Much More Ado About Healthcare Business Buy–Sell Insurance Agreements

Posted on October 21, 2014 by Dr. David Edward Marcinko MBA MEd CMP™

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HOW THEY SHOULD BE STRUCTURED?

By Dr David Edward Marcinko MBA CMP™

Dr. DEMwww.CertifiedMedicalPlanner.org

A buy–sell agreement provides a ready market for the sale of a medical practice or healthcare business interest, provides liquidity on a timely basis, and provides for a smooth transfer to the desired successors.

A buy–sell agreement may be funded to insure retirement, disability, and death protection. A properly designed agreement may help provide for a smooth financial and managerial transition.

The buy–sell agreement should also include the method for determining the value of the medical office or healthcare business-entity; and the payment terms. A buy–sell agreement may be structured in one of two ways: [1] redemption or a [2] cross-purchase agreement.

Redemptions

A redemption is an agreement between the medical business owner in which insurance proceeds, or other corporate funds, are used to buy out the deceased or retired physician owner’s interest. If life insurance proceeds are to be used to fund the buy-out of a deceased owner, the potential risks that need to be considered include:

  • The possibility of alternative minimum tax (AMT) that would only affect a C corporation.
  • The potential for insurance proceeds to be exposed to corporate creditors.
  • The possibility that undesirable dividend treatment may occur if the constructive ownership rules of Code Section 318 are met. (This requires close scrutiny of Sections 302, 303, and 318 when structuring a plan.)

Private medical business owners who currently have redemptions in their estate plans may desire to switch to a cross-purchase agreement. This modification prevents exposure of the insurance proceeds to corporate creditors and the potential for corporate AMT.

Cross-Purchase Agreements

A cross-purchase agreement between or among the parties, unlike the redemption agreement, provides a stepped-up outside basis. It may be cumbersome to coordinate funding with many shareholders because life insurance policies must be acquired on each particular life. Some CPAs, financial advisors, insurance agents and attorneys suggest that a business insurance trust can solve this, but the current popular solution is a partnership.

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Buy-Sell

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Example:

Drs. Jon, Bob, and Brent are three unrelated physicians who are shareholders in a professional corporation. They sign a cross-purchase buy–sell as shareholders, agreeing to purchase the outstanding stock of a deceased shareholder based upon a formula including the prior year’s earnings and the current net worth. They purchase life insurance policies on one another so that they have a way to fund the purchase of the shares from the decedent’s estate. The policies are an approximation of the required funds and are reviewed annually to verify that sufficient insurance exists to cover the needs. They have created a funded cross-purchase agreement.

The shareholders considered having a disability buy-out clause also, but have been unable to agree upon appropriate dollar amounts and have had problems selecting disability insurance coverage. They felt that it was best to have a signed contract on the portion that they could agree on, rather than tie the whole process up seeking agreement on everything.

“Wait and See” Buy–Sell Agreements

The less frequently used option of the “wait and see” buy–sell agreement postpones the decision on how to transfer the business until after the death of the business owner, when more information is available. The purchase price and funding are established currently, but the identity of the purchaser is left open. Typically, the business has the first option to buy. Then, after a set period, the owners have the option to buy. Finally, to protect the heirs of the deceased, if neither of the first two options is exercised, the business must purchase the stock.

Estate Valuation

Certain criteria must be met for a buy–sell to fix the value of the medical business interest for estate tax purposes. For agreements entered before October 9, 1990, that have not been substantially modified, the values established in the buy–sell agreement should serve to establish the value for estate tax purposes, unless the agreement was a device to transfer the business to a family member below fair market value or if the agreement is not a bona fide business arrangement.

For agreements substantially modified after October 8, 1990, or those entered into after that date, the value of the property is determined without regard to any option, agreement, or right to acquire or use the property at less than fair market value or any restriction on the right to sell or use such property, unless the option, agreement, right, or restriction:

  • Is a bona fide business arrangement, and
  • Is not a device to transfer such property to members of a decedent’s family for less than full and adequate consideration in money or money’s worth, and
  • The terms of the option, agreement, right, or restrictions are comparable to similar arrangements entered into by persons in an arm’s length transaction.

If the buy–sell option meets these requirements, its terms may be utilized in the valuation of the interest transferred for estate or gift tax purposes. [IRC § 2703]

If these specific tests are not satisfied, the buy–sell agreement will not establish the value for estate tax purposes and the valuation factors of Revenue Ruling 59-60 probably would prevail. This may leave the estate in the position of having to litigate if the taxing authorities set a value higher than the actual sale value.

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Business

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To assist in meeting the three criteria, advisors should not encourage the use of formulas as in the past; but individual appraisals and personalized valuations. Some practices or entities even fix the value of the business annually and justify this by pointing out that nobody knows whether there will be a purchaser or a seller. They have every incentive to try to make a fair valuation. But, the advisor should keep in mind that such a valuation could be used against an owner in the event of a divorce or separation, so he or she should use prudence before publishing a stated value.

In most cases, the IRS will argue that the agreement doesn’t meet the requirements of Code Section 2703 because of the need for the agreement to be comparable to similar arrangements. This means the buy–sell agreement may not be solely determinative in valuation issues, regardless of how carefully it is constructed.

Assessment

A buy–sell between unrelated parties who are not the “natural objects of each other’s bounty” is deemed to have met the three tests for exclusion from Code Section 2703. This means that the new rules generally only apply to intrafamily transfers, although some experts believe that this term may be broad enough to include any potential heir.

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Conclusion

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Marital Dissolution, Buy-Sell Agreements and Practice Value

Posted on July 3, 2008 by Dr. David Edward Marcinko MBA MEd CMP™

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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.

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

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