Originally published in Healthcare Michigan, Volume 40, No. 9
Adverse tax issues can arise for physicians and other professional practice groups interested in issuing equity to attract and retain junior physicians. If equity is issued at below fair market value, the new equity owner will incur significant federal income tax consequences on issuance. If the new practice entity owner leaves the practice, the practice entity could experience difficulty in funding the amount needed to repurchase the equity from the departing professional. These adverse tax and other consequences at buy-in and buy-out can be avoided by proper planning and a well-designed buy-sell agreement.
Issues for the New Practice Owner
Federal tax law taxes income of all types, whether cash, property, or other forms. For employees of a practice entity, if an employee is issued equity in a practice and does not pay for the equity at its fair market value, the employee must include in income for federal tax purposes the “bargain element” of the equity received. This applies regardless of the form of the equity – be it stock in a professional corporation (PC), a membership interest in a professional limited liability company (PLLC), or a partnership interest in a professional limited liability partnership (PLLP).
Issues for the Practice Entity
Even though regardless of entity type, the practice entity is entitled to a compensation deduction for federal tax purposes for the income taxed to the junior physician (or other new practice entity owner) on issuance, if the entity “zeroes out” its taxable income through bonuses paid to its owners (such as a PC typically does), the practice entity may not be able to take advantage of this deduction to reduce its taxable income.
Further, since the laws of most states require practice entities to repurchase the equity of a practice owner who no longer provides services to the entity for the equity’s “fair value”, this repurchase obligation may force the practice to borrow the funds needed to repurchase the equity of a junior physician equity owner (or other practice entity owner) who leaves a practice.
Minimization of Adverse Tax and Other Consequences by Proper Planning
Using a properly drafted buy-sell agreement and a salary continuation agreement can minimize the adverse federal tax and other consequences.
Technique 1: Limit “Fair Market Value” to Book Value
Suppose the practice entity issues equity at its “book value” and a buy-sell agreement requires practice owners to sell the equity back to the practice entity at “book value.” In that case, the new equity owner will not be taxed on issuance if he/she purchases the equity at book value and the funds needed by the practice entity to repurchase the equity will be limited. Since practice entities are typically cash basis taxpayers (the entity is not taxed when it bills but only when it is paid by patients and payors for services), the book value of a practice entity will generally be much less than its fair market value. Book value excludes the value of accounts receivable and the goodwill/going concern elements of fair market value of the entity. A salary continuation agreement would compensate the departing physician for the value of his/her accounts receivable as collected by the practice.
Technique 2: Use of a Vesting Schedule on Issued Equity
Because equity is taxed to an employee only when the employee has the right to sell the equity, the practice entity could issue equity to the junior physician subject to a vesting schedule. By use of a vesting schedule, the physician would be taxed on the bargain element to the equity only as it vests (i.e., is no longer subject to forfeiture and can be sold by the junior physician).
Using a vesting schedule will defer but not eliminate the federal tax consequences to the junior physician on equity issuance.
Technique 3: Making a Section 83(b) Election
Another technique that can minimize the taxation of equity issued to a new practice owner is an election (called a Section 83(b) election) by which the equity owner would include in income at issuance the value of the new equity issued by the practice entity even if it is subject to vesting and restrictions on sale. This technique is beneficial if the practice and its new owner believe that the value of the equity will appreciate in the future and the new owner is confident that they will remain employed throughout the vesting period.