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Before Selling a Physician Practice, Weigh Tax Risks Carefully

October 15, 2013

Fully understanding asset valuation and other key issues in advance of selling a medical practice is imperative, but tax considerations should not be the driving force behind a deal, one expert says.

This article originally appeared in Managed Care Contracting & Reimbursement Advisor, October 2013.

Selling your practice is a major decision with revenue and tax implications that can affect you far into retirement. More physician practices are being approached with buy offers as accountable care organizations (ACO) form across the nation, so it is important to know the key issues beforehand.

"Over the past several years there has been an acceleration of hospital ­acquisitions of medical practices," says James B. Riley Jr., JD, a partner with the law firm of McGuire Woods in Chicago. "ACOs are increasing the sales, and so are other drivers like physician practice management groups." Both buyers and sellers must understand the tax implications of different practice acquisition structures, Riley says.

The structure of the sale is one of the first decisions to make, he says. Will it be a sale of assets or stock? Each option comes with different advantages and disadvantages with regard to taxes, and the form of a transaction is often dependent upon the transferability of seller obligations as well as the corporate practice of ­medicine (CPM) laws and fee-splitting laws of a particular state.

Riley explains that the CPM doctrine generally prohibits a business corporation from ­practicing medicine or employing a physician to provide professional medical services. In some states corporate employers, such as hospitals, HMOs, and ­professional corporations, are exceptions to the CPM doctrine ­prohibition. Other states merely prohibit the practice of medicine without a license or the sharing of fees between licensed and unlicensed individuals. Still other states flatly prohibit the ownership of medical practices or employment of professionals by nonprofessionals.

The CPM issue must be addressed early in the consideration of a sale, in accordance with state law. Once that issue is settled, you can move on to the tax implications of an asset versus a stock sale, Riley says.

"The tax implications of the transaction are ­extremely important and one that I don't think physicians initially focus on when they think about this as an option for their practice," he notes. "How much you can dictate some of the decisions and steer the deal to your best tax advantage will depend on who is buying. If you are in a state that allows nonphysicians to own the practice, that gives physicians more flexibility to decide whether to structure the sale as an assets sale or a stock sale."

An asset sale is one in which a buyer purchases certain assets and liabilities of a physician practice but not others. A stock sale, on the other hand, is what most people think of when they imagine someone "buying a practice"-the buyer is acquiring the practice with the intention of replacing the seller as the doctor within the practice. The stock sale involves a buyer purchasing a seller owner's equity in a physician practice as well as its assets and liabilities. Additionally, most or all of the accounts on the physician practice's balance sheet are sold with the practice.

The incorporation of the practice-namely, whether it is a ­C corporation or an S corporation-becomes ­important during a sale, Riley says. With a C corporation, income is taxed once as earnings, and then shareholders are taxed again when corporate earnings are distributed. In contrast, S corporation earnings are generally taxed just once, with the shareholders. When evaluating an offer to purchase your practice, consider how the incorporation will affect the proposed price. The net purchase price after taxes can be substantially less for C-corporation shareholders than for S-corporation shareholders, Riley says. (See the story on p. 4 for more on the different sale options.)

Asset valuation is another important area to consider. A buyer will record a practice's assets and liabilities at their fair market value, which could alter their carrying value and/or amount of annual depreciation, Riley explains. The selling physician practice will recognize a taxable gain or loss based on the difference between the allocated sale price and the tax basis of the assets and liabilities. C corporations usually end up with an increased tax burden, Riley says.

How much can the tax hit be? It can be pretty big. Federal long-term capital gains rates are between 15% and 23.8%, and federal ordinary income tax rates go as high as 39.6%. If the practice being sold is an S corporation but formerly was a C corporation within the 10-year built-in gain tax recognition period, additional taxes could be owed, Riley notes.

With a stock sale, the practice's assets and liabilities stay with the business. Sellers often favor this option because they want to simply sell the whole kit and caboodle and be done with it, Riley explains. It is typical, however, for purchase agreements to include indemnification clauses that make the seller responsible for some liability during the transition period, he adds.

Capital gains also can become an issue with a stock sale because the seller may have a gain or loss based on the difference between the price paid and the ­current basis in the stock, Riley explains. This loss or gain usually is treated as a capital gain, making it subject to lower federal capital gains rates-currently 15%-23.8% for most sellers.

Smaller physician practices, such as practices with only two or three physicians who are all retiring at once, may not have much leverage when it comes to structuring the sale, Riley notes. If a physician in such a practice wants to retire within a ­certain time frame, the buyer may have all the power to dictate terms. Being flexible and willing to postpone ­retirement can give the seller more power, he says.

The worst outcome from selling a practice would be a sale of assets by a C corporation without considering the tax implications, Riley says. The double taxation could be a ruinous surprise after the deal is done.

"We've seen practices in that situation. They didn't plan in advance for the potential sale of their practice, or there may have been certain components of the practice that were sold," Riley says. "If they had a cath lab in the practice under a C corp and sold that lab to a hospital, they could be subject to double taxation."

But as important as tax considerations are, they should not be the biggest driving force when negotiating a sale, says Neil S. Maxwell, JD, a partner with the law firm of Kurzman Eisenberg Corbin & Lever in White Plains, N.Y. The sale of a practice requires extensive planning and research, so you should plan to devote a full year to this preparation before signing a contract, he says. In addition to research and contract negotiations, you should spend that year getting the practice in the best shape possible so that you get a top-dollar offer.

"If you see that hospitals are buying out the physician practices in your area, don't wait until someone comes to you with an offer," Maxwell says. "Get started now with your assessment. Do your own valuation. Know your strengths and what kind of deal you want before they come to you and express an interest."

Besides, while an actual purchase of the practice might be what a hospital is looking for, it might not be the best choice for the physicians, he says.

"Hospitals are paying very, very little for assets and instead they are looking to employ the doctors," he explains. "The employment contract might take into account the value of the practice and assets, but the hospital doesn't want your old computers and desks. They don't need them."

An office lease also can become an issue. The hospital may want the physicians to move into the hospital's property, leaving the practice to make its own deal to get rid of its current office space. In some cases, the hospital will sublease the space or buy some of the practice's equipment as part of the employment deal. It is unlikely that the hospital really wants the office space or equipment; this kind of offer is probably just made to sweeten the deal, Maxwell says.

"Always work with an accountant on any deal like this, not just an attorney," he says. "Generally if one component of the deal is good for you, it's not good for the other side. This all becomes a negotiation and there is a lot of money at stake."

Overall, the sale process can be challenging; even financially savvy physicians and their advisors can make mistakes, Maxwell notes. That's why he advises always including an "unwind" provision in the sale contract. "Let's make sure that if it doesn't work out in a year or two, we can get back to where we were," he says. "Not everyone is going to agree to it, but if they argue that, you can tell them to give you a five-year guarantee instead. It's a negotiation."

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