Partnership deal requires planning

New partners may be surprised to find their income dropping instead of rising if the deal is not structured optimally.

ByJeffrey B. Sansweet, MD

Jeffrey B. Sansweet

After an ophthalmologist works for a practice as an associate for 2 to 3 years, it is typically time for partnership. This article reviews important issues to be addressed when one becomes a partner.

Because negotiating a partnership arrangement can be complicated and sometimes contentious, the negotiations should begin as early as 6 months before the targeted effective date. I have been involved in deals in which the documents were not signed until more than a year after their effective date. If a detailed letter of intent is prepared along with the initial employment agreement, the process usually is less time-consuming because many of the deal points have already been spelled out. However, such letters of intent are becoming less popular because practices want to be careful not to commit to anything prematurely.

Becoming a partner usually implies two things to an ophthalmologist: more money and more security. However, many of my clients are surprised when I review their documents and point out that they may make less money after factoring in the buy-in and that they will have no additional security. This should not be the case.

In terms of security, at least with small groups, I believe that a partner should not be able to be terminated without cause. Surprisingly, that is not always the case. In groups with fewer than six partners, a unanimous vote should be required to terminate a partner without cause. In larger groups, perhaps a supermajority vote of 80% of the partners should be required to terminate a partner without cause. The definition of “cause” also should be spelled out in the documents.

The buy-in

Structuring the buy-in is usually the most important part of the partnership arrangement. Most ophthalmology practices still require a buy-in that includes “goodwill.” In order to minimize the tax burden on the junior partner, the stock price is typically tied to the value of the tangible assets (equipment, furniture, fixtures) less practice debt. In many ophthalmology practices, the tangible assets may be appraised to determine a fair market value. Some practices, instead, use a modified book value approach. This means valuing the assets using straight-line depreciation over 10 or 15 years, perhaps with a floor of 10% to 20% of cost. Pure book value may result in little or no value if many of the assets are more than 5 years old. Typically, inventories of contact lenses and eyeglasses are valued at cost.

The new partner is either expected to pay the other partners up front for the stock or allowed to pay over several years with interest. For tax purposes, the new partner gets “basis” in the stock but no tax deduction. The selling partners report any gain on the sale of the stock as capital gain.

The remainder of the buy-in, for the accounts receivable and goodwill, is often structured as a percentage reduction in net income over a period of time. This avoids a dispute over the exact value of the intangible assets. It also has the result that the new partner, in effect, pays more if the practice is more profitable and less if it is less profitable. In addition, it allows the new partner to buy in to the intangible assets with pre-tax dollars.

For example, if there are to be two partners and they will otherwise divide the net income of the practice equally, the new partner may receive 70% of an equal share of the net income in year 1 of the partnership (70% of 50% is 35%, so that is a 65-35 split), 80% of an equal share in year 2 (a 60-40 split), 90% of an equal share in year 3 (a 55-45 split), and total equality in year 4.

I have seen these formulae start as low as 60% of an equal share in year 1. If that is the case, one should project what that means in terms of salary as compared to one’s salary before becoming a partner. The new partner’s salary should not go down in the first year of partnership, even after factoring in the buy-in. If that is a possibility, I believe that the buy-in price is too high and thus the formula should be adjusted.

Receivables and goodwill

Some groups prefer to use a specific value for receivables and goodwill as opposed to a percentage income reduction. In that case, the face value of the receivables should be reduced by a reasonable collectability factor based upon historical data, and any accounts with no charge or payment for a 6-month period should not be counted.

Goodwill is more subjective. Although there are several methods of determining goodwill values, most practices use a percentage of collections. The percentage can be anywhere between 20% and 80% of a year’s gross collections. Others use a percentage of average annual collections over 2 years. A key issue that also arises is whether to use the gross from the year before the associate joined the practice or the year before the associate becomes a partner, as the associate has certainly contributed to the gross and goodwill.

