By Joseph P. Nicola, Jr., J.D., CPA

Published August 2001

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To understand the pain, it is helpful review the acquisition (and pre-acquisition) period of the 1990s. Prior to acquisition, most physician groups were organized as professional corporations owned by the physicians. The physicians had great autonomy and exercised financial and managerial control over every element of the practice. As the acquisition period began in the early-1990s, acquiring organizations (usually tax-exempt) employed a variety of incentives, including aggressive valuation techniques, to lure physicians into the acquisition process.

In most cases, the physician groups were sold in such a manner that the acquiring organization purchased the stock of the professional corporation, whose value was determined by an independent business appraiser. Since many such acquiring organizations were tax-exempt organizations, the purchase price of each acquisition was theoretically required to fit within well-defined parameters established by the Internal Revenue Service.

Unfortunately, aggressive valuations, coupled with often-lengthy negotiation processes, pushed acquiring organizations to the outer reaches of credibility with respect to financial packages. Fitting within the guidelines established by the Internal Revenue Service often required the organization to fashion a financial offer that employed state-of-the-art compensation alternatives and similar packages designed to provide significant financial incentives to physicians. Upon acquisition, it was not uncommon for the professional corporation to be liquidated, followed by the employment of the individual physicians by the acquiring organization.

Beginning in 1997, it became apparent that many acquiring organizations, particularly hospital organizations, began to experience financial difficulties on numerous fronts. Most significant among such difficulties related to the maintenance of large numbers of physician practices acquired within the preceding five-year period. Similar problems were beginning to surface in the case of the university setting, as well as in the case of many insurance providers. Physician compensation costs, as well as the financial overhead related to the numerous groups acquired within the short preceding period of time, caused many acquiring organizations to begin to crumble beneath the heavy weight of financial obligation.

As stated above, the unfortunate remedy in most cases was to begin a plan of strategy under which management began to reduce general and specific operating costs. The obvious targets of such planning were the same physicians who had recently joined the organization. Since 1997, physicians have been faced with the critical dilemma of choosing between a lay-off or an opportunity to reacquire the practice previously sold to the acquiring organization (with all the attendant costs of doing so). To maintain a stream of income, many physicians have chosen to reacquire their practices, as a result of which numerous tax and legal issues have arisen.

Tax Issues

From the tax-exempt organization’s perspective, the tax issues are most serious. As an initial matter, any sale or transfer of the practice by the organization to the physicians will draw close scrutiny by the Internal Revenue Service. The most significant concern of the Service will invariably relate to the "private inurement" rules of the Internal Revenue Code. These rules prohibit any portion of the value of the tax-exempt organization from inuring to the benefit of any individual. Private inurement occurs, for example, when a tax-exempt organization compensates an individual at a level that is higher than a reasonable level of compensation. In the case of a sale of the practice by the organization back to the physicians, private inurement may occur if the physicians acquire the practice at a price that is less than fair market value or less than the price at which the practice was originally sold to the organization. As a practical matter, the practice should be appraised before any sale to the physician occurs.

In some cases, the sale of the practice may occur in such a manner that the stock of the professional corporation is sold back to the physicians. Such a transaction would occur, for example, in a case in which the organization maintained the corporate identity of the practice upon acquisition (perhaps as a subsidiary). Such a sale (back to the physicians) should be handled with great care, since similar valuation issues will arise, and will again draw the attention of the Internal Revenue Service.

To the extent that the organization and the physicians exercise caution, cooperation and careful planning can produce tax-savings opportunities. For example, the sale can be timed in such a manner that the original sale of the practice to the organization might be nullified, perhaps resulting in a similar nullification of the adverse tax consequences experienced by the physicians upon the original sale of the practice to the organization.

In many cases, the physicians are required to form a new corporation for the purpose of acquiring the assets of the professional practice. This is particularly the case in situations in which the prior professional corporation was dissolved by the organization. In such a case, the physicians should seek the advice of tax counsel, in order to properly (and strategically) allocate the purchase price among the assets acquired.

Finally, the acquiring physicians should seek tax counsel with respect to expenses incurred in connection with the re-acquisition of the practice. There is significant controversy with respect to whether such expenses are currently deductible, or whether such expenses must be deducted (if at all) over a period of time.

Legal Issues

In addition to the tax issues, the physicians should focus on legal issues as well. Most of these issues are similar to those that were encountered on a daily basis by the physicians prior to the sale of their professional corporation to the acquiring organization. As such, the physicians should ensure that they are represented by competent legal counsel.

The first step in the process of re-acquiring the practice should entail a review of any restrictive covenants to which the physicians may be bound. The physicians should ensure that they are released from any covenants that may restrict their practice of medicine.

The physicians should also ensure that they have proper accounting assistance in order to properly record and classify all income and expenses. Moreover, the physicians should seek the services of an appraiser to ensure that they will pay no more than fair market value of the practice. If accounts receivable are included in the acquisition, the physicians should review the receivables to determine whether they are properly recorded (and reduced for an appropriate allowance for uncollectible accounts).

If the physicians plan to form a corporation or any other professional entity, they should draft an appropriate buy-sell agreement for purposes of establishing a ready market for the stock and for purposes of assisting in the estate planning process.

Legal counsel should be well-versed in the Medicare Fraud and Abuse rules, as well as Stark-related issues. For example, the physicians will want an opinion of counsel (or the appropriate government agency) that the re-acquisition will not constitute a violation of these rules, particularly if the acquisition price is less than the price at which the practice was sold.

As a practical matter, the physicians should seek the advice of counsel in order to determine whether all steps are taken to transfer the control of all business and medical records, as well as responsibilities for billing, testing, laboratory, leasing and other arrangements.

Finally, the physicians should establish a retirement plan in order to replace any retirement plan offered by the organization. Under recent tax legislation, there is now significant flexibility available to physicians who wish to establish and operate a retirement plan.

Joseph P. Nicola, Jr., J.D., CPA, is a shareholder with Alpern, Rosenthal & Company in Pittsburgh.