Practice Buy-Sell Agreements: Drafters Beware

Dickinson Wright PLLC


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My prior article addressed tax issues in repurchasing equity in physicians and other practice groups. This article provides information about drafting buy-sell agreements for practice entities...
United States Food, Drugs, Healthcare, Life Sciences
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My prior article addressed tax issues in repurchasing equity in physicians and other practice groups. This article provides information about drafting buy-sell agreements for practice entities that include provisions for repurchasing equity from owners. These agreements limit an owner's ability to transfer equity and require its sale if employment terminates or the owner retires, becomes disabled, or dies. Buy-sell agreements also help the practice entity comply with state law requirements that only active practicing professionals can own equity in the entity.

Topic 1: Structuring the buy-sell agreement

Since buy-sell agreements require its owners to transfer equity in the practice group upon termination of employment, death, disability, or retirement (each, a "Trigger Event"), the practice group should identify its desired purchaser if a Trigger Event takes place. If the entity is the purchaser, the agreement will be a redemption agreement; if the other practice owners are the purchasers upon a Trigger Event, a cross-purchase agreement should be used. Regardless of which type of agreement is used, the agreement should specify how the purchase price for the equity is determined (fixed, formula value, etc.).

If the entity has many owners, it will be simpler to use a redemption buy-sell agreement and for the practice entity to purchase the equity if a Trigger Event takes place. Another option would be for the agreement to require the owner first to offer to sell to the other owners and if they decline to purchase, the practice entity would then purchase the equity.

If the practice entity wants to use insurance on the lives of its owners as a source for funding of the purchase of equity of a deceased practice owner, it would only need to purchase one life insurance policy on each practice owner under a redemption buy-sell agreement. Under a cross-purchase agreement, each owner would need to purchase a life insurance policy on each other owner.

Topic 2: Tax Issues

If an incorporated practice group uses a redemption agreement, drafters should make certain that the selling owner (or estate of a deceased owner) can claim capital gains treatment for the proceeds of the redemption. Federal tax provisions that penalize the use of distributions by a corporation as disguised sales may result in taxation of the sale proceeds as a dividend (at ordinary income rates) rather than as a sale (at preferential capital gains rates). If the purchase price is a fixed amount payable in full at closing or is seller financed with a specified interest rate and is not dependent on future earnings or financial performance of the practice entity, the transaction will likely comply with these tax laws and be taxed as a sale not as a dividend.

Drafters of redemption buy-sell agreements should ensure that any life insurance policy owned by the practice entity to purchase the equity of the deceased owner is not taken into account when determining the value of the equity of the deceased owner for federal estate tax purposes. In Connelly v. US, recently argued before the Supreme Court, a stock redemption agreement required the redemption of stock owned by a deceased shareholder using the proceeds of a corporate-owned life insurance policy. Since the deceased shareholder's estate and the surviving shareholder did not follow the buy-sell mechanism contained in the redemption agreement, the IRS disregarded the purchase price paid by the corporation to redeem the stock of the deceased shareholder and included for federal estate tax purposes the corporate-owned life insurance in the value of the stock owned by the deceased shareholder.

Regardless of the results of Connelly v. US, when practice groups want to fund the purchase of equity of a deceased practice owner using life insurance, buy-sell agreement drafters might consider using cross-purchase agreements to avoid inclusion for federal estate tax purposes of the entity-owned life insurance in the value of the equity of the deceased owner.

Topic 3: Fraud and Abuse Limitations (False Claims Act, Anti-Kickback Statute)

In response to a request by a medical center entity that was owned by a non-profit corporation and a group of physicians, the Office of the Inspector General (OIG) approved a plan that would enable physicians who wanted to retire from the practice of medicine after attaining age 67 to sell their equity back to the entity in three installments with the consideration for each tranche of equity sold paid by the entity over two years. At issue was the six-month waiting period after a retiring physician received the first installment of consideration for the first tranche of equity before the physician was required to retire from the practice of medicine. Even though the plan did not meet any regulatory safe harbor under the federal Anti-Kickback Statute (AKS) that prohibits the receipt of financial incentives for the referral of patients, the OIG found that the plan was unlikely to result in any changes in the referral pattern of a retiring physician to the medical center entity over these six months. Given the low risk of fraud and abuse in the arrangement, the OIG agreed not to impose administrative sanctions for violation of the AKS. Drafters of buy-sell agreements should take heed of the analysis in Advisory Opinion 93-12 to avoid violation of the AKS and other similar statutes.

Originally published in Healthcare Michigan, Volume 41, No. 5

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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