SUMMARY OF BUY-IN AND BUY-OUT ARRANGEMENTS FOR MEDICAL PRACTICES

 

 

Shareholder Admission

A.         General Concepts

                        1.         A buy-in typically consists of two components.  The first component is a purchase of stock. Generally, the stock represents the “hard assets of the entity.”  The second component is a buy in to accounts receivable.

 

                        2.         With respect to every buy-in, consideration should be given to whether stock should be purchased from the entity or from the other shareholders.  To the extent that the buy-in is accomplished by a purchase from the corporation and such purchase price is reallocated to the other shareholders internally, a pay-out of the purchase price by such method will result in ordinary income to the other shareholders.  For example, if shareholder number five pays the corporation $200,000 and such amount is reallocated to the other shareholders ($50,000 each), the amount will generally be paid out to the previous shareholder as ordinary income. 

 

                        3.         If the new shareholder purchase shares from the other shareholders, the current shareholders will receive the proceeds of the sale of stock as capital gains rather than ordinary income.  If the capital will be retained internally for use as capital, then the purchase should be from the corporation.

 

                        4.         The new shareholder’s buy-in to receivables can be accomplished on a pre-tax or post-tax basis.  A pre-tax basis is achieved by reducing the amount of salary/distributions/bonuses that would otherwise be paid to the new shareholder under the group’s compensation plan and reallocating the buy-in amount internally to the other shareholders.  For example, if the buy-in amount is $200,000, then the new shareholder’s compensation might be reduced by $50,000 per year for four years.  During that time, such reduction is reallocated to the other shareholders.  Such approach is tax effective and often attractive to an incoming shareholder because he/she doesn’t have to write a check.  The pre-tax approach is often accomplished over a period of time.

 

                        5.         An after-tax buy-in is accomplished by having the new shareholder write a check from his after-tax dollars to the corporation.  The after-tax approach could be accomplished by requiring the entire check initially or allowing payments over time. 

                       

                        6.         Both approaches to the receivables buy-in result in ordinary income to the previous shareholders.  The impact may be reduced by having the buy-in accomplished over a couple years.

 

 

                        7.         An alternate approach to the receivables buy-in is to have a physician remain a non-shareholder until the receivables buy-in is accomplished by virtue of a salary that is less than his or her share pursuant to the group formula.  This approach has the effect, of a pre-tax buy-in.

 

                        8.         An additional alternative is to allocate all receivables as of the date of the buy-in to the shareholders other than the new shareholders.  Such approach essentially eliminates the buy-in.  The new shareholder would not be eligible for a draw until collections commenced after the date of the buy-in.  Most groups cash flow the early draws with the collections from the accounts receivables.

 

                        9.         Buy-ins and buy-outs are really separate issues and do not necessarily need to be consistent.  For most groups, it makes sense to get paid any “goodwill” as shareholders buy-in.  Deferring goodwill payments until a physician’s departure puts the group in the position of losing a source of revenue at the same time that it is required to make a large goodwill payment.

 

B.        Amount of the Receivables Buy-In

 

                        1.         The amount of the receivables buy-in can be determined in a variety of ways.  One approach is to have the new shareholder buy into all of  the receivables dividing total receivables by the number of shareholders.  For example, if the receivables are $1,000,000 on the buy-in date and the new shareholder is the fifth shareholder, then the receivables buy-in for the new shareholder will be $200,000.  As an alternate, the new shareholder could essentially be required to buy his own receivables.  Some groups will choose its buy-in method dependent on the group’s compensation formula.  For example, a group whose compensation plan is an “eat what you kill” approach might choose to have the new shareholder buy his/her own receivables.  The theory for having the new shareholder buy his/her receivables is based on the concept that the ability to generate the revenue represented by such receivables is a result of the existence of the practice prior to the new physician becoming a part of the practice.  In addition, the group took the risk of loss for the physician’s performance during the period the physician was not a shareholder.  Finally, the group financed the physician is his/her first few months of practice by providing office space, equipment and staff.

