-advantaged structure possible. The parties often fail to address the economic realities of the situation, as well as to consider several important tax issues, which could materially lower the net after-tax cost of the transaction.
Mistake 1 Including Accounts Receivable Value in Stock Price
If patients paid their medical bills at the time services were rendered, the medical practice would have no accounts receivable. All revenues would translate into current compensation to the physicians rather than give rise to this “accrued asset.” In structuring their buy-ins and buyouts, physicians often wrongfully include a share of the accounts receivable in the buy-in stock price, which mischaracterizes the true economic nature of this component of value (that it is simply deferred revenue) and subjects it to higher than necessary income taxation.
Assume, for example, $100 of accounts receivable value and that the combined federal and state tax rates are 40% on ordinary income and 20% on capital gains. Since payment of the stock purchase price is not deductible, the buy-in physician will be required to earn $167 in pretax income to cover the after-tax payment of $100 to the current owners, who will then retain only $80 after paying capital gain taxes. Accordingly, under this structure, there will be an aggregate tax cost of $87 on the $167 of income devoted to funding this buy-in payment.
Action Step Remove the $100 of accounts receivable value from the buy-in stock price, have the buy-in physician forgo $133 in compensation, and then pay an additional $133 in compensation to the current owners. Since a compensation payment is fully deductible, the buy-in physician will be required to generate only $133 of gross income (rather than $167) to fund the payment to the current owners, and the current owners will realize the same $80 in after-tax income (as ordinary income) on the $133 they receive. Accordingly, this refashioned structure saves the buy-in physician $34 in pretax income (and $20 in after-tax income) for every $100 of buy-in price that has been so restructured.
Mistake 2 Including Goodwill Value in the Buy-in Stock Price
A professional practice may develop valuable goodwill over time, building an institutional reputation that fosters return visits and referrals from patients and other physicians. If so, this is a separate component of the medical practice’s value and should be reflected in the buy-in price paid that a new physician owner would pay. However, if the goodwill value is included in the stock price, then the buy-in physician would be forced to devote a greater amount of pretax earnings than necessary to the buy-in.
Action Step To effectuate the buy-in, the goodwill value should be removed from the stock price. Instead, the new physician should forgo compensation entitlements in this amount, which should then be paid to the current physician owners. However, this restructuring will provide the current physician owners with ordinary income in payment for the goodwill. If the current physician owners feel that they are entitled to lower capital gains taxation on this price component (an issue that may be subject to honest debate), the amount should then be increased to account for the higher ordinary income taxation of this compensation payment. As noted in Mistake 1, a payment of $133 in reallocated compensation will still produce the expected $80 in after-tax income to the current physician owners and will burden only the buy-in physician’s pretax earnings by $133 (as compared with $167 of the physician’s pretax earnings if reflected in the stock price). Accordingly, this restructuring will save the buy-in physician at least $20 of after-tax income for each $100 buy-in price, thus producing a lower net economic cost to the buy-in physician. Similarly, on the buyout, this component of value should be reflected as deferred compensation paid to the buyout physician.
Mistake 3 Reflecting Goodwill Value in the Buyout Price When the Goodwill Is Personal and Portable
Physicians who pay for the practice’s goodwill in their buy-in are entitled to be paid for that value on their buyout, but only if it is left behind with the medical practice. It makes little economic sense for departing physicians to be paid for goodwill in their buyout if the goodwill is personal to them and they take it with them.
Action Step If the medical practice as an entity has a reputation (as distinct from each doctor having a personal individual reputation), then the practice has goodwill value, and this component of value should be embodied in the buyout price. However, there should be such a payment only when the goodwill value is expected to stay with the ongoing practice (on death, disability, or retirement of the departing physician) and not when the departing physician will be engaging in a competitive practice and thereafter attracting patients or referrals away from the original practice.
Mistake 4 Including Receivables That Are “Bad Debts” in Calculating the Buy-in Price
Consider this scenario: A new physician is asked to pay more than he should in his buy-in because the calculation of the accounts receivable wrongfully includes an accumulation of past due accounts or contingent receivables (perhaps from personal injury cases) that may never be collected.
Action Step The level of accounts receivable should be carefully reviewed at the time of buy-in to ensure that all uncollectible receivables are eliminated from value and problematic or contingent receivables are appropriately discounted in value.
Mistake 5 Not Providing for the Cost of Collecting the Practice’s Receivables
Assume that the medical practice pays the departing physician on buyout for the full amount of his or her share of collectible accounts receivable, when it will cost the continuing practice the expense of ongoing administrative services to collect those receivables.
Action Step The component of value attributable to collectible accounts receivable should be reduced by 5% to cover the overhead costs attributable to collection of the receivables.
