The Tax Man Cometh: Tax Perils in Physician Recapitalization Transactions
Physician recapitalization transactions are complex by nature and often present myriad issues. At Foley, in our representation of both investors in, and sellers of, physician practices, we note how often tax issues become gating items that drive the structural aspects of the transaction. These tax issues generally arise as a result of (a) the target practice’s pre-signing tax structure, (b) the nature of the transaction consideration and how it will be paid, and (c) post-closing operational and compensation matters.
Understanding these issues and achieving alignment between private equity investors and physician practice sellers is critical to optimizing transaction goals and successfully navigating from the letter of intent to closing. In our experience, such analysis and alignment are best addressed early in the process when it is much easier to both implement changes as well as socialize the issues with the various constituencies.
Separating Rollover Equity from the Target Practice
Physician practices are typically (and historically) organized as Subchapter C or Subchapter S corporations for federal and state income tax purposes, both of which present challenges in connection with these transactions. This is particularly true where the physician owners will receive a significant portion of the transaction consideration in equity of the investor-owned management company (MSO) or its parent. This equity is often referred to as “rollover” equity.
The most common physician recapitalization transaction structure is the payment of cash and rollover equity (which is sometimes as much as 40 percent of total enterprise value of the selling practice) to the selling physicians and practice. The selling physicians and practice always desire that the receipt of rollover equity be tax deferred. While the cash is relatively easy to distribute from the target practice to the physician owners, the rollover equity presents an issue when the practice is organized as a C or an S corporation. Unlike an entity taxed as a partnership, where the rollover equity may usually be distributed by the practice directly to the physician owners without any immediate tax consequences, if practice is taxed as a C-corporation or an S-corporation, such a distribution would result in an immediate recognition of gain by the recipient physicians (i.e., vitiating the tax deferred treatment).
These tax structures become particularly problematic where the target practice is going to be the “platform practice” for the MSO, in that instance the parties must separate the rollover equity from the operation of the target practice necessitating a pre-closing reorganization (often called a “pop-up” F reorganization) of the practice that is designed to preserve (i) the existing federal employer identification number (EIN) of the practice (so as to preserve relationships with payors, and practice cash flow) and (ii) the tax deferred treatment of the rollover equity to the physicians.
Deferred Payments and Imputed Interest
Recently, certain physician recapitalization transactions have involved deferred payments. Buyers often make any such payments contingent on a physician’s continuing employment at the time payments are made. While such deferred payments typically receive “installment sale” treatment under the Internal Revenue Code (Code) (meaning that tax is deferred until the time the payment are actually received),1 if interest is not paid on those amounts, the IRS will impute interest. This imputed interest results in a re-characterization of a portion of each deferred purchase price payment as interest, with such interest taxed as ordinary income, instead of capital gains and, thus, at higher marginal tax rates.
Allocations of Purchase Price
It is common for physician owners to allocate purchase consideration in a manner that reflects each physician’s contribution toward practice EBITDA.2 While an entity taxed as a partnership provides flexibility in how distributions can be made, distributions by a C-corporation or an S-corporation must be made in accordance with share ownership. Since physician practices tend to be owned in equal proportions rewarding physician sellers in a manner that doesn’t follow percentage ownership in the practice can create its own set of tax issues if, for example, a physician receives a percentage of the purchase consideration that exceeds his or her percentage ownership interest in the target practice.
The most tax efficient way to address this disconnect is to structure a portion of the transaction consideration as a sale of personal goodwill by the individual physicians. Such proceeds typically qualify for capital gains treatment and can be structured to comply with the physicians’ desire to reflect relative contributions toward EBITDA. Unfortunately, a sale of personal goodwill is only possible where there is no existing non-compete between the physicians and the practice (i.e., the physician, not the practice, owns the goodwill in question).
