Protecting your medical practice from your partner’s tax mistakes

Anthony Venette: ©Withum

Don’t believe the hype, the IRS still has teeth so don’t let your practice get bit. A sloppy partnership agreement can jeopardize even the most successful medical practice. An LLC or a limited partnership does not fully insulate you from your partners’ problems. For instance, if one of the other partners dies unexpectedly, runs into tax trouble, or goes through a nasty divorce, you could be forced to sell your practice and leave your patients without care.

In January, the District Court for the District of New Jersey upheld that one partner’s delinquent tax filing was enough to bring down the other partners of a dental practice who had filed on time. United States vs. Driscoll is a reminder that your agreement might be due for a checkup. In Driscoll, the IRS eventually forced the sale of the entire thriving dental practice (including the building it owned). Don’t suffer this iatrogenic injury.

That’s why I advise all of our professional services clients to have up-to-date buy-sell agreements. I recommend reviewing your buy-sell agreement regularly and updating valuations at least every year or two years.

Components of a medical practice buy-sell agreement

For medical practices, the buy-sell agreements should accomplish the following:
(1) Include provisions that require partners to maintain tax compliance.
(2) Give other partners the right to buy out a delinquent partner’s interest.
(3) Establish valuation methods for partner buyouts.

Medical practices aren’t your average business. They don’t have customers; they have patients. Therefore, medical partnerships need agreements that go beyond the usual language pertaining to retirement or disability of one of the partners. The agreements should provide protection against all scenarios including tax delinquencies, as in Driscoll.

Here’s what I like to see in buy sell agreements for medical partnerships
All partners should be required to maintain tax compliance and provide periodic proof, such as tax transcripts or certificates of compliance from taxing authorities. Like a disease, early treatment of a tax problem creates the best outcome. While this provision is a strong first step, the agreement needs to address what happens in the event of a delinquency.

The agreement should include buyout rights that give non-delinquent partners the first opportunity to purchase a tax-delinquent partner’s interest before the IRS pursues collection. Triggering events such as divorce, death, or disability can be addressed as well. These provisions should clearly specify both the triggering events and the process for exercising the buyout rights.

The agreement can establish a specific cadence of updated valuations and valuation methods for partnership interests, such as procedures for obtaining third-party valuations. The partnership should always have an updated valuation that reasonably reflects the practice today.

A valuation is a snapshot at a point in time. Like a set of x-rays, you don’t need to update the valuation daily, but you don’t want it to go too long without a checkup either. The practice’s valuation should be updated annually or biannually. That way you’ll always have a realistic “ballpark” number ready to go if you need one in a pinch or need to buy out another partner on short notice due to adverse circumstances described above.

Qualified appraiser

A back-of-the-napkin formula might seem convenient, but when valuing something as critical as your practice, caution is key. You need a valuation from a qualified appraiser. A qualified appraiser is a dedicated professional who considers all the facts and circumstances of a practice that common formulas might not. You can even provide some guidance on the major assumptions (what multiple to use or what discounts to apply) like guardrails. But once you get too prescriptive, you are going to lose that tether to reality.

For more about medical practice valuations see: Valuing your medical practice: Key approaches and considerations for ownership transitions.

A better approach

If I had advised the dental practice in the Driscoll case, I would have suggested some safeguards against what happened. Good insulation through well-crafted documents and strong adherence to them can prevent the vast majority of problems before they start. Remember that the agreements are only as good as your compliance with them.

These agreements would have included appropriate buy-sell provisions in the partnership agreement, addressed required tax compliance, and identified tax delinquency as a clear trigger. Additionally, I would have recommended holding the real estate in a separate LLC with similar provisions.

In accordance with the buy-sell provisions, the partners have had a recent valuation on file within the last 12 months. Through that process, we would be able to identify the capital specifically to fund each partner’s buy-out if needed. This would have allowed us to plan and identify any shortfalls in the repurchase obligations.

Hopefully that would prevent the IRS from even initially targeting the partnership, but if not, there may be some additional options. Depending on the magnitude of the tax liability, there may be an opportunity to raise sufficient capital likely through the real estate holding company. This could take the form of raising debt or even a sale-leaseback transaction. Raising capital for the medical practice may be more challenging but not impossible. Debt raises are possible but may be challenging if a significant part of the practice’s value is in intangible assets. However, an equity capital raise may be possible, and hopefully a strategy that we were already considering as we look to the next generation.

Negotiating with the IRS is never easy, but they are a counterparty like anyone else. Understand their needs and plan to provide them with consideration that satisfies those needs.

Conclusion

Finally, putting legal and tax implications aside, a well-crafted buy-sell agreement should ensure consistent and quality coverage for your patients, so they have no disruptions during time of need. You can’t put a price tag on that.

Anthony Venette, CPA/ABV is a Manager, Valuation Services, at Withum. He specializes in providing precise, defensible valuation analyses for trust and estate filings, shareholder transactions, and corporate planning. Anthony also advises clients on business transition strategies, succession planning, and tax-efficient wealth transfers to achieve their long-term objectives.