The Tax Man Cometh: Tax Perils in Doctor Recapitalization Transactions

Doctor recapitalization transactions are advanced by nature and infrequently current myriad points. At Foley, in our illustration of each traders in, and sellers of, doctor practices, we be aware how usually tax points grow to be gating gadgets that drive the structural points of the transaction. These tax points typically come up on account of (a) the goal observe’s pre-signing tax construction, (b) the character of the transaction consideration and the way it will likely be paid, and (c) post-closing operational and compensation issues. 

Understanding these points and attaining alignment between personal fairness traders and doctor observe sellers is vital to optimizing transaction targets and efficiently navigating from the letter of intent to closing. In our expertise, such evaluation and alignment are finest addressed early within the course of when it’s a lot simpler to each implement adjustments in addition to socialize the problems with the varied constituencies.

Separating Rollover Fairness from the Goal Observe

Doctor practices are sometimes (and traditionally) organized as Subchapter C or Subchapter S companies for federal and state revenue tax functions, each of which current challenges in reference to these transactions. That is notably true the place the doctor homeowners will obtain a good portion of the transaction consideration in fairness of the investor-owned administration firm (MSO) or its mother or father. This fairness is also known as “rollover” fairness.

The commonest doctor recapitalization transaction construction is the cost of money and rollover fairness (which is typically as a lot as 40 p.c of complete enterprise worth of the promoting observe) to the promoting physicians and observe. The promoting physicians and observe all the time need that the receipt of rollover fairness be tax deferred. Whereas the money is comparatively simple to distribute from the goal observe to the doctor homeowners, the rollover fairness presents a problem when the observe is organized as a C or an S company. In contrast to an entity taxed as a partnership, the place the rollover fairness might often be distributed by the observe on to the doctor homeowners with none rapid tax penalties, if observe is taxed as a C-corporation or an S-corporation, such a distribution would end in a right away recognition of achieve by the recipient physicians (i.e., vitiating the tax deferred therapy).

These tax buildings grow to be notably problematic the place the goal observe goes to be the “platform observe” for the MSO, in that occasion the events should separate the rollover fairness from the operation of the goal observe necessitating a pre-closing reorganization (usually referred to as a “pop-up” F reorganization) of the observe that’s designed to protect (i) the present federal employer identification quantity (EIN) of the observe (in order to protect relationships with payors, and observe money stream) and (ii) the tax deferred therapy of the rollover fairness to the physicians.

Deferred Funds and Imputed Curiosity

Lately, sure doctor recapitalization transactions have concerned deferred funds. Patrons usually make any such funds contingent on a doctor’s persevering with employment on the time funds are made. Whereas such deferred funds sometimes obtain “installment sale” therapy underneath the Inside Income Code (Code) (that means that tax is deferred till the time the cost are literally acquired),1 if curiosity just isn’t paid on these quantities, the IRS will impute curiosity. This imputed curiosity ends in a re-characterization of a portion of every deferred buy value cost as curiosity, with such curiosity taxed as extraordinary revenue, as an alternative of capital good points and, thus, at greater marginal tax charges.

Allocations of Buy Value

It’s common for doctor homeowners to allocate buy consideration in a fashion that displays every doctor’s contribution towards observe EBITDA.2 Whereas an entity taxed as a partnership offers flexibility in how distributions may be made, distributions by a C-corporation or an S-corporation have to be made in accordance with share possession. Since doctor practices are typically owned in equal proportions rewarding doctor sellers in a fashion that doesn’t comply with share possession within the observe can create its personal set of tax points if, for instance, a doctor receives a share of the acquisition consideration that exceeds his or her share possession curiosity within the goal observe.   

Essentially the most tax environment friendly method to deal with this disconnect is to construction a portion of the transaction consideration as a sale of private goodwill by the person physicians. Such proceeds sometimes qualify for capital good points therapy and may be structured to adjust to the physicians’ need to replicate relative contributions towards EBITDA. Sadly, a sale of private goodwill is barely potential the place there is no such thing as a present non-compete between the physicians and the observe (i.e., the doctor, not the observe, owns the goodwill in query). 

