The One Contract Your Practice Must Have
Though the odds of a premature death of a practice partner are not high, the same cannot be said about a life changing disability. Because both of these risks can have such devastating effects on the finances of the practice and the future income of the remaining healthy partners, we find it troubling that so few Doctors properly address this risk.
A medical practice is a business. As such, it is created for the purpose of generating financial benefit for its owners. Practice CEOs are supposed to take calculated risks and manage these risks to maximize long-term after-tax income. There is no excuse for them to completely ignore the potentially devastating risk of disability or death of physician-partners. Are you the de facto CEO of your practice? If so, how are you protecting against these risks?
Most states prevent non-Doctors from owning professional medical practices. This is certainly true in California. California Business and Professions Code Section 2052 provides that “any person who practices or attempts to practice, or who advertises or holds himself or herself out as practicing… [medicine] without having at the time of so doing a valid, unrevoked, or unsuspended certificate…is guilty of a public offense, punishable by a fine, by imprisonment in the state prison, by imprisonment in a county jail not exceeding one year, or by both the fine and either imprisonment.”
Additionally, California Business and Professions Code Section 2400 provides that “corporations and other artificial legal entities shall have no professional rights, privileges, or powers.” The policy expressed in Business and Professions Code section 2400 against the corporate practice of medicine is intended to prevent unlicensed persons from interfering with, or influencing, the physician’s professional judgment.
This means that, as compared to a regular business owner, a Doctor building a medical practice is not generally building wealth for his or her family. If you want to ensure that you do build wealth for the family through your practice and actually turn your practice into a “wealth building engine” for your family, you must draft, fully-execute, and fund a Buy-Sell agreement.
In this chapter, we will discuss the reasons why a premature death or disability of a partner is such a big risk and what the financial repercussions are of failing to address this issue. We will then discuss the “medicine” for such an ailment—the Buy-Sell Agreement. We also address the importance, and method, of funding the agreement and how to work with the right team of advisors. With all of this knowledge, you should be motivated and prepared to address this important issue in your practice.
Always Expect The Unexpected
As owners of a professional practice, Doctors can spend 10 hours per day, six or seven days per week getting their practices to the point where the practice provides a measure of security for their families. We know, because we have been there ourselves. Nonetheless, those who ignore one fundamental legal contract jeopardize all of their hard work. This very important legal contract is the Buy-Sell agreement. This is an agreement that all owners sign, agreeing how the practice will be valued at the time of one partner’s death or disability, and how the purchase of the shares will be paid.
Without a Buy-Sell agreement, partners and remaining families have no guidelines as to how a practice will deal with an early death or the disability of a physician-owner. At a time when the family is grieving or caring for a disabled family member and possibly struggling to pay their bills, they will look to the remaining partners’ practice to help them in their time of need. At the same time, the remaining partners may be struggling to get by without the services of a valuable partner. The last thing either of these two groups need is a struggle over money. In too many cases, the absence of a Buy-Sell agreement at the time of death or disability can cause bankruptcies for the families of all of the partners.
Let’s consider some of the questions that Doctors should ask themselves:
· What would happen to my family if I died or was permanently disabled? Is it fair that I worked so hard to build the practice and all my family will get will be my outstanding accounts receivable?
· What happens if and when any of my partners die or become permanently disabled? How will their families fare?
· If I have another business and a partner dies or becomes permanently disabled, do I want the surviving family members as new partners? How will I buy them out at that time?
· What happens to my share of the practice if I decide I want ‘out’ of the practice or I decide to eventually retire? (We will discuss exit buy-outs at the end of this chapter.)
Let’s look at a quick case study of Steve and David, involving only one of the many situations where a Buy-Sell agreement has great utility. As you’ll see, their story of a two-person practice losing one partner is a pretty typical case.
