Choice of Professional Entities: Buy In and Buy Out Strategies
By: NEIL A. WEIKART
November 2002
With the advent of limited liability companies (LLCs), many physicians ask whether they should convert their existing professional corporation practice entities (PCs) to LLCs. As a general rule, the answer is no, although a physician or group of physicians starting a new professional practice may need to examine this issue more closely. The limited liability company shields for LLCs and PCs are substantially the same. A PC (which has not made an "S election") is a separate taxable entity. Its income is taxable to it. When it distributes its income to its physician shareholders, there is a risk that the distribution will also be taxed to the shareholders, resulting in a double tax on the income. This double tax can be avoided by paying the income of the PC to its employed shareholder physicians as compensation. Compensation is tax deductible to the PC, resulting in one level of tax (to the physicians as ordinary income).
An LLC can be taxed either as a corporation (with the possible double taxation issue discussed above) or as a partnership. If it chooses to be taxed as a partnership, there is only one level of income tax. All income of an LLC which is taxed as a partnership is "passed through" and taxed to the partners or members. There is no partnership level income tax. While this removes any risk of double taxation, there is a disadvantage: For income tax purposes, a partner is not treated as an employee of a partnership. Tax favored benefits for partners are not as generous as they are for employees, although changes in the tax laws are making benefits for partners more similar to those for employees.
So long as a PC is able to pay out substantially all of its income as deductible compensation to its physicians, there are no compelling reasons to switch entities. Moreover, moving from a corporation to a partnership or an LLC taxed as a partnership could result in a significant one-time tax cost (acceleration of income on all of the accounts receivable of the practice). There is a recent troublesome U.S. Tax Court case dealing with how much compensation is "reasonable," and thus tax deductible by a PC, for shareholder physicians. To the extent the IRS finds purported compensation unreasonable, the payment will be treated as a dividend, which is subject to two levels of tax (at the corporate and shareholder levels).
With respect to a professional practice, our advice is generally to keep the buy in price to new owners low in order to be competitive in attracting new owners and to keep the buy out price to departing owners low to retain the remaining owners. A low buy out price allows the practice to maximize compensation to current owners. It also keeps the buy out price low, which helps retain current owners, allows for successful recruiting and maximizes the use of qualified (tax-favored) retirement plans to fund retirement. The use of qualified pension and profit sharing plans is much more tax efficient and secure than a large, unfunded buy out when a physician leaves the practice.
In order to keep buy in and buy out prices low, and tax efficient, it may make sense to separate the treatment of the accounts receivable of a professional practice from the treatment of the other assets. When a physician buys into a practice or is bought out, the price for his or her interests (his or her stock in a PC or his or her units in an LLC) should be based on the net value of the assets other than the accounts receivable. The value of these "hard" assets of the practice, less the liabilities of the practice, will generally result in a low net value. When this amount is paid-in by a new physician or is paid out to a departing physician, the buy in or buy out will be with after tax dollars. In other words, neither the physician who is buying in nor the corporation which is buying out a departing physician will receive a tax deduction for these payments.
A repurchase of stock by the PC in effect results in two levels of tax on the dollars used to fund the stock purchase (a corporate level tax on the earnings used to fund the buy out and a capital gains tax imposed on the shareholder). Thus, for tax purposes, it makes sense to keep these values low by "carving out" the accounts receivable, which are usually the most significant asset of a professional practice.
If the value of a departing physician's share of the accounts receivable is paid out as deferred compensation, this deferred compensation payment should be deductible to the PC. This will mean that there is no tax at the PC level and only a single tax (to the recipient) on the payment of deferred compensation. The deferred compensation payments will be ordinary income to the departing physician, as opposed to capital gain for stock payments. However, since accounts receivable represent income from professional services, this seems fair to the departing physician. Accounts receivable represent payment for services which will, in the ordinary course, be paid out as compensation. For tax reasons, and to more accurately reflect economic reality, it makes sense to eliminate accounts receivable from the ownership value on buy ins and buy outs and to treat them as "compensation assets" through deferred compensation agreements. It is important to have a written buy-sell agreement covering the value of the stock. In addition, it is important to have a written deferred compensation agreement to cover the value of a physician's share of the accounts receivable. There are many ways to set up buy ins and buy outs using these basic principles. We would be happy to talk with you regarding your practice and how these principles can be used to make sure that your buy in and buy out procedures are both fair and tax efficient.