 

                        2.         Adjustments to the buy-in number may need to be made. For example, if the new shareholder’s actual collections while a nonshareholder exceeded the nonshareholder employee’s salary, benefits and share of overhead, computed the same way as for the shareholders, the difference could be credited against the new shareholder’s buy-in to accounts receivable. If the new shareholder, while a nonshareholder employee, was paid a fixed salary and participated in a bonus pool, then credit could be given for that portion of receivables that the bonus was based on. For example, if the new shareholder, while a nonshareholder employee, was eligible for a bonus based on his/her production and all of that production has not been collected, some credit might be given.

 

                        3.         Goodwill.  The group might decide that the receivable buy-in will involve an element of goodwill.  For example, the group might determine the accounts receivable buy-in and multiply that amount times 1.1 or some other factor that is considered to represent goodwill.

 

C.        Stock Purchase

 

The options for valuing the stock to be purchased include the following:

 

                        1.         Arbitrary Number. An arbitrary number is set for the value of the stock such as its par value or some other number.

 

                        2.         Book Value. The purchase price of the stock is based on the Corporation’s net book value as calculated by the Corporation’s accountants.

 

                        3.         Adjusted Book, Value. This option is the same as the book value option except that the fair market value of the. Corporation’s personal property and real estate, if any, is substituted for its depreciated value.

 

                        4.         Set Amount. The purchase price could be a set amount determined by the group based on the overall perspective about the value of the hard assets and intangible factors.

 

                        5.         Goodwill.  Any of the above approaches might add a goodwill factor.

 

II.         Shareholder Exit

 

A.         General Concepts

 

                        1.         The shareholder exit generally involves the same two components as the buy-in:  Stock purchase and Receivables payment

 

                        2.         Groups should consider whether departing shareholders will be treated differently dependent on reason for retirement (e.g. quit to form competing group versus disability, death or retirement from practice).

 

                        3.         A terminating shareholder should generally receive any accrued but unpaid amounts due calculated pursuant to the group’s compensation formula.

 

B.        Termination pay

 

Some of the possible ways to calculate termination pay include the following: 

 

                        1.         Actual Collections: The terminating shareholder receives a percentage of his/her accounts receivable that are collected for a set period of time after termination. Any remaining accounts receivable after the set period of time has expired are retained by the Corporation. The percentage of accounts receivable retained by the Corporation is to cover the billing and collection overhead.

 

                        2.         Set Value: A value is established for the termination pay based on the terminating shareholder’s “share” of accounts receivable on the books as of the effective date of termination.  The terminating shareholder’s share can be based on shareholder’s actual receivables.  Alternatively, the shareholder might receive a pro rata share of all of the group’s receivables.

 

                        3.         Allocation of Non-shareholder Amounts.  Some groups increase termination pay to include the terminating shareholder’s “share” of the accounts receivable generated by non-shareholder physician employees, physician assistants and nurse practitioners.

 

                        4.         Pay-out Term.  The receivables might be paid out as received (typical if actual collections is used)  or over a period of time.

 

C.        Termination pay Adjustments and/or Reductions

 

The termination pay payable is typically increased to account for the following:

 

                        1.         Cost of collection.  Groups typically reduce the amount of termination pay to reflect the actual cost of collection of the receivables. 

 

2.         Vesting Reductions.  Many groups specify that a shareholder’s interest in the receivables upon termination vest over a period of time.  For example, vesting might occur at the rate of twenty percent per year for each year that the shareholder remains a shareholder of the group.  A terminating physician’s share of termination pay would be limited to the extent he/she is vested in the receivables.

 

3.         Insufficient Notice. A reduction is often made for failure to give sufficient notice of voluntary termination. For example, the employment agreement might give the shareholder the ability to terminate the employment agreement upon 90 days’ notice and he/she gives the Corporation 60 days’ notice. The reduction is made on a pro rata basis. In the example above, the terminating shareholder’s termination pay would be reduced by one-third.

 

                        4.         Overhead. Many groups reduce termination pay by a portion of the Corporation’s fixed overhead to be incurred after termination. The reasoning behind such is to acknowledge that it will take awhile to replace the terminating shareholder yet the Corporation will continue to have fixed costs such as rent. This reduction typically does not apply in the event of death, disability, retirement or termination of the shareholder’s employment by Corporation, without cause.

