By David B. Mandell, JD & Jason M. O’Dell
As owners of a professional practice, Doctors can spend 10 to 12 hours per day building their practices to the point where the practice provides a measure of security for their families. We know because we have been there ourselves. Nonetheless, those who ignore one fundamental legal contract jeopardize all of their hard work. This very important legal contract is the Buy-Sell agreement. This is an agreement that all owners sign agreeing how the practice will be valued at the time of one partner’s death or disability and how the purchase of the shares will be paid.
Without a Buy-Sell agreement, partners and remaining families have no agreement as to how a practice will deal with an early death or disability of a physician-owner. At a time when the family is grieving or caring for a disabled family member and possibly struggling to pay their bills, they will look to the remaining partners’ practice to help them in their time of need. At the same time, the remaining partners may be struggling to get by without the services of a valuable partner. The last thing either of these two groups need is a struggle over money. In too many cases, the absence of a Buy-Sell agreement at the time of death or disability can cause bankruptcies of the families of all of the partners.
Let’s consider some of the questions that doctors should ask themselves:
· What would happen to my family if I died or was permanently disabled? Is it fair that I worked so hard to build the practice and all my family will get will be my outstanding accounts receivable?
· What happens if and when any of my partners die or become permanently disabled? How will their families fare?
· If I have another business and a partner dies or becomes permanently disabled, do I want the surviving family members as new partners? How will I buy them out at that time?
· What happens to my share of the practice if I decide I want ‘out’ of the practice or I decide to eventually retire?
There are various types of Buy-Sell agreements. Despite the many types, there are some basics regarding all Buy-Sell agreements that apply to any type of business. Buy-Sells can be used for corporations (“S” and “C”), partnerships, limited partnerships, limited liability companies (LLC) and other forms as well. For these discussions, we will use the words “business owner” generically to mean any type of business owner (i.e., shareholders in a corporation, partners in a partnership, members in a LLC, etc.).
Benefits to All Living Partners
From the standpoint of a healthy practice owner, the Buy-Sell agreement can provide the individual partner with an opportunity to negotiate and obtain the fairest or best price for his share of the practice. In the case of retirement or disability, the agreement can be an additional source of funds for each owner.
Benefits to the Practice and Remaining Owners
There are various benefits of the Buy-Sell agreement for both the practice and its remaining owners when one partner dies or becomes disabled:
Provide Continuation and Control. First, from the standpoint of the practice and its remaining partners, a properly planned Buy-Sell agreement will provide for the orderly continuation of the ownership and control of the practice. This continuation should survive the death, disability, divorce or bankruptcy of any owner and should provide for a seamless transition in the event any owner wants to retire and sell his or her ownership share.
Keep out Unwanted Owners. Second, the Buy-Sell agreement can prevent unwanted outsiders from becoming owners and can eliminate the need for negotiation with remaining spouses and children. The agreement may also perform the role of a succession plan by providing for continuity or orderly succession of practice management. As above, this is not as relevant for the professional practice as it is for surgery centers and other medically-related businesses where non-Doctors can be owners.
Provide Liquidity to Buy out Surviving Family Members. Third, the Buy-Sell agreement is often used in conjunction with life and disability insurance policies to effectively provide liquidity for the practice to purchase the outstanding ownership interests of the disabled or deceased partner.
Benefits to Surviving Family Members
The Buy-Sell agreement benefits the family members of disabled or deceased partners in various ways:
Provide Liquidity to Surviving Family Members. For a deceased or disabled owner’s family, the existence of a properly-funded Buy-Sell agreement can assure the family a liquid asset rather than an illiquid minority interest in a privately held practice that would be extremely difficult, if not practically impossible, to sell. As mentioned earlier, this can be extremely important as the remaining family may be burdened with estate tax payments or additional expenses to care for a disabled family member. The agreement itself may provide a valuation of the practice interest which can be used for estate tax filing purposes. This may save the survivors the additional headache and expense of securing another valuation and fighting the IRS on that value.