Case Study: Steve and David
Steve and David are owners of a very successful surgery center. Steve has the clinical expertise that patients want, while David runs the operations and marketing. Their overall profitability results from their joint efforts. If Steve were to die prematurely, David would have to find a Doctor capable of doing what Steve does. With the new hire, it’s unlikely that the person could duplicate Steve’s results.
At the same time, Steve’s widow would want to continue to take the same money out of the practice that the family received before Steve’s death. In fact, if Steve’s widow is raising a young family or has children in college, she may have to force a sale of the surgery center at a distressed price just to meet her needs. Maybe Steve’s son fancies himself a savvy businessman and has his own ideas on how things should be run. Perhaps Steve’s spouse wants to see Steve’s son take over his father’s place. It wouldn’t matter that Steve Junior is incompetent. There are so many problems that can arise. Needless to say, it may be impossible for David to continue a profitable practice under such circumstances.
Special Issue For Medical Practices: Why The Buy-Sell Is Needed For The Engine
Notice that the case study above was for a surgery center—not a professional medical practice. In the case of a professional medical practice, non-physicians generally cannot own the practice. So, at the time of a physician’s death or disability, the remaining family has no right whatsoever to any of the practice’s assets or future income.
This restriction means that a Doctor can work hard over a career to build a practice that can never be left to remaining heirs. In fact, this creates a huge “gap” in the wealth planning for most Doctor families when compared to clients who have similar sized businesses in other areas. The business owner builds the value of the business while building net worth for the family. The Doctor, on the other hand, is generally not doing that. The only way to accomplish this goal is to convince all partners to agree to a Buy-Sell Agreement and to fund that agreement. This is why the Buy-Sell Agreement is essential to making your practice a financial “Engine” as well as a “Fortress.” Let’s dig into the details of Buy-Sell Agreements so you can see how they should be used in your situation.
The Buy-Sell Agreement
A Buy-Sell agreement is an agreement that all practice owners sign agreeing how the practice will be valued at the time of one partner’s death or disability and how the purchase of the shares will be paid. There are various ways to structure Buy-Sell agreements, depending on the goals and circumstances of the owners and the structure of the practice. In all arrangements there are some basics regarding the agreements that can apply to any type of practice. Specifically, the benefits different stakeholders and their families can gain from a Buy-Sell agreement are universal.
Practically speaking, Buy-Sells can be used for medical and non-medical corporations (PCs, PAs, and PLLCs all qualify whether they are “S” or “C” corporations for tax purposes), partnerships, limited partnerships, Limited Liability Companies (LLC), and other forms as well. To simplify the text, we will use the words “practice owner” generically to mean any type of physician practice, including shareholders in a corporation, partners in a partnership, and members in an LLC. In the following discussion, we will address the benefits to the living partners, to the practice and its remaining owners after a death or disability, and to the surviving family members who have lost a loved one.
Benefits To All Living Partners
From the standpoint of a healthy practice owner, the Buy-Sell agreement can provide the individual partner with an opportunity to negotiate and obtain the fairest or best price for his share of the practice. In the case of retirement or disability, the agreement can be an additional source of funds for each owner.
Benefits To The Practice And Remaining Owners
There are various benefits of the Buy-Sell agreement for both the practice and its remaining
owners when one partner dies or becomes disabled:
A. Provide Continuation and Control
First, from the standpoint of the practice and its remaining partners, a properly planned Buy-Sell agreement will provide for the orderly continuation of the owner-ship and control of the practice. This continuation should survive the death, disability, divorce, or bankruptcy of any owner and should provide for a seamless transition in the event that any owner wants to retire and sell his or her ownership share.
B. Keep out Unwanted Owners
Second, the Buy-Sell agreement can prevent unwanted outsiders from becoming owners and can eliminate the need for negotiation with remaining spouses and children. The agreement may also perform the role of a succession plan by providing for continuity or orderly succession of practice management. As above, this is not as relevant for the professional practice as it is for surgery centers and other medically-related businesses where non-Doctors can be owners.
