Physicians News Health news for doctors and patients.
By Joseph P. Nicola, Jr., JD, CPA
As the era of the baby-boomer begins to mature toward retirement, succession planning as it relates to the ownership of a business operation becomes critical. Similarly, estate and gift tax planning takes on equally heightened significance, particularly in light of the recent passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, which phases the estate tax out of existence over a period of nine years, but retains the gift tax in a modified format.
Most physicians are business owners and, as a result, such planning becomes a paramount concern. The concern is further punctuated by the fact that most physicians practice medicine through the vehicle of the professional corporation. In many cases, the stock of the professional corporation represents the largest asset (by value) of the personal estate of the physician. Since such stock is illiquid, it cannot be converted to cash in an expedient fashion. This inevitably creates numerous practical and logistical problems upon the retirement, death or divorce of the physician. In the case of retirement, many physicians find that they are left without an adequate level of monthly cash flow to maintain their standard of living. In the case of death, the inability to pay taxes creates financial nightmares. In the case of a divorce, the physician is relegated to making cash payments to his or her spouse in order to divide the marital estate.
Planning is Essential
To avoid the problems that are generated by these issues, financial, estate and succession planning should be at the top of the physician’s current agenda. Perhaps the most important element of any plan is the determination of the fair market value of the professional corporation stock that is owned by the physician. Absent such a valuation, planning is necessarily doomed to certain failure. To the contrary, a properly completed valuation of corporate stock permits the physician to effectively plan for retirement, while operating as a strategic defense mechanism in the event of death or divorce.
For example, in the case of a divorce, the value of the stock of a professional corporation is typically considered to be marital property that is subject to equitable distribution, which is the process by which assets are divided between the spouses. The valuation of such stock, if completed on a thorough and well-researched basis, can be an invaluable aid to the physician in settlement negotiations. As discussed in more detail below, however, the process of valuing the stock of a professional corporation is not (and historically has not been) without controversy.
Perhaps the most contentious feature encountered in the typical process of valuing the stock of a professional corporation is the goodwill of the corporation and the physician. In many cases, goodwill is the most valuable asset of the corporation and the physician. Of equal controversy is the applicability of minority discounts and discounts for lack of marketability.
Valuation Law and Theory
The process of determining the fair market value of corporate stock is an imprecise science. Thrown into the fire of complex litigation and the scrutiny of federal and state taxing authorities, the process becomes (and has become) incredibly controversial. This is most evident in a notorious string a recent decisions from the federal and state court systems, where the valuation of corporate stock has been the subject of much debate.
The valuation process generally has it genesis in Revenue Ruling 59-60, 1959-1 C.B. 237, issued by the Internal Revenue Service in 1959. In that ruling, the Service established the procedural means by which to determine the value of the stock of a closely-held corporation. The Service stated that a determination of fair market value is a question of fact, and depends upon the circumstances in each case. The term “fair market value” is defined as the price at which stock would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
In Revenue Ruling 68-609, 1968-2 C.B. 327, the Service focused on the asset that is at the heart of the professional corporation, namely, goodwill. The Service stated in that ruling that a “formula” approach, such as the capitalization of earnings in excess of a fair rate of return on net tangible assets, may be used to determine the fair market value of goodwill. Alternatively, the value of goodwill can be determined by reference to other methodologies under which multiples and rules of thumb are employed. Regardless of the methodology chosen, a physician must come to grips with the notion that the goodwill can represent a proverbial “double-edged sword.” For example, if the physician is engaged in negotiations to sell his or her practice, the physician will undoubtedly desire a higher value for goodwill. Conversely, in tax planning, as well as in the context of a divorce, the physician will desire a depressed value. This struggle is most significant in cases involving the divorce of a physician from his or her spouse. Careful planning in Pennsylvania can prevent disastrous financial results.
The Controversy Surrounding Goodwill
Recent case law in Pennsylvania has addressed the issue of goodwill. Recognizing the difficulty in determining the value of goodwill, the Pennsylvania Superior Court in Gaydos v. Gaydos defined the term “goodwill” as essentially the positive reputation that a particular business enjoys, the favor that the management of a business has won from the public, and the probability that old customers will continue their patronage. The Court further stated that goodwill that is intrinsically tied to the attributes and/or skills of certain individuals is not subject to equitable distribution because the value thereof does not survive the disassociation of those individuals from the business. This is significant, since goodwill that is attributable solely to an individual’s attributes is non-transferable and purely personal to the professional spouse. Such goodwill is often referred to as “professional goodwill,” and is not subject to equitable distribution in Pennsylvania.
