By: Erick Cutler
What would happen to your practice if you died, suffered a disability or needed to retire? Unlike with most businesses, you couldn’t just hand over the reins to a trusted family member. Most states bar non-doctors from owning medical practices. If the worst happened, your family would not have an automatic right to the practice’s assets or future income.
The physician’s buy-sell agreement offers a cure for this terrible ailment. This binding contract specifies who can sell their business interest, to whom, and for what price if a practice owner dies, becomes ill, retires, goes bankrupt, loses his professional license, or is convicted of a crime. It is an essential tool for succession planning to help preserve and extract value from the practice when someone leaves.
What Is a Buy-Sell Agreement?
A buy-sell agreement is a legal contract that all practice owners sign. It establishes how the practice will be valued when a trigger event happens, who can buy the ownership interest (usually other physicians in the practice but solo practitioners could sign a buy-sell with a separate practitioner), and how the sale price will be paid.
As a succession planning tool, buy-sell agreements are essential for:
- Eliminating the need for negotiation with surviving spouses and children at a traumatic time
- Creating funds that may be used to buy out the outgoing practitioner without affecting practice liquidity
- Securing a tax-effective exit strategy for practice owners and their families
- Preventing outsiders from becoming owners
- Giving peace of mind that the practice will continue if a practice owner leaves
Funding a Buy-Sell Agreement
Trigger events are often unexpected, so it’s important that money is ring-fenced to buy out the departing owner’s interest. Most buy-sell agreements use life insurance as a funding vehicle since insurance pays out a predetermined amount at exactly the time when the money is needed. As an additional benefit, the departing owner or the family receives the insurance proceeds income tax-free.
How you set up a policy depends on how many owners the practice has and whether the practice is a partnership, limited liability partnership, limited liability company or corporation. You’ll need to hire a tax planning expert since incorrectly setting up the policy could result in additional tax liabilities and could even put your liquidity at risk if the policy does not pay out in the manner you are expecting.
Structuring a Buy-Sell Agreement
There are two basic ways to structure a buy-sell agreement: cross-purchase or entity-purchase. In a cross-purchase structure, each practice owner buys life insurance on the other practice owners. For example, owner one would be the policy owner and beneficiary for owner two, and vice versa. At the death or incapacity of an owner, the other would use the insurance proceeds to buy out the business interest.
In an entity-purchase structure, the practice entity owns the life insurance and uses the policy benefits to purchase the departing owner’s shares. This arrangement works well if there are multiple practice owners or the practice is incorporated. The drawback is that the remaining owners will not receive a stepped-up basis for the departing owner’s interest, which may result in a larger capital gains tax liability. With expert planning, it may be possible to minimize the tax liability with an entity purchase arrangement.
Regardless of the structure, you’ll also need to consider the following:
For tax reasons, the transfer of business ownership must be an arm’s length transaction for fair market value at the time of the transfer, so you shouldn’t agree on a fixed dollar amount upfront. The agreement should provide for a valuation firm to value the practice on the happening of a trigger event. The valuation can be used for estate tax filing purposes, which should save the surviving family the additional headache of proving value to the IRS.
Assets and Liabilities:
The agreement must contain an explicit provision for such assets as accounts receivable, real estate, bank accounts, cash reserves, pension funds and personal effects. It should also include the liabilities the purchasing owners will assume such as property leases, equipment leases, service and maintenance agreements, staffing, billing, audit, and investigations.
By law, a physician may not transfer medical records to another physician or practice without the patients’ consent. The buy-sell agreement must make special provision regarding the retention or transfer of medical records per state law, licensing regulations, and ethical and professional standards.
Even with a solid buy-sell agreement in place, disagreements can occur. It’s a good idea to review your agreement annually to make sure it still fits everyone’s expectations and understanding of what the practice is worth. If there is a gap in valuation, you’ll want to bring in an independent CPA to resolve the dispute.
The Need for Joined-Up Thinking
Writing a buy-sell agreement is an essential step to avoid financial disasters. It protects against the risk of a practice owner leaving unexpectedly and allows for a smooth transition of ownership with minimum impact on the practice’s liquidity or value.
As you can see, there’s a lot to consider when writing a buy-sell agreement. It’s crucial to assemble a team of qualified advisers with expertise in business law, healthcare law, insurance products, succession planning and the valuation of practices. An attorney, qualified tax adviser, and wealth adviser should form the backbone of your team. For the best results, choose professionals who have a track record of working with physicians and an in-depth knowledge of their unique succession needs. Contact the tax professionals at Goldin Peiser & Peiser for additional information on buy-sell agreements or any other business or tax related questions or issues.