Mistake 6 Not Providing for the Contingency of Multiple Concurrent Buyouts
Buy-out agreements traditionally have focused attention on the payment terms for a single departing physician owner, but have not characteristically addressed the situation in which multiple owners become entitled to buyouts at the same time.
Action Step Agreements should provide for such a contingency by incorporating “antichoke” provisions, which would cap the aggregate amount of the installment payments due the multiple departing owners at a monthly fixed amount (or a percentage of monthly gross revenue), and defer the excess so that it is paid under a longer installment payment schedule than would otherwise apply in the case of a single-person buyout.
Mistake 7 Not Planning for Use of Office, Telephone, Etc., on Practice Breakup
In formulating their buy-sell agreements, physician owners often do not plan ahead for the contingency of a breakup of a medical practice. A common area of disagreement results from the failure to establish the rights with respect to the ongoing use of the practice’s telephone numbers, patient information, equipment, and/or use of the corporate office space and personnel.
Action Step The buy-sell agreement should carefully delineate which physician has the right to use the practice’s telephone number; obtain original or copies of patient information; use specific medical equipment; and continue to use office space. The ongoing employment of office personnel also should be addressed. In addition, it is often useful to establish in advance the protocols to be used when announcing terminations and when answering post-termination telephone calls.
Mistake 8 Not Providing for the Possible “Ganging Up” on Minority Owners
The governance structure of most medical practices usually provides simply that each physician has one vote. This structure works without difficulty when everything is amicable and each physician is chosen to serve as an officer and director, with mutually acceptable compensation and duty arrangements. However, the simple “one-person, one-vote” structure permits a situation in which the majority owners can use their power to “gang up” on one owner and perhaps unfairly change his or her rights to bonuses or other compensation entitlements or the right to serve as an officer and director or be subject to a fair sharing of duties or on-call scheduling.
Action Step The bylaws and/or shareholder agreement could eliminate such a situation by providing that no changes can be effectuated on certain vital practice issues (e.g., compensation, duty schedules, directorships, and officerships) in the absence of a super-majority vote of the physician owners (a vote requiring more than a simple majority) or perhaps without unanimous approval.
Mistake 9 Not Planning for the Taxable Gain Realized on Payments “In Kind” Upon Buyout or Practice Breakup
Many buy-sell agreements provide that in the event of a breakup of the medical practice, the departing physicians or physicians may receive a share of the practice’s tangible assets (e.g., equipment). However, the parties often fail to consider the likelihood that the practice’s tax basis for these assets may be lower than their fair market value. This “value-basis” differential usually arises because the accelerated depreciation deductions permitted for tax purposes are greater than the economic reduction in value for these assets. When this situation arises in the context of an incorporated practice, the distribution on buyout or liquidation will engender a taxable gain, which would not be proportionately shared among the physician owners.
Action Step The physician owners may agree to a “sharing” of the tangible assets and take the position that the respective “book value” of each asset is representative of its fair market value. However, the Internal Revenue Service might challenge the assumption that book value and fair market value are the same for each asset. Alternatively, the physician owners may agree to share the assets so that each receives a grouping of assets that represents a pro rata share of the latent gains and/or losses to be realized on distribution. Each physician owner’s entitlement can then be calculated after taking into account the resulting tax cost to the practice. Although that approach will not necessarily eliminate the gain or loss to the practice or to the physician owners, it will ensure that each physician owner pays his or her proportionate share of the resulting taxes rather than have the tax burden fall disproportionately (unfairly) on only some of the physician owners.
Mistake 10 Failing to Address Personally Guaranteed Debt on Buyout
Medical practices often incur bank debt that is used to fund the cost of “fitting” up its office space, equipment purchases, and working capital needs, and the bank often requires the physician owners to personally guarantee the loan. Although such liabilities are taken into account on buyout to reduce the buyout price paid to the departing physician owner, the departing physician often remains personally liable for the loan. As a result, if the practice subsequently defaults on the loan, the departing physician may be forced to bear the economic burden of the loan a second time.
Action Step On buyout, the loan can perhaps be restructured with the lender to have the departing physician’s guaranty either eliminated or subordinated to the other guaranties. Further, the buyout agreement could provide for the individual remaining physicians to obligate themselves to indemnify the departing physician and contribute proportionately to any debt obligation that he or she is forced to personally bear as a result of his or her ongoing guarantee.
Conclusion
Whether considering buy-ins for new physician owners or buyouts for the existing owners, physicians should ensure that the agreements reflect the value of the practice and its assets in a tax-advantaged way. They can do so by addressing the economic realities accurately and by considering the tax issues that could materially lower the net after-tax cost of any transaction.
Written by:
Richard J. Flaster, Esq.
Peer reviewed by:
Neil J. Barr, Esq.