The Pennsylvania Supreme Court in Solomon v. Solomon has recognized that there exists another type of goodwill that is wholly attributable to the business itself, and is subject to equitable distribution. As the single individual’s contributions become less substantial, the good reputation enjoyed by a business entity becomes less related to the single individual and more a product of the business entity in general, and thus, more capable of surviving the disassociation of the single individual. Goodwill of this nature is often referred to as “enterprise goodwill.”
Both forms of goodwill are intangible and difficult to value. In Solomon, the facts involved a veterinary sole proprietorship, which specialized in horse breeding. The owner was engaged in divorce proceedings with his wife, who claimed that the goodwill of the practice should be subject to equitable distribution. The Court found that the goodwill in this case was “professional goodwill.” As such, it was not available for equitable distribution. The court stated that the positive reputation of the horse breeding enterprise was inseparable from the professional reputation of husband.
Similarly, in Beasley v. Beasley, the Pennsylvania Superior Court found that, under the facts of that case, the goodwill of a sole proprietorship law practice had no presently realizable value, but instead related only to the professional spouse’s future earnings. In Butler v. Butler the Pennsylvania Supreme Court reaffirmed that (1) goodwill which is wholly attributable to the business itself is subject to distribution, but (2) goodwill which is intrinsically tied to the attributes and/or skills of the professional spouse cannot be viewed as a value of the business as a whole, and thus is not subject to equitable distribution.
The value of corporate stock, including goodwill, can be established through a buy-sell agreement. Care must be exercised, however, since such an agreement will draw the attention of the Internal Revenue Service in tax matters and opposing counsel in divorce matters. Following the statutory framework of the Internal Revenue Code can mitigate problems that might be encountered in this regard. As such, a buy-sell agreement can serve as a viable succession planning and estate planning tool. Great caution should be exercised, however, in asserting buy-sell values for purposes of equitable distribution in Pennsylvania. The Pennsylvania Superior Court has recently ruled, in Brody v. Brody, that values set forth in buy-sell agreements are not binding on the court, and may be used only as a guide in determining the fair market value of stock.
Valuation Discounts in the Federal Court System
Once the value of the stock owned by the physician is determined, the value of the physician’s ownership interest must be reduced for any minority discounts and discounts for lack of marketability. This area has generated a great deal of confusion in the federal court system. It is a particularly divisive issue, since it reduces the value of stock subject to taxes. (It also reduces the value of stock for purposes of equitable distribution.)
The United States Tax Court has recently experienced several reversals upon appeal, particularly where the taxpayer has argued for larger discounts. For example, in Gross v. Commissioner, the Tax Court refused to consider the potential corporate tax consequences of certain built-in gains taxes that could be imposed upon corporations that have made an election under Subchapter S of the Internal Revenue Code (S corporations). Such tax consequences, even if not yet incurred, tend to dramatically reduce the value of corporate stock. The Sixth Circuit Court of Appeals reversed the Tax Court and held that tax consequences should be considered in determining the discount to be applied to the value of the stock of a shareholder.
In Bolton v. Commissioner the Tax Court reduced the discount advocated by the taxpayer by reducing the value attributable to potential capital gains taxes that might be imposed in the future. The Fifth Circuit disagreed, stating that the Tax Court’s approach was not appropriate, and that a larger discount might be appropriate.
Finally, Estate of Paul Mitchell v. Commissioner advocated a discount equal to 61.5 percent of the value of the stock. This was considered by most measures of reasonableness to be fold. As a result, the Tax Court disagreed with the taxpayer, and held that a reduced discount of 35 percent was more appropriate. The Ninth Circuit disagreed, and held that the Tax Court did not properly explain its valuation methodology.
As in any case, careful planning can be a powerful financial tool. It can also operate as a superior defense mechanism in matters involving taxes and divorce litigation. At the center of such planning is the valuation of the stock of a professional corporation.
Joseph P. Nicola, Jr., JD, CPA, is a shareholder with Alpern, Rosenthal & Company in Pittsburgh.