Absent the availability of personal goodwill sale, there are few alternatives other than treating the amounts paid to a physician in excess of his or her percentage ownership in the target practice as “bonus” compensation and, thus, ordinary income.3
Redemptions of Departing Physicians
As noted above, most physician recapitalization transactions involve a rollover contribution by the selling physicians on a tax deferred basis. Subsequent physician departures, whether as a result of termination, retirement, or other reasons, typically give rise to optional or mandatory redemption of that rollover with the purchase price generally varying depending on the circumstances of that departure. While it is expected that the redemption of the departing physician would result in gain being recognized by that physician, where the rollover is held by selling physicians through an S-corporation the manner in which that rollover is redeemed could result in tax consequences for all of the selling physicians. Typically, the MSO’s governing documents require that redemption of a departing physician that owns through holding company be structured as a purchase by the MSO (or its parent) of a portion of the total rollover held by that holding company that reflects the departing physician’s pro rata ownership therein, with the holding company then making a “back-to-back” redemption of the departing physician’s equity in the holding company itself. Unfortunately, when the holding company is an S-corporation, the gain recognized when the S-corporation sells rollover in the first step of the process is allocated among all of the physician owners of the S-corporation in proportion to their ownership of the S-corporation. Accordingly, the non-departing physicians may owe tax in connection with such departure.4
A more tax efficient alternative is to grant the S-corporation a right of first refusal with respect to the departing physician’s rollover in the S-corporation without any requirement of a redemption by the MSO of the equity owned directly by the S-corporation itself. In this instance, none of the remaining physicians incur any tax as a result of the sale. The payout to the departing physician can be structured as a note for some or all of the redemption amount, with such payments terms as the parties desire, including a balloon payment upon a change of control or other liquidation event with respect to the MSO.5
Associate Physician Participation
Practices often desire to reward junior/associate physicians to the extent they are not otherwise participating in the transaction. This will typically take the form of cash bonuses payable over time in order to encourage retention. Since the cost of these bonuses is generally borne by the selling physicians, but is paid by the practice, proper structuring is necessary to ensure that the selling physicians retain the benefit of the tax deduction associated with the payment of such bonuses.
An additional incentive to associate physicians to align their interests more closely with the practice post-closing is to grant those physicians so-called “profits interests” which participate in the future growth of the enterprise and not in the existing value of the enterprise at the time the interests are granted. As a result, a nominal (or no) cash outlay is needed and the issuance doesn’t result in the incurrence of any present tax liability. Accordingly, profits interests are attractive.6 Such interests can be subject to such vesting and repurchase provisions as are desired, although typically the MSO will want to have some control and/or insight into those terms. Careful structuring is essential to ensuring the desired tax result, including the manner in which the value of the enterprise is determined at the time of each such issuance.
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Private equity recapitalization transactions are complex arrangements, with tax issues adding to the complexity. Careful consideration of these issues as early as possible in the deal negotiations is crucial to ensure that the transaction is as tax efficient to the parties as possible.
Foley is here to help you address the short- and long-term impacts in the wake of regulatory changes. We have the resources to help you navigate these and other important legal considerations related to business operations and industry-specific issues. Please reach out to the authors, your Foley relationship partner, or to our Health Care Practice Group or Tax Practice Group with any questions.
1 Care should be taken to avoid treating such payments as compensation income subject to ordinary income tax rates, and with a C corporation, potentially subject to excise tax under the requirements of 280G of the Code (excess parachute payments).
2 In other pieces found in Foley’s Health Care Law Today we have detailed the manner in which physicians create forward looking EBITDA (earnings before interest, taxes, depreciation, and amortization) by agreeing to percentage reductions (or “scrapes”) in their future compensation. Those physicians who take the greatest amount of scrape are generally rewarded with more of the cash purchase price than those who take lesser scrapes.
3 Careful structuring is important with respect to any such arrangements in order to ensure that the entity receiving the transaction proceeds is able to take the corresponding deduction for the payment of such bonuses. Loss of such deduction could result in the seller paying tax on the transaction proceeds in addition to the physician paying tax as compensation.
4 Physician holding companies will often try to address this issue by having the departing physician indemnify the other physicians in respect of their tax costs (or otherwise defer a portion of the upfront payment to the departing physician in an amount equal to such tax costs) which brings its own set of issues and considerations.
5 Where the selling physicians have been able to negotiate this provision with the private equity investor, such right is typically subject to the S-corporation maintaining a certain minimal level of physician ownership to avoid concentrating MSO ownership in too few participating physicians.
6 There are various ways and methods of issuing such interests, each of which is driven by tax structure.
