How to Buy a Partner Out of the Practice

Physician's Money Digest, February 2007, Volume 14, Issue 2

Buying out a partner can be a complicated process. The method should be decided and addressed long before the event occurs, in a buy–sell agreement or a shareholder's or partnership contract. This prevents controversy should the partners be less than amicable, or if the spouse of a deceased partner has an unrealistic opinion of the value of the business.

The Value of the Practice

Most medical practices maintain their books on a cash basis because of the tax advantages. This often results in a low book value since the largest asset, the accounts receivable, is not recorded. There is often a related partnership or limited liability company that owns the office building, which results in three assets to be valued and purchased.

The buy–sell agreement often values the practice at book value, and the departing partner receives their pro-rata share. The value of practices with little furniture and equipment is usually assumed to be the depreciated value on the books. If there is a lot of expensive equipment, specific formulas can be used that basically depreciate the equipment over 10 years. For example, if an item is 1 year old, 90% of cost can be used, if it’s 5 years old, 50%, and so on.

Another factor affecting the value of a practice is life insurance on the owners. In the event of retirement or termination, the partner is given the option to take the policy. The cash value then reduces the balance due.

The accounts receivable are valued at the net amount expected from the insurance carriers and Medicare. The departing partner is entitled to their share— often referred to as deferred compensation. This is done for tax reasons so that the entity can deduct the payments.

The real estate in a separate entity is generally appraised, and the book value of the entity is adjusted to reflect the appraisal. Both parties obtain an appraisal, and if the two appraisers significantly disagree on the value, then a third appraiser is appointed. Usually the third appraisal is binding for both parties.

How Assets Are Paid Out

The deferred compensation is paid by the entity, normally over a period of years. This is generally beneficial to both parties. The entity uses the income formerly paid to the partner to fund the payments and also to pay the salary of the replacement. Spreading the payments can act as an additional pension; they can bridge the income gap until Social Security age is attained; or they can allow for smaller withdrawals from retirement plans so that the funds continue to grow tax-deferred for the future.

The payments for the value of the practice and the real estate can be paid in either of two ways: The entities can make the payments and redeem the ownership interest, thereby increasing the ownership interest of the remaining partners, or, if a new partner is being admitted, they can make the payments and simply take over the ownership interest.

The length of the payment varies. The practice might be paid for over 3 to 5 years, the real estate over 7 to 10 years. Interest is generally paid on these two items but not on deferred compensation. The deferred compensation is often paid over 3 to 5 years, but the owners should consider a 10-year period, especially for larger amounts.

There are also some potential tax advantages if properly structured. If the departing partner moves to another state, the 10-year payout can prevent the original resident state from trying to tax the payments. If the entity is a partnership and some modifications are made to the payment terms, it is possible to avoid Social Security taxes on the deferred compensation. As with most agreements of this nature, the use of competent professionals is important.

William Nagle, CPA, is a partner in the Edison, NJ, office of New York City–based Weiser LLP. He has more than 30 years of experience in the tax field, including research, planning, and compliance, primarily for medical professionals, high-net-worth individuals, and closely held businesses. He has also been involved in negotiating and structuring the purchase or sale of many businesses. He welcomes questions or comments at wnagle@weiserllp.com.