C. Provide Liquidity to Buy Out Surviving Family Members
Third, the Buy-Sell agreement is often used in conjunction with life and disability insurance policies to effectively provide liquidity for the practice to purchase the outstanding ownership interests of the disabled or deceased partner.
Benefits To Surviving Family Members
The Buy-Sell agreement benefits the family members of disabled or deceased partners in various ways:
A. Provide Liquidity to Surviving Family Members
For a deceased or disabled owner’s family, the existence of a properly funded Buy-Sell agreement can assure the family a liquid asset rather than an illiquid minority interest in a privately-held practice that would be extremely difficult, if not impossible, to sell. As mentioned earlier, this can be extremely important as the remaining family may be burdened with estate tax payments or additional expenses to care for a disabled family member. The agreement itself may provide a valuation of the practice interest, which can be used for estate tax filing purposes. This may save the survivors the additional headache and expense of securing another valuation and fighting the IRS on that value.
B. Eliminate Practice Risks to Surviving Family Members
If one owner becomes disabled or dies, the Buy-Sell contract guarantees that the disabled owner’s family does not have to become involved in the practice in order to protect the total family’s interest. The Buy-Sell agreement frees the disabled or deceased owner and his or her family from the risk of future practice losses and creates funds that may be used to pay medical bills and living costs of his or her family.
Funding The Agreement
Because the Buy-Sell agreement contemplates a Buy-Sell transaction at the time of an owner’s death or disability, insurance policies are generally recommended to fund the transaction. There are many reasons for this, including the following:
· Insurance policies pay a predetermined amount with proceeds that are available at exactly the time when they are needed. This means there will be no liquidity concerns for any of the involved parties who need money at this time.
· Proceeds will be available regardless of the financial state of the practice at that point (so long as premiums have been paid).
· The practice “Leverages” the cost of insurance premiums to create the proceeds. Therefore, it costs the practice less to buy insurance than it would cost to save money in a special buy-out side fund.
· The economic risks of early death or premature disability of any owner are shifted from the medical practice to the insurance company.
· Insurance proceeds are paid to the owner or owner’s family income tax-free.
If the payment contemplated under the agreement is not a lump sum cash or periodic payment other than through a disability insurance policy, it is important to consider some type of security arrangement for the departing owner. These agreements might include personal guarantees from remaining owners, mortgages or security interests in real estate, a bank standby letter of credit, or even collaterally-assigned life insurance policies.
The Need For A Coordinated Team
Creating a Buy-Sell arrangement that fits a particular practice’s circumstances requires expertise and experience. Expertise in areas of corporate and health care practice law, tax law, insurance products, and the valuation of practices are all absolute requirements. Just as important is experience in dealing with different owners and being able to negotiate and draft an agreement that meets the needs of all parties involved.
Too often, practice owners make one of two key mistakes in deciding who should oversee the creation of a Buy-Sell arrangement. These include:
1. Choosing a friend who is a lawyer, rather than an expert with experience in this area, to create the strategy and draft the document.
2. Failing to work with a coordinated team to implement the plan
Once you realize that you need a coordinated team to administer the Buy-Sell arrangement, you have to find the right team. This team would involve the following:
· An attorney who has experience creating these types of arrangements.
· A life and disability insurance professional who has worked on these issues many times.
· A practice appraisal firm, whose expertise may be needed in the future for annual practice valuations.
As with any legal or insurance planning, the early bird is richly rewarded. Nowhere in practice planning is this truer than in the Buy-Sell agreement. The reason is not so much economic, but political. If this planning is done before any owner is close to a disability, divorce, retirement, or death, all owners are in the same position relative to each other. That makes the negotiation of a standard deal for all owners a much easier and smoother process. Planning early for a Buy-Sell agreement will truly benefit you, your family, and your practice. In order to avoid financial disasters, the agreement should be an essential part of your financial planning.