Understanding the "Physician to Physician" Standard
(Or, Why The Correct Hypothetical "Any Willing Buyer" May Not Be A Taxable C Corp Regardless Of What The CAPM, IRS And Others May Tell You!)
When hospitals and other nonphysician providers commenced acquiring physician practices there was significant concern in the regulatory community. D. McCarty Thornton, Chief Counsel in the inspector general's office (OIG, Health and Human Services) in a series of appearances before trade organizations and a well known 1994 letter to the American Hospital Association, indicated that the OIG would be less concerned about Fraud and Abuse in the payment of goodwill when computed in the context of a (retiring) physician to physician transaction. In a number of exemption rulings in Integrated Delivery System transactions, notably Friendly Hills and Harriman Jones, the Internal Revenue Service preferred the discounted free cash flow method of valuation, but predicated the rulings on the transaction not being in violation of the Medicare Fraud and Abuse statute. It should be noted as well that these two exemption rulings involved transactions valued at $165 million and $20 million, respectively, while the vast majority of transactions involve solo or small group practices with prices less than $1 million.
It is generally well-accepted (in the author's view) that physician to physician transactions are executed on the basis of pre-tax cash earnings using excess earnings methods of valuation, whether implicit or explicit. Prior to the current wave of hospital and practice management company acquisitions, in most parts of the country the hypothetical any willing buyer was another physician (or physicians), and this is the standard the OIG was interested in encouraging.
The IRS maintains that the hypothetical any willing buyer for its purposes is a taxable C corporation. This is fine, and, in fact, accurate, for an integrated delivery system, hospital or practice management company transaction. On the other hand, it is wholly inaccurate for a small physician to physician transaction, where there is simply no evidence that earnings are retained in the practice and subject to double taxation; in fact, the evidence goes the other way, with substantial time and effort devoted to avoiding double taxation.. A significant portion of the buyers in the market for small practices continue to be other physicians, including small group practices looking to expand. One can also view the universe of hypothetical any willing buyers as being small physician practices units for purposes of employing an excess earnings method to meet the "physician to physician" standard when cross-checking the taxable C corporation result.
The limited amount of "market" data available in the form of the Goodwill Registry (The Health Care Group, Inc.) historically included primarily physician to physician transactions. Therefore, in the interest of meeting the regulatory "standard" set out by the OIG, it was advisable to test valuations using those methodologies typically used by physicians as opposed to integrated delivery systems, hospitals or practice management companies. The excess earnings methods employed in the author's practice were designed to afford a relatively uncomplicated manner of testing the results of the free cash flow method preferred by the IRS with common physician to physician methodologies. This, in turn, should hopefully comply with the enunciated OIG standard and includes that portion of the "any willing buyers" in the market who are not taxable C corporations.
If one were to use pre-tax earnings in a discounted free cash flow or capitalized cash earnings model, than one would expect to adjust the discount rate by the tax rate used to compute after-tax earnings. To illustrate, if pre-tax earnings were $100 and the tax rate 40%, after-tax earnings would be $60. If the discount rate for after-tax earnings were 20%, than the rate for pre-tax earnings would be 33.3%. Assuming for simplicity that the cap rate equaled the discount rate, capitalizing after-tax earnings of $60 at a rate of 20% results in a value of $300. Capitalizing pre-tax earnings of $33 at a rate of 33.3% results in a value of $100, as well. There should, of course, be no difference in the value for a given method whether one used pre-tax or after-tax earnings, all things being equal.
This being said, the author does not believe that the discount rates (implicit from transactions) used by physicians as a subset of the universe of "any willing buyers" are the same as that of a hypothetical taxable C corporation after adjusting for taxes. By the same token, the disposition of the earnings of the acquired practice (explicit from experience) is not the same either. However, the market value of the practice to both subsets of any willing buyers should be the same if the valuator presumes to measure fair market value. In fact, the value of primary care physician practices has increased dramatically in those areas of the country where capitated payment methods are present or anticipated. Therefore, the discount and capitalization rates used in the excess earnings methods must be adjusted to reflect the actual post-transaction impact on pre-tax rather than after-tax earnings, based upon physicians as any willing buyers.
Why would the discount rate for the any willing physician buyer be different from that of a hospital, IDS or PPM in the form of a taxable C? A physician buying the practice will typically work in the practice to produce his or her principal source of income. Ownership and management will vest in the same individual (Note: Not in the sense of "buying a job" but rather under the "competent management assumption" of the hypothetical "any willing buyer"). There will be a direct and strong financial incentive to produce. These factors reduce the risk, and accordingly, the discount rate, during the initial period after the acquisition. The transaction structure used by the universe of taxable C buyers bears this out: Many require the selling physician to remain with the practice and forfeit some portion of the purchase price in the event of an early termination. Nonetheless, various reports in the hospital trade press indicate that these physician acquisition have generally been financial failures.
The criteria for selecting this discount rate must be evaluated within the context of what a physician buyer would pay for the practice in the 'open market.' The market is the ultimate arbiter of fair market value and a valuation that does not reflect the marketplace does not measure fair market value. Physician to physician transactions using the excess earnings method are not conducted on an after-tax basis (see preceding paragraph), since all the earnings will be withdrawn from the entity by the owner(s). Discount rates, including the impact of taxes, should be reflective of the values reported in the trade press and such publications as the Goodwill Registry: actual transactions determine discount rates, not the other way around.
In the author's view, capitation is the underlying structural force driving consolidation in healthcare industry. Eventually, most small physician practice units become nonviable. They lack actuarial stability, negotiating leverage, and cannot compete for the capital necessary to acquire the management information systems required for medical management. In a market where development has reached this stage, the excess earnings methods become increasingly irrelevant, and the methods more common to other business enterprises, including capitalized cash earnings and discounted free cash flow, replace