Is Your Buy-Sell Agreement Hazardous?

Many physicians contribute an enormous amount of their time, energy and wealth into establishing a successful practice. Consequently, they need to be careful and intentional in monetizing the value that they create.

A proactive method in preparing to recognize the practice’s value is a buy-sell agreement. Fortunately, multiple options are available to fund this agreement. For example, insurance products provide a viable vehicle.

Common funding methods

Cross-purchase agreement

The partners or shareholders obtain life and/or disability insurance coverage on each of the other owners in amounts sufficient to fund the purchase of the other owners’ interest.

Entity-purchase (redemption) agreement

The business entity buys and is beneficiary of insurance policies on each owner. Upon death of an owner, the agreement requires the entity to purchase the decedent’s ownership interest from the heirs or estate.

An entity-purchase agreement can reduce the number of insurance policies needed to fund the plan, and equalize the cost of premium payments among the owners.

However, an entity-purchase agreement can be more complicated to set up than a cross-purchase agreement because of tax considerations involving transactions among partnerships or corporations and their owners. In any case beware of alternative minimum tax (ATM) for C corporations.

Other options

Key person buyout

This alternative requires an owner’s heirs or estate to sell that owner’s interest in a business to a non-owner who is a key employee. The key employee purchases and is beneficiary of an insurance policy on the owner to fund the buyout.

Right of first refusal/mandatory purchase

This choice gives the business entity first chance to purchase some or all of the departing owner’s interest. Next, the remaining owner(s) may purchase some or all (or must purchase the remainder). Finally, the entity may be required to purchase any remaining balance.

The initial purchase option could alternatively rest with the remaining owners.

Factors to consider

Valuation

Determining what the value of a business will be at an unspecified future date is difficult. The value must be fair to the parties involved in the sale and be acceptable to the IRS for calculating estate tax, inherited basis, etc.

Many buy-sell agreements are based on a fixed price, book value, outside appraisal or a valuation formula. A professional valuation firm or a specifically experienced CPA should be engaged to conduct any required valuation agreement.

Flexibility

As business values rise and fall, the owners’ responsibilities change. Or as new owners are brought into the business, a rigid buy-sell agreement can quickly become obsolete. The buy-sell agreement should contain provisions for changing values and ownership percentages should the need arise.

Stock redemption and attribution rules

Be careful when dealing with a distribution from a corporation. Potential problems include stock attributions rules and partial stock redemptions.

Insurance premium and proceeds

Premiums paid for life insurance are not deductable by anyone who is directly or indirectly a beneficiary of the policy. Furthermore, proceeds are generally not taxable to the recipient.

However, if the owner of a policy sells it to another party, “transfer of value” rules may apply, causing a portion of the subsequent proceeds to become taxable. These rules apply regardless of how the premiums are paid, or whether the beneficiary is an individual, partnership or corporation. For example, a partnership or corporation can pay the premiums through a cross-purchase agreement without affecting deductibility of premiums or taxability of proceeds.

Advantages

Disadvantages

Cross-Purchase Agreement

Simple to set up and administer

Flexible

Transactions occur among individuals

Avoids possible problems with ATM and excess accumulated earnings for corporations

Keeps policies safe from business creditors

Basis is “stepped-up”

May require a large number of policies.

Can be a disparity in premiums among owners of different ages

Transfer for value rules (if heirs wish to sell policies back to the remaining owners

Stockholders’ percentages may change when sale occurs

Conflicts may arise with more than two owners

Entity-Purchase Redemption Agreement

Fewer policies required

Spreads cost of premiums evenly among owners.

Policies are safe from individual owners’ creditors

Maintains same stockholder proportion after sale

Entity’s purchasing power results in lower cost

Less Potential for conflict if more than two owners

Higher percentage stockholders indirectly pay highest amount from premiums

Stock redemption rules are complicated. Involve both legal and tax issues

Life insurance proceeds are a preference item for corporations subject to the ATM

“Stepped-up” basis does not carry through to remaining shareholders

So, why even have a buy sell agreement?

Most buy-sell agreements are designed to:

• Provide a guaranteed buyer for a departing owner’s interest at a predetermined price. The expectation is that the financial security of the owners and the heirs is protected.
• Maintain stability of business operation. A rapid, orderly transition of management is predetermined, operating capital is protected, business policies remain intact, and a good credit rating is maintained.
• Avoid conflict. A well-designed agreement prevents power struggles between heirs and remaining owners, thereby reducing the likelihood of family squabbles. Additionally, the security of minority owners increases.
• Avoid potential problems with the IRS. Agreements help establish the value of ownership interest for estate valuation and tax purposes. The nature of income to the heirs and estate can be predetermined, therefore simplifying and minimizing taxes.
• Allow current owners to exert some control over the business when they withdraw.

Generic buy-sell agreements are hazardous! Considering the risk tolerance, the long-term planning and the short-term desires of all stakeholders in a physician practice, individual circumstances result in different needs and priorities.

Consequently, bringing the right professionals together — legal, administrative and accounting — is essential so that stakeholders have their best interests met. After all, the reward of working hard and building value is having control over how the earned wealth is enjoyed.

Read more:

Buy-Sell Agreements: Critical for Any Practice

Boyle J. Henderson, Jr. CPA, is an owner of Daenen Henderson & Company in Alexandria, La. Boyle’s chief emphasis within the firm is to direct the tax practice and the health care consulting practice. Additionally, he has been a practicing certified public accountant for 43 years. Boyle can be reached at boyle@dhc-cpas.com.

Daenen Henderson & Company is also a proud member of the National CPA Health Care Advisors Association (HCAA). HCAA is a nationwide network of CPA firms devoted to serving the healthcare industry. Members provide proactive solutions to the accounting needs of physicians and physician groups. For more information contact the HCAA at info@hcaa.com.