Structure agreements carefully to maximize benefits when an owner or partner leaves or is brought on board.
Your practice can’t avoid the tax implications related to buy-ins and buy-outs of partners if it wants to survive and expand in a competitive environment. When offering a new equity position or buying out a retiring partner, considerations vary depending on the structure of the practice, so it is important to note the differences when dealing with a partnership, as distinguished from a corporation. The appropriate structure of a practice depends on the needs and desires of the practice owners.
TAX CONSIDERATIONS ARISING FROM A BUY-IN
The price of an ownership interest in a practice usually depends on a variety of factors. It always should include, at a minimum, the value of the practice’s furniture, fixtures, and equipment (FFE) allocable to the equity interest being purchased by the new owner—for example, 20% of the FFE if the new equity owner is purchasing a 20% interest in the practice.
Next, the price should account for the new owner’s pro rata interest in the practice’s accounts receivables. The practice can either require the new equity owner to purchase the value of the accounts receivable allocable to the equity interest it is purchasing or allocate the existing collectible accounts receivable directly to the existing owners, payable to them over a period of, say, 12 to 24 months.
Goodwill. The purchase price also may account for goodwill payments, which are designed to compensate the existing owners for their work in developing the practice and the referral sources that generate income for the practice. Any payments greater than the allocable portion of the FFE and collectible accounts receivable constitute goodwill payments.
Some practices lessen the financial burden of a buy-in by using salary differentials for a period of years to “charge” the new owner for the existing benefits. For example, the new owner might receive a smaller percentage of his or her normal entitlement (60% in the first year, 70% in the second year, etc.). The income differential approach works well when the practice intends to distribute available cash flow on a pro rata basis. It does not entirely address the needs of the existing owners if the practice’ compensation methodology is based on productivity or allocation of overhead.
Property contributions by the purchasing partner/shareholder. In some buy-ins, the buyer will contribute property to the practice in exchange for his or her ownership interest. A property contribution will have varying tax implications, depending on the structure of the practice. If the practice is a partnership, a contributing partner is not required to recognize gain or loss upon contribution of property. In most circumstances, the contributed property has built-in gain or loss or is otherwise encumbered by certain liabilities. The pre-contribution gain or loss is allocated directly to the contributing partner to the extent realized by the partnership on the property’s disposition. This action ensures that the partner contributing the property receives the financial benefits or disadvantages associated with the property.
If the contributing partner’s contribution increases the practice’s liabilities, then each existing owner’s basis will increase accordingly as if the contribution were a cash contribution the partner had made to the practice. Each partner’s share of interest in the resulting partnership debt increases his or her basis in his or her partnership interest. This arrangement is beneficial to the partners because basis is necessary for each partner to take advantage of the partnership losses for tax purposes. Each partner can deduct his or her share of partnership losses to the extent of his or her basis in the partnership. In other words, any increase in a partner’s basis enables the partner to deduct more losses.
If the practice is a corporation, the contributing shareholders are not required to recognize a gain or loss from contribution of property in exchange for an equity interest, provided that immediately after the contribution of the property, the shareholders have control of the corporation. “Control,” in this case, means the contributing shareholders collectively own at least 80% of the combined voting power of all classes of voting stock and at least 80% of each class of nonvoting stock. If the control requirement is not satisfied, the contributing shareholders will be liable for the tax on the amount by which the value of the property received for the contribution exceeds his or her adjusted basis in the property.
The tax implications following contributions of property with built-in gain or loss are not nearly as great for corporations as they are for partnerships. The gain or loss inherent in the property being contributed by a shareholder will not be allocated to the contributing shareholders, as is the case in a partnership. Instead, the pre-contribution gain or loss usually will be allocated to all shareholders in proportion to their stock interests. Therefore, a shareholder contributing appreciated or depreciated property may, in effect, shift a portion of his or her pre-contribution gain or loss to the corporation’s other shareholders.
PARTNER/SHAREHOLDER OUTSIDE BASIS
Outside basis will depend on how the practice is organzied.
