Saving Private Practice: Preserving Income after Departure
A professional practice (dental, medical, legal, etc.) is unlike any other type of business in that it is not freely transferable and it cannot be owned or operated by someone who is not a licensed member of the profession.
This coupled with the fact that it is typically our most valuable income source, there is a great need to address the inevitable. Establishing an exit strategy is essential, specifically one that creates value for your family and does not leave behind partners and patients in chaos upon your departure.
The Magic Ingredient
A Buy-Sell Agreement (also known as a buyout agreement) is essentially a binding agreement between partners (shareholders, members, partners, are used interchangeably here) whereby each agrees to purchase the interests of a withdrawing or deceased shareholder. The magic ingredient to successful completion is to enter into a Buy-Sell Agreement before it is evident which owner will be the first one to exit (due to death, illness, loss of license, etc.) so that the terms are fairly negotiated amongst all partners not knowing whether they will be the buying or the selling partner. The Buy-Sell Agreement outlines the buyout triggers: most typically death or disability but it can also be triggered by retirement, divorce or termination of employment by the entity. In addition, Buy-Sell Agreements establish buyout terms including price and payment period.
Ensuring Value & Operations after Departure
With professional practices, ensuring a succession plan is more important than a typical business since there are restrictions on who can operate a professional practice after a death of a shareholder and for how long. If a fellow licensed professional is not able to buy your share out, and run the practice during the transition period, significant value will be lost. Moreover, if a valuation is not established then there could be executory problems with even the best drafted Buy-Sell Agreements. A value can be agreed upon by the partners and updated annually or a formula for valuation can be agreed upon, which would avoid hiring a business appraiser.
The 90-Day Rule
In the absence of an exit plan, an unattended private practice will find itself quickly losing patients and value. Once there is a vacancy, any offers received will be a fraction of the annual income, rather than a multiple of annual income. In addition to the governing board’s restrictions for each licensed profession in California, the Corporations Code of California §13407 restricts 1) who/what entity can be transferred those shares, and 2) who can manage a professional practice upon the death or departure of a licensed professional. However, the same Section does allow a professional corporation to purchase its own shares without regard to any restrictions provided by law upon the repurchase of shares, if at least one share remains issued and outstanding. There is a strict time limitation for transfers of 90 days following the date of a disqualification or 6 months from the date of death of a shareholder before the certificate of registration of the corporation may be suspended or revoked.
Negative Tax Considerations
There are two basic types of Buy-Sell Agreements, namely a redemption agreement (where the business entity itself buys back the exiting owner’s interest, which in turn redistributes to the remaining owners through concentrated ownership) or a cross-purchase agreement (where one or more of the remaining owners buys out the departing owner’s interest). There are also hybrid agreements to address various concerns, both tax and nontax considerations. Deciding which type of agreement is right for your practice must include a myriad of complex tax and business considerations. A redemption agreement is easier to execute and maintain amongst the owners of the practice, as it will not need to be re-worked upon the exit of one partner. However, it may also cause negative tax consequences, particularly if it’s funded with life insurance. Redemption Agreements also do not provide a stepped-up basis for the update value of the shares upon buy-out of the exiting partner. This is a key consideration for larger and more established practices that may have a very low “cost” basis, particularly if the remaining partners intend to sell or exit prior to their own deaths.
Funding the Buy-Out
Part and parcel with a good Buy-Sell Agreement, co-owners of a practice must agree on how the buyout will be funded and over what period it will be paid for. There are various life insurance products designed to assist with this, but often times co-owners may opt to limit the assistance of life insurance and focus more on a buy-out over a period of years to the exiting partner (or his or her remaining family). These discussions hinge on the insurability of the triggering event, the insurability of the partner(s) and the value of the practice. Insurance can be part of the solution, but may be coupled with a practice building up a reserve and/or individual partners paying on a promissory note over a period of years.
ABOUT THE AUTHOR: Noelle Minto, Esq.
Ms. Minto has been a business and estates transactional attorney based in California since 2003. Her practice is now located in Tustin, CA but represents individuals and entities based throughout the United States and abroad.
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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.