Absent the supply of private goodwill sale, there are few options apart from treating the quantities paid to a doctor in extra of his or her share possession within the goal observe as “bonus” compensation and, thus, extraordinary revenue.3

Redemptions of Departing Physicians

As famous above, most doctor recapitalization transactions contain a rollover contribution by the promoting physicians on a tax deferred foundation. Subsequent doctor departures, whether or not on account of termination, retirement, or different causes, sometimes give rise to non-obligatory or obligatory redemption of that rollover with the acquisition value typically various relying on the circumstances of that departure. Whereas it’s anticipated that the redemption of the departing doctor would end in achieve being acknowledged by that doctor, the place the rollover is held by promoting physicians by means of an S-corporation the way wherein that rollover is redeemed might end in tax penalties for all of the promoting physicians. Usually, the MSO’s governing paperwork require that redemption of a departing doctor that owns by means of holding firm be structured as a purchase order by the MSO (or its mother or father) of a portion of the whole rollover held by that holding firm that displays the departing doctor’s professional rata possession therein, with the holding firm then making a “back-to-back” redemption of the departing doctor’s fairness within the holding firm itself. Sadly, when the holding firm is an S-corporation, the achieve acknowledged when the S-corporation sells rollover in step one of the method is allotted amongst the entire doctor homeowners of the S-corporation in proportion to their possession of the S-corporation. Accordingly, the non-departing physicians might owe tax in reference to such departure.4

A extra tax environment friendly various is to grant the S-corporation a proper of first refusal with respect to the departing doctor’s rollover within the S-corporation with none requirement of a redemption by the MSO of the fairness owned straight by the S-corporation itself.  On this occasion, not one of the remaining physicians incur any tax on account of the sale. The payout to the departing doctor may be structured as a be aware for some or the entire redemption quantity, with such funds phrases because the events need, together with a balloon cost upon a change of management or different liquidation occasion with respect to the MSO.5

Affiliate Doctor Participation

Practices usually need to reward junior/affiliate physicians to the extent they don’t seem to be in any other case collaborating within the transaction. This can sometimes take the type of money bonuses payable over time with a view to encourage retention. Since the price of these bonuses is usually borne by the promoting physicians, however is paid by the observe, correct structuring is critical to make sure that the promoting physicians retain the good thing about the tax deduction related to the cost of such bonuses. 

An extra incentive to affiliate physicians to align their pursuits extra carefully with the observe post-closing is to grant these physicians so-called “earnings pursuits” which take part sooner or later development of the enterprise and never within the present worth of the enterprise on the time the pursuits are granted. In consequence, a nominal (or no) money outlay is required and the issuance doesn’t outcome within the incurrence of any current tax legal responsibility. Accordingly, earnings pursuits are engaging.6 Such pursuits may be topic to such vesting and repurchase provisions as are desired, though sometimes the MSO will need to have some management and/or perception into these phrases. Cautious structuring is important to making sure the specified tax outcome, together with the way wherein the worth of the enterprise is set on the time of every such issuance.


Non-public fairness recapitalization transactions are advanced preparations, with tax points including to the complexity. Cautious consideration of those points as early as potential within the deal negotiations is essential to make sure that the transaction is as tax environment friendly to the events as potential. 

Foley is right here that will help you deal with the short- and long-term impacts within the wake of regulatory adjustments. We now have the sources that will help you navigate these and different vital authorized concerns associated to enterprise operations and industry-specific points. Please attain out to the authors, your Foley relationship companion, or to our  or with any questions.

1 Care needs to be taken to keep away from treating such funds as compensation revenue topic to extraordinary revenue tax charges, and with a C company, doubtlessly topic to excise tax underneath the necessities of 280G of the Code (extra parachute funds).

2 In different items present in Foley’s Well being Care Regulation As we speak we’ve got detailed the way wherein physicians create ahead trying EBITDA (earnings earlier than curiosity, taxes, depreciation, and amortization) by agreeing to share reductions (or “scrapes”) of their future compensation. These physicians who take the best quantity of scrape are typically rewarded with extra of the money buy value than those that take lesser scrapes.

3 Cautious structuring is vital with respect to any such preparations with a view to make sure that the entity receiving the transaction proceeds is ready to take the corresponding deduction for the cost of such bonuses.  Lack of such deduction might outcome within the vendor paying tax on the transaction proceeds along with the doctor paying tax as compensation.

4 Doctor holding firms will usually attempt to deal with this challenge by having the departing doctor indemnify the opposite physicians in respect of their tax prices (or in any other case defer a portion of the upfront cost to the departing doctor in an quantity equal to such tax prices) which brings its personal set of points and concerns.

5 The place the promoting physicians have been in a position to negotiate this provision with the personal fairness investor, such proper is often topic to the S-corporation sustaining a sure minimal stage of doctor possession to keep away from concentrating MSO possession in too few collaborating physicians.

6 There are numerous methods and strategies of issuing such pursuits, every of which is pushed by tax construction.

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