By Jeffrey B. Sansweet,Esq.
The economy is in shambles. Third party reimbursement is terrible. Malpractice insurance costs are still exorbitant. Health insurance premiums continue to rise. In this depressing context, what should a “typical” practice buy-out look like?
Notwithstanding the title of this article, there is no “typical” buy-out. With some practices, a doctor retires and walks away with nothing, other than no longer being responsible for the rent, no longer being concerned about a frivolous malpractice suit, and assured that his or her patients will be well taken care of by his/her former partners. Yet, other practices provide for a significant buy-out that mirrors the buy-in and that may have been negotiated many years ago in better times.
In general, however, most group practices do provide for a buy-out upon retirement, death, disability or withdrawal. The buy-out, which should be spelled out in the Shareholders Agreement, Buy-Sell Agreement, Partnership Agreement or Operating Agreement, is usually based upon the sum of the value of the practice’s (i) tangible assets – equipment, furniture, supplies and leasehold improvements; (ii) accounts receivable; and (iii) goodwill, less any practice debt that exists at the time of departure. A situation to clearly avoid is not having a document in place which has a forced buy-sell provision with a set formula for the buy-out. If you wait until it is time to retire to negotiate something with your partners, it becomes very difficult and could lead to costly litigation.
The tangible assets can be valued at book value (cost less accelerated tax depreciation), which may often be zero, or at fair market value by an appraisal. Since usable assets clearly have value, book value is often unfairly low, whereas appraisals may be costly and very subjective. A common alternative is to use a modified net book value approach, which for example, may value equipment and furniture at cost less straight-line depreciation over a 10-year useful life, computers at cost less depreciation over five years, and leaseholds at cost less amortization over 15 years, with no asset being valued at less than 20 percent of its cost. Supplies may be valued by taking an inventory or estimating the number of months’ worth of supplies on hand at any time and multiplying the annual supply cost by such number of months divided by 12. Another method is to simply use 50 percent of cost.
A departing partner may be entitled to receive his or her own accounts receivable as they are collected after leaving, perhaps less a fee of 10 percent of collections to cover overhead. In some deals, the departing partner may instead be entitled to an equal share of the entire practice’s receivables. Rather than actually tracking the receivables as they are collected, the receivables may be valued as of the date of termination using historical collection percentages to reach an agreed upon set number irrespective of actual collections.
While it is true that times are tough in general, the concept of goodwill value in medical practices is still viable. However, while it may have been customary in the past to base a partner goodwill buy-out on something like 100 percent of his or her average compensation over the prior few years, it is now much more common to use a 50-to-75 percent of annual compensation figure. The percentage can vary depending on a multitude of factors. In addition, this figure often includes the departing doctor’s share of receivables. It is better not to base the goodwill on a percentage of gross collections, as that does not factor in the overhead.
Clearly, the asset value must be decreased by any outstanding loans or lines of credit. A remaining lease term is not typically considered a debt, but is rather an ongoing expense. The governing document may also provide that the remaining partners use their best efforts to attempt to have any creditors remove the departed physician as a guarantor or surety on any debt. However, ultimately that is up to the creditor.
A typical buy-out agreement also limits or eliminates a portion or all of the buy-out in certain situations. These include not giving the requisite notice upon a voluntary termination, competing after termination, payment of malpractice “tail” coverage or an MCARE assessment, voluntarily leaving prior to reaching a certain age or a number of years of service, and being terminated for cause.
Tax Structure/Payment Term
Assuming the practice is a corporation, the actual buy-out of the stock is often based just on the tangible asset value, which is usually a small part of the buy-out. Thus, it is often paid in full upon departure. The corporation cannot deduct its stock purchase payment and the departing partner is taxed at favorable capital gains rates to the extent the payment exceeds what he or she initially paid for the stock. The receivables and goodwill, if any, are often paid as separation pay or deferred compensation, which is tax-deductible by the corporation and taxed at ordinary income rates to the recipient. Often, it is paid over 36 to 60 monthly installments, without interest.
If a practice is structuring a buy-in and/or buy-out arrangement for the first time, the deal may be structured as primarily a stock deal, with perhaps deferred compensation tied just to the receivables. This is due to new Internal Revenue Code Section 409A, which generally imposes onerous restrictions and reporting requirements on certain deferred compensation arrangements. A complete discussion of 409A is beyond the scope of this article.
If the practice’s governing documents are well-drafted and there are not any unique circumstances surrounding the departure, a Separation Agreement is usually not needed, and in fact, can create unnecessary conflicts. Clearly, however, if the buy-out is being negotiated at the time of departure, or re-negotiated from the existing terms, a Separation Agreement and Mutual Releases spelling out the terms of departure are essential. The practice should also prepare a retirement announcement to patients and referring physicians. The practice also will need to take care of the retirement plan distribution paperwork.
Finally, even though Section 409A, the general economic downturn and the particularly tough times in medicine may lead one to a conclusion that an existing favorable buy-out arrangement should be modified, it is very difficult to change what is already in place. However, it is important to try to reach a consensus for the betterment of the group as a whole.
Jeffrey B. Sansweet, Esq., is a shareholder with the health care law firm of Kalogredis, Sansweet, Dearden and Burke, Ltd. in Wayne, Pennsylvania.