Eliminate Practice Risks to Surviving Family Members. If one owner becomes disabled or dies, the Buy-Sell contract guarantees that the disabled owner’s family does not have to become involved in the practice in order to protect the total family’s interest. The Buy-Sell agreement frees the disabled or deceased owner and his family from the risk of future practice losses and creates funds that may be used to pay medical bills and living costs of his own family.
Funding the Agreement
Because the Buy-Sell agreement contemplates a Buy-Sell transaction at the time of an owner’s death or disability, insurance policies are generally recommended to fund the transaction. There are many reasons for this, including the following:
· Insurance policies pay a pre-determined amount with proceeds that are available at exactly the time when they are needed. This means there will be no liquidity concerns for any of the involved parties who need money at this time.
· Proceeds will be available regardless of the financial state of the practice at that point (so long as premiums have been paid).
· The practice “leverages” the cost of insurance premiums to create the proceeds. Therefore, it costs the practice less to buy insurance than it would cost to save money in a special buy-out side fund.
· The economic risks of early death or premature disability of any owner are shifted from the medical practice to the insurance company.
· Insurance proceeds are paid to the owner or owner’s family income-tax free.
If the payment contemplated under the agreement is not a lump sum cash or periodic payment other than through a disability insurance policy, it is important to consider some type of security arrangement for the departing owner. These agreements might include personal guarantees from remaining owners, mortgages or security interests in real estate, a bank standby letter of credit, or even collaterally assigned life insurance policies.
Disability: The Overlooked Reason for the Buy-Sell
Buy-sell agreements receive a lot of attention when used to deal with the death of a business owner. However, equally important, and much more likely, is that before any owner dies, he/she will become permanently disabled.
Business owners may need two-way protection in the event of disability. First, they have to consider providing for adequate income to meet routine personal expenses, including increased medical expenses, through a disability income program. Then, they must protect the value of their ownership interests, which can most easily be accomplished by expanding a buy-sell agreement to cover the risk of total disability.
An owner’s disability may jeopardize the continued existence of the business. Similar to a death or retirement that has not been adequately provided for, the loss of an owner of a business because of total disability can create the following hardships:
· Impair credit standing and cause a forced sale at a distressed price.
· Necessitate sale to parties not compatible with the interests or philosophies of remaining management.
· Reduce employee morale because the future of the business may be in doubt.
· Cause economic hardships to the business if a totally and permanently disabled owner continues as an employee.
· Create future problems if a totally disabled owner retains a decision-making position.
· Impose adverse tax consequences.
The Need for a Coordinated Team
Creating a Buy-Sell arrangement that fits a particular practice’s circumstances requires expertise and experience. Expertise in areas of corporate and practice law, tax law, insurance products and the valuation of practices are all absolute requirements. Just as important is experience in dealing with different owners and being able to negotiate and draft an agreement that meets the needs of all parties involved. Too often, practice owners make one of two key mistakes in deciding who should oversee the creation of a Buy-Sell arrangement. These include choosing a friend who is a lawyer, instead of an expert with experience in this area, to create the strategy and draft the document; and failing to work with a coordinated team to implement the plan
Once you realize that you need a coordinated team to administer the Buy-Sell arrangement, you have to find the right team. This team would involve the following:
· An attorney who has experience creating these types of arrangements.
· A life and disability insurance professional who has worked on these issues many times.
· A practice appraisal firm, whose expertise may be needed continually in the future for annual practice valuations.
As with any legal or insurance planning, the early bird is richly rewarded. Nowhere in practice planning is this truer than in the Buy-Sell agreement. The reason is not so much economic, but political. If this planning is done before any owner is close to a disability, divorce, retirement or death, all owners are in the same position relative to each other. That makes the negotiation of a standard deal for all owners a much easier and smoother process. Planning early for a Buy-Sell agreement will truly benefit you, your family and your practice. In order to avoid financial disasters, the agreement is an essential part of your financial planning.
David Mandell, JD, MBA, is an attorney, lecturer, and author of five books for physicians. Jason O’Dell, CWM, is a financial consultant, lecturer and author of two books for physicians. They are both co-founders of the financial consulting firm O’Dell Jarvis & Mandell with over 1,000 doctor clients nationwide.