MPM Publications
Why Buy-Sell Agreements Work to Your Advantage
Editor's Note: Last quarter’s Medical Practice Manager included an article by Attorney Steve Edmonds, "Keys to a Well Managed Professional Corporation" in which he reviewed the legal aspects of several corporate documents. In this issue, Mr. Iezzi offers a CPA's perspective on buy-sell agreements.
A buy-sell agreement is an agreement between two or more parties, which provides that on the occurrence of a triggering event (e.g., death, permanent disability, and voluntary termination of employment or retirement) one party has an obligation to buy the business interest from the party having the obligation to sell. No matter how many partners are in the firm, every multi-physician medical practice must plan for these contingencies that affect the business's future survival and the financial security of its remaining members.
This agreement guarantees a buyer for an asset that has no other ready market, in this case a physician's medical practice that typically would not pay dividends to an estate. It also establishes an estate value for Federal tax purposes, and provides for a smoother transition for the remaining physicians. Professional advisers (insurance agents, attorneys and CPAs) have a ready supply of horror stories about what can happen in the absence of such a plan.
Most advisers recommend valuing a practice based on a formula tied to revenues or accounts receivable plus the book value of any fixed assets, rather than arriving at a set price. An allowance is subtracted for receivables that cannot be collected.
Once the practice agrees such an agreement makes sense, the next question becomes how the buy-sell agreement should be structured. The three basic types of agreements for medical practices include: cross purchase, entity purchase (stock redemption), and the "wait and see." Each agreement has its own advantages and disadvantages.
The factors that should be considered in deciding what kind of buy-sell is appropriate include: the number of partners, the relative income tax brackets of the business and the physicians, and whether the business or the individual purchasers should provide the funding for the purchase. For example, in the case of a multi-physician practice establishing an individual cross purchase plan, each physician needs to have a separate agreement drawn up with every partner, which creates quite a few individual insurance policies. While the surviving partners would tend to get more favorable capital gain treatment if the practice were ever sold on a living basis under an individual cross purchase agreement, the administrative issues are easier when dealing with a corporate entity. Therefore, most agreements are written on a stock redemption basis.
The advantage to a stock redemption is it's easy to understand. Funding is provided by the business rather than by the individual physicians. Also, it permits older physicians to help the younger physicians with the buy-out of his interest. If a physician dies, the insurance company pays the policy proceeds to the corporation, which then purchases the shares from the estate of the deceased physician.
The next question becomes what resources will be used to fund the redemption. Your choices include: existing funds, borrowed funds, sinking funds, installment payments, or life and disability insurance. Life and disability insurance owned by the practice is the most economical method since proceeds are income tax exempt and complete financing is guaranteed from the beginning. Cash value is a tax-deferred asset on the balance sheet of the practice. These values can solidify the financing of the agreement should an event occur to trigger the agreement other than the death of the partner. Because life insurance cash values still maintain tax advantages as to withdrawals, lifetime buyout payments from these values is the most tax efficient use of capital by the practice. Since the practice will buy the physician's stock, only one policy is required for each insured physician. Of the financing arrangements available, it is clear that insurance provides the vehicle with the most flexibility. Funding of these agreements is becoming an important issue in the recruitment of new associates and their willingness to remain with your practice long-term. After all, the agreement is not worth much if the physician cannot guarantee the payments.
While most agreements are properly funded at death, rarely are they adequately funded at the disability of the physician? Physicians should be sure the agreement is insured for both life and disability coverage. The agreement should speak to the disposition of all insurance policies purchased for funding, thereby ensuring a smooth transition when the agreement is termination These options include the surrender of the policy for its cash value through withdrawals and/or loans, or allowing the physician to purchase the policies for its cash value and unearned premiums. If insurance is not an option or the proceeds are insufficient to cover the full liability, the agreement should outline the time period that installment payments would be paid, with interest.
Clearly a buy-sell agreement works to your practice's advantage. While advice on how to structure such a plan may vary, legal and insurance professionals agree the existence and funding of such an agreement should be mandatory.
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