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Doctors, Divorce and Medical Practice Worth

[By Mark P. Gross; JD]

Determining how to value the business interest of each medical partner is a critical element of the buy-sell agreement.

Family law courts, however, have broad discretion about whether to accept or reject the validity and binding effects of the formula stated in these agreements. When assessing whether the formula is binding in the dissolution proceeding, the courts consider, in general: (1) the proximity of the date of the agreement to the date of the marital separation to ensure that the agreement was not entered into while contemplating a marital dissolution; (2) the existence of an independent motive outside of divorce for entering into the buy-sell agreement, (e.g., the desire to protect all shareholders against the affects of a business dissolution); and (3) whether the value determined by the formula used in the agreement is similar to the value produced by other methodologies.

Case Law

For example, in one case [Nichols v Nichols (1994) 27 Cal. App.4th 661, 671-672], these factors were enunciated. The attorney-husband became a partner shareholder and signed a stock purchase and sales agreement under which the price of the stock was determined by a formula based on the book value of all the firm’s assets, except its accounts receivable, goodwill and work in progress, etc. When the husband and wife began divorce proceedings, the husband’s expert valued the community interest of the husband’s stock according to the stock purchase agreement.

The wife’s expert valued the interest by the book value of the firm’s net assets including accounts receivable, goodwill, and work in progress. The dispute went to the family law court and the court ruled in favor of the husband. The appellate court upheld the decision.

The appellate court noted that the agreement was entered into eight years prior to separation and thus did not appear to anticipate the divorce. The firm had an independent motive for entering into the stock purchase agreement, (i.e., avoiding a major economic impact on the firm when a partner leaves). More importantly, the court found no evidence that the stock purchase agreement was designed to deprive the wife of any rights.

A Marital Settlement Agreement

In drafting the buy-sell agreement, the principals of any medical practice or business should view it as a marital settlement agreement.

In a separate divorce case [Slater v Slater (1979) 100 Cal. App. 3d 241, 245, 160], the asset being divided was the husband’s interest in his medical practice partnership.

During the parties’ marriage, the husband and wife both signed the partnership agreement which specifically provided that the partnership could buy back the husband’s interest upon his death, withdrawal, or expulsion. Under the agreement, the purchase price was to be the husband’s interest in the capital account plus the total of the accounts receivable [ARs] less than six months old.

The agreement further stated that “the partners agree that a portion of the purchase price as determined above includes the sale of their interest in the goodwill of the partnership, and in the event of their withdrawal or expulsion from the partnership, that they will not enter into the practice of medicine in that portion of Alameda County for a period of three years.”

Trial Court Proceedings

The trial court proceedings, in determining the value of the husband’s medical practice according to the partnership agreement, found it had a goodwill factor of zero.

The wife appealed claiming the trial court erred in setting a value of zero on the goodwill of the husband’s practice, pursuant to the withdrawal provision of the partnership agreement. The appellate court reversed the trial court’s decision with directions to value of the husband’s interest in the partnership. It rejected the husband’s contention that his wife was bound by the terms of the agreement—even though she had signed it. It found that the agreement was irrelevant because the asset being divided in the dissolution of marriage was not the husband’s contractual withdrawal rights; rather it was his interest in the partnership.

Therefore, the wife was not bound by the terms of the withdrawal provision, and the trial court was not precluded from valuing the goodwill of the husband’s practice. This is a troubling decision and probably an incorrect one.

Fair Market Valuation [FMV] Factors are Key

In order for a buyout plan to better withstand rigorous examination in the family law court, the buyout price should be related to fair market factors of the business and should not be intended to deprive the non-shareholder spouse of any community interest.

A formula should be used based on profitability instead of a fixed price (as in the actuarial business example), and an explanation for the formula should be developed. Having the spouse sign the agreement is probably a good idea.

Fiduciary Duty

Other issues in drafting a buy-sell agreement include breach of fiduciary duty.

California Family Code Section 721(b), for example, states that transactions between a husband and wife are subject to the general rules governing fiduciary relationships. Because the buyout provision is tantamount to an agreement disposing of a community asset, the rules governing fiduciary duties may apply and render the provision voidable or chargeable to the principal spouse for greater value. Therefore, a buy-sell agreement that too heavily favors the principal spouse may not be of any value in a dissolution proceeding.

Community Interest

Finally, when both parties in a divorce agree to the disposition of the community interest in the stock of a company upon dissolution of marriage, the rules governing disclosure apply, including disclosure of valuation. Neither spouse may dispose of community personal property for less than fair and reasonable value [FMV] without the written consent of the other, and each part has an obligation to fully disclose proper valuations of assets. In equitable distribution states, similar disclosure rules are applicable.

Assessment

Buy-sell agreements should be created early in the family-owned business. Once accomplished, unpleasant issues can be discussed before the emotional baggage weighs upon the parties’ sensibilities. It is much easier and more prudent to include the divorce scenario in the agreement up front instead of waiting until it becomes an issue (the agreement already deals with death, disability, and business dissolution). To ensure proper wording of the marital dissolution portion of the buy-sell agreement, a draft of the document should be reviewed by a family attorney prior to execution. With a solid plan in place in the event of divorce, the family business will be better able to weather the stormy events that can sometimes occur within a family.

What are your thoughts and opinions on this often contentious topic, from the spouse, doctor, legal and medical partner perspective? Your comments are appreciated.

About the Author: Mark P. Gross Esq. is a shareholder in the Encino, Calif., law firm of Alpert, Barr & Gross.

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Filed under: Financial Planning, Practice Worth, Risk Management | Tagged: buy-sell agreements, medical practice worth |