Post-Transaction Compensation

October 10th, 2007 | Income Approach & Methods | Regulatory Matters | Valuing Goodwill

I received a question the other day inquiring as to the basis for  my statement in the November 2005 Journal of Accountancy that "the IRS says physician compensation in a valuation model should agree with any post-transaction employment contract."  I thought my response to that question would assist a lot of other appraisers.

This concept originally appeared in a letter attached to the valuation submitted in connection with the exemption ruling for the Friendly Hills Transaction as described below:

Quote from my book:

“The Friendly Hills HealthCare Foundation was the first ruling by the IRS in favor of tax exemption for an Integrated Delivery System (IDS) involving physician compensation in tax-exempt settings.  Certain aspects of the Ruling, including the use of the Discounted Cashflow Method, were later elaborated upon in the 1995 Exempt Organization Continuing Professional Education Technical Instruction Program Textbook.  Notably, the value determined in Friendly Hills was based, in part, on an agreed-upon reduction in physician compensation.”

“In fact, the valuation submitted in connection with the Friendly Hills transaction  contains a letter signed by the managing partner stating that the partners recognized they were selling a portion of their earnings and that their future incomes would be less by virtue of that sale.  In relevant part he states “… It has been clearly stated to the partners that, in the past, their compensation reflected not only the value of their medical services, but also the profits attributable to their ownership of the Network; that the latter element will be replaced by a cash payment, which they can invest … that the Medical Group’s income will thereafter be derived from arms-length contract for medical services; and that these rates will necessarily be significantly lower than the total historical income they have been receiving …” (emphasis added).  (Friendly Hills Valuation Report)”

See the 1994 Exempt Organization CPE text INTEGRATED DELIVERY SYSTEMS (eotopicn94.pdf) and 1995 Exempt Organization CPE text INTEGRATED DELIVERY SYSTEMS AND JOINT VENTURE DISSOLUTIONS UPDATE (eotopicl95.pdf).  Note in particular bottom of page 8 forward in 1994 text and the general discussion of compensation in 1995.  You can obtain these at These are still cited as recently as 2004.

Fundamentally, why would a hospital buy a practice for a value based upon the physicians receiving X compensation for their future services, when the Employment contract provided they would be paid X+?  You would not buy my practice, or I yours, for a $1 million and continue to pay me/you everything it generates, I suspect.  For a hospital to do so raises serious inurement and excess benefit issues, and more importantly, Stark and AKS issues.

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