 

                        5.         Excess Liabilities. If the Corporation has a negative book value, some groups reduce the termination pay by the terminating shareholder’s pro rata share of such amount. Consideration should be given to whether the reduction should require the shareholder to contribute to the Corporation in those situations where the reductions to termination pay exceed the termination pay.

 

                        6.         Incomplete Buy-In to Receivables. If a departing shareholder has not completed his/her buy-in, then termination pay should typically provide for a reduction to reflect any unpaid buy-in amount.  Consideration should be given to a buy-in and buy-out structure that will typically have a shareholder fully bought in before being fully vested in his/her termination pay.

 

                        7.         Covenant Not to Compete Violation. If the Corporation has a restrictive covenant in its employment agreement, a violation will typically require forfeiture of the termination pay. Groups often use the reduction to termination pay for overhead in lieu of a covenant not to compete due to enforceability issues of such covenants.

 

E.         Tax Treatment of Termination pay Payments

           

                        1.         Income Tax Withholding. The termination pay payments are subject to income tax withholding at the time of payment. Accordingly, if the termination pay is paid in installments, income tax must be withheld from each installment. Due to the fact that the termination pay is an unsecured liability, i.e. the shareholder is an unsecured general creditor of the Corporation, constructive receipt of the total amount due is avoided thereby deferring the income tax payable/withholding until the time each installment is made.

 

                        2.         FICA. The termination pay payments are subject to FICA taxes when no longer subject to risk of forfeiture. This occurs when the shareholder’s right to receive the termination pay becomes fixed, i.e., the effective date of the shareholder’s termination of employment, even though the amount may be payable in installments or the amount is unknown at the time of termination because the shareholder receives a percentage of accounts receivable collected for a period of time after termination of employment. The termination pay amount may escape FICA taxes if the shareholder’s other earnings from the Corporation exceed the FICA taxable wage base for the year of termination of employment. When the termination pay is actually paid, the payments are not again subject to FICA taxes.

 

3.         Medicare. The rules for Medicare taxes are the same as for FICA. However, since the Medicare tax base is unlimited, Medicare taxes would need to be withheld on each termination pay installment.

 

4.         Qualified Plans. Termination pay will generally not considered “compensation” for purposes of the Corporation’s qualified retirement plans; however, the definition of Compensation in any plan should be reviewed.

 

F.         Stock Value

 

The options for determining the amount to be paid for stock include the following:

 

                        l.          Arbitrary Number. The purchase price of the stock could be an arbitrary number.

 

                        2.         Book Value. The purchase price of the stock is based on its pro rata share of the Corporation’s net book value, excluding accounts receivable. If net book value is a negative number, the terminating shareholder typically would be required to “contribute” his/her pro rata share of such negative value.  Consideration should be given to whether a contribution is required if the negative amount exceeds all termination pay and stock value.

 

                        3.         Adjusted Book Value. The book value is adjusted for the fair market value of the Corporation’s personal property and real property, if any.

 

                        4.         Set Number.  Some groups arrive at a set number.  The agreement might provide for annual re-agreement or some inflation factor.

 

                        5.         Goodwill.  The buy-out is typically not the time to be paying goodwill.  In the event a set number other than book value or a variation is used, then consideration should be given to whether treatment should be different based on time and type of buy-out.  That is, the buy-out might be more for the retiring or disabled physician but less for a physician who is going into competition with the group he or she is leaving.   Care must be given to avoid a structure that will be treated as an unenforceable non-compete.

 

G.        Tax Treatment of Stock Redemption.

 

                        1.         Shareholder. Under the present tax regime, the proceeds of the sale of stock will be capital gain or capital loss to the shareholder. .

 

                        2.         Corporation. The amounts paid by the Corporation to the departing shareholder are non-deductible payments.

 

                        3.         Balance.  In any actual buy-out situation, consideration should be given to structuring the buy-out in the most tax favorable manner such that the total value to the practice and the terminating shareholder can be achieved.

 

III.        Transition/Fairness Issues for Current Shareholders

 

                        1.         Grandfather Provision.  Those close to retirement or who have a certain number of years of service with the Corporation could have the ability, upon termination of employment, to select the method (i.e. current method or new method) that provides them with the most dollars.

 

   

 

 

 

 

 

 

© 2008 Parsonage Vandenack Williams LLC

 

For more information, contact info@pvwlaw.com

 

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