Practices organized as a partnership. A partner’s basis in his or her practice interest is referred to as outside basis. A partner’s outside basis is equal to the cash and/or adjusted basis of the property he or she contributed to the practice partnership, plus the amount of gain recognized by the member upon such contribution. If the contributed property is subject to indebtedness or if the practice assumes the partner’s liabilities, then the basis in the contributing partner’s interest is reduced by the amount assumed by or allocated to the other partners. Any increase in the practice’s liabilities is treated as if it were a cash contribution made by each partner to the practice, thereby increasing the outside basis.
Practices organized as a corporation. Conversely, the outside basis of a shareholder is not affected by the debt obtained by an S corporation. This fact presents a disadvantage for shareholders. Shareholders can minimize this basis disadvantage by borrowing personally and contributing the loan amounts to the corporation to increase their basis. This course is not always possible, however, because lenders often prefer to lend to the practice rather than to the individual partners attempting to obtain loans with the property to be purchased with the loan proceeds.
If property is transferred in exchange for stock in a C corporation and the transaction qualifies as a nontaxable transaction, then the transferring partner’s basis in the stock he or she receives will equal his or her basis in the transferred property immediately prior to the exchange, increased by any gain recognized and decreased by liabilities assumed by the corporation.
PARTNER/SHAREHOLDER INSIDE BASIS
Inside basis also will depend on how a practice is organized.
Practices organized as partnerships. A practice’s basis in its assets is referred to as inside basis. The practice’s inside basis in its property is equal to the basis that the contributing partner had in the contributed property. A disparity may exist between the inside basis and outside basis due to, for example, the contribution of property with built-in gain or loss. This disparity may be remedied by what is known as an Internal Revenue Code (IRC) 754 election.
An IRC 754 election
Increases the adjusted basis of the partnership property by the excess of the basis of the transferee partner of his or her interest in the partnership over his or her proportionate share of the adjusted basis of the partnership property, or decreases the adjusted basis of the partnership property by the excess of the transferee partner’s proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership.
Also consider this election when negotiating the purchase price, because it will affect the calculation of the purchasing partner’s basis in his or her partnership interest, and thus affect the amount of gain and loss recognized.
Consider the example presented in the accompanying tables, which illustrates the benefits of such an election. D purchases C’s one-third interest in the capital and profits of the ABC practice for $35,000 at a time when the practice’s balance sheet is as follows:
Assume that D is admitted as a partner in the practice, and that the partnership has not made an IRC 754 election at the time of the purchase. D’s purchase price for his or her interest is $35,000; thus, his or her outside basis is $35,000. No adjustment is made to the basis of the practice’s property, however, so when the practice sells its assets for $30,000, it will recognize $15,000 of ordinary income.
Because A, B, and D share equally in the profits and losses of the practice, D must report one-third of the partnership’s income on the sale, or $5,000, even though the $35,000 purchase price that D paid for C’s interest considered the value of C’s one-third interest in the practice’s inventory and even though C recognized $5,000 of ordinary income that was attributable to the appreciation in the inventory at the time of the sale of C’s interest. The election, in effect, prevents D from being taxed twice on his or her proceeds from the sale.
Similarly, one-third of the $30,000 capital gain that the practice recognizes on a later sale of its capital assets will flow through to D, even though the amount that D paid for the interest included the value of C’s one-third interest in the practice’s capital asset.
Any gain on the practice’s sale of its assets that flows through to D increases D’s outside basis. On a later sale of D’s interest in the practice, D may recognize a loss equal to the $15,000 gain that D was required to recognize on the practice’s sale of the capital asset. The offsetting loss, however, may not compensate D for the gain that he or she was able to recognize.
In most cases, D’s loss on the sale of the interest will be a capital loss, whereas the gain that D recognized from the practice’s sale of the asset is ordinary income. If D holds the interest until death, no loss will be permitted on a later sale of the interest, because D’s estate or D’s heirs will take the interest with a stepped-down basis, equal to the fair market value of the interest at the time of D’s death or at the time the interest is valued for estate tax purposes.