As an example, let us assume the goodwill and receivables of a two-physician practice are valued at $450,000, and the net income to split in each of the first 4 years of partnership is $500,000. The new partner, assuming 50-50 ownership and an otherwise equal split of net income, would make $175,000 each year and the senior partner $325,000 each year, calculated as follows:

The new partner’s buy-in would be $225,000 (50% of $450,000), which is to be “paid” by taking $75,000 less in income each year for 3 years. An equal split in net income would be $250,000 less $75,000, or $175,000. The $75,000 foregone in each year would go instead to the senior partner. In year 4, each partner would make $250,000.

If we instead use the percentage approach described above, the new partner would make $175,000 in year 1 (35% of $500,000), $200,000 in year 2 (40% of $500,000), $225,000 in year 3 (45% of $500,000), and $250,000 in year 4.

Division of net income

In addition to the buy-in methodology, the division of net income is also a critical economic consideration. Some practices divide the pie equally and are not concerned with keeping track of relative productivity and time spent on the job. This promotes a team approach, does not penalize someone who may perform less lucrative procedures than others and does not penalize someone who spends a lot of time on administrative matters.

Other practices may prefer dividing everything based upon relative productivity, usually by collections, not charges. If that is the case, the buy-in reductions start from the productivity figures, not from an equal share of net income.

If a productivity-based formula is used, many practices simply divide the net income using relative collections, which results in the overhead of the practice also being paid for based upon relative productivity. Others may instead allocate some of the overhead equally among the partners and some by relative productivity, as some of the overhead may be more fixed than variable.

Another strategy is to use a combination of equality and productivity. That seems to be the trend among ophthalmology practices. For example, 50% of the net income may be divided equally and 50% by relative productivity. Or an equal base salary may be set for all partners, with bonuses based upon relative productivity.

When structuring any productivity-based formula, one must be careful to avoid violating the Stark and anti-kickback laws. Partners should not be compensated based upon services not personally performed by them.

The buy-out

When structuring the buy-in, many new partners do not focus on the buy-out. If the senior partner is going to retire shortly, the buy-out is just as important as the buy-in.

The buy-out is typically structured similarly to the buy-in. The stock is valued based upon the tangible asset value minus debt. The bulk of the buy-out is structured as deferred compensation or separation pay, which is tax deductible by the corporation. If a percentage-reduction method was used for the buy-in, as opposed to specific valuation of the intangible assets, typically the deferred compensation will be a set percentage of the departing doctor’s salary and bonus for the 12 months before termination. That percentage can vary anywhere from 25% to 100% of compensation. Typically, the deferred compensation is payable over 24 to 60 months in order not to overburden the practice.

The deferred compensation entitlement is usually subject to forfeiture or reduction if the departing doctor leaves and competes, does not give sufficient notice or is terminated for cause. The new partner is typically not entitled to a full share of deferred compensation until the buy-in is complete.

If the buy-out amount is substantial, I believe there is no need for a restrictive covenant for partners, as long as at least the intangible asset portion of the buy-out would be forfeited upon leaving and competing.

Finally, a new partner is typically asked to sign on as a guarantor on any existing debt that the partners have personally guaranteed. I believe, however, that a new partner should be indemnified against any financial responsibility for a tax or billing audit that results from actions that occurred before he or she became a shareholder. In addition, a new partner may be offered the opportunity to buy an interest in related entities such as a real estate partnership that owns the practice location or a limited liability company that owns an ambulatory surgery center.

These are some of the key issues to be addressed in negotiating a partnership arrangement. Each deal and each practice is unique, so you cannot always compare your deal to others. It is important to engage an experienced health care attorney who is familiar with the marketplace and the issues to guide you through this important process.

For more information:

Jeffrey B. Sansweet, JD, is a health care attorney with Kalogredis, Sansweet, Dearden and Burke Ltd. in Wayne, Pa. He can be reached at 610-687-8314; e-mail: jsansweet@ksdbhealthlaw.com.