An IRC 754 election would have resulted in an adjustment to the basis of the practice’s assets when D purchased C’s interest. Because of the adjustment, the practice’s basis in the asset would have increased to $20,000. The $5,000 increase would apply only with respect to D to prevent D from recognizing the gain that accrued before D purchased the interest in the practice. On a later sale of assets for $30,000, the practice would recognize $10,000 of ordinary income which would be shared equally by A and B.
Similarly, an IRC 754 election would cause the practice’s basis in its capital asset to increase to $25,000. On a later sale of the capital assets for $45,000, the practice would recognize $20,000 of capital gain, which would be shared equally by A and B.
In cases where an IRC 754 election is in effect, an adjustment is required under IRC 734(b) for distributions that involve gain or loss to the distributing partner and distributions in which the basis of the property distributed is different for the distributing partner than it is for the partnership.
Here’s an example: Member X has a basis of $10,000 for his one-third interest in practice XYZ. The practice has no liabilities and has assets consisting of cash of $11,000 and property with a partnership basis of $19,000 and a value of $22,000. X receives $11,000 in cash in liquidation of his entire interest in the practice. He has a gain of $1,000. If an election under IRC 754 is in effect, the partnership basis for the property becomes $20,000 ($19,000 plus $1,000).
BUY-OUT TAX CONSIDERATIONS
Buy-out considerations depend on the particulars of the buy-out, such as how shareholder stock is treated as well as the practice arrangement involved.
Cross purchase/redemption. If a corporation acquires the departing owner’s stock, the basis of the remaining owners’ interests stays the same. Alternatively, if the remaining owners purchase the departed shareholder’s stock, the surviving owners will receive a step-up in basis to the extent of the price paid for the acquired stock. This method reduces the gain on the liquidation or sale of the business (or increases a deductible loss, if applicable). The latter method is called a cross purchase arrangement and is the recommended structure in a corporate setting.
In most cases, payments made to a shareholder for the shareholder’s equity in the corporation are considered payments for a capital asset. Capital assets held for more than 1 year before the exchange are subject to long-term capital gain treatment.
Partnerships. A significant difference between the sale and redemption of an exiting partner’s partnership interest is that any gain or loss realized from the sale or exchange of the interest is characterized as capital gain or loss, except to the extent that the Internal Revenue Service treats any amount received by the exiting partner in exchange for the partner’s interest in unrealized receivables or inventory items of the partnership as an amount realized from the sale or exchange of property other than a capital asset. Ordinary income is recognized on the sale or exchange of the interest to the extent of the exiting partner’s interest in the partnership’s unrealized receivables and inventory allocable to the transferred partnership interest.
A partnership redemption, by contrast, generally occurs through a distribution or series of distributions by the partnership to the exiting partner. The tax consequences of these payments depend on whether they are characterized as distributive shares of the partnership’s income or as guaranteed payments. A distributive share entitlement is the partner’s share of the partnership income and is taxed as ordinary income and deductible to the partnership. IRC 736(a) payments are deductible by the partnership, even if such payments may properly be considered attributable to unstated goodwill or similar intangibles.
As noted previously, a medical practice constitutes a business in which capital is not a material income producing factor, because all of the income derives from professional services. Accordingly, payments of unrealized receivables and goodwill by a physician are treated as 736(a) payments, and the partnership may take a deduction for the payments.
The tax issues stemming from medical practice buy-ins and buy-outs are complex and are best approached using professional guidance. But putting in the time and effort to structure a buy-in or buy-out properly will help ensure that all parties to the deal come away satisfied.
This example was adpated from Susan Kalinka, “Sale or Exchange of a Member’s Interest: Tax Cnsequences to the Purchaser or Heir of an Interest in a Limited Liabilty Company and the 754 Election,” in Limited Liability Companies and Partnershps: A Guide to Buisness and Tax Planning. 3rd Ed. (Vol.s. 9-9A Louisiana Civil Tax Treatise). Used with permission of Thomson Reuters.
I worked with a team of experts for doctors selling and buying a medical practice. Contact Connie Dello Buono 408-854-1883 firstname.lastname@example.org Buyers save about 40% in taxes while sellers save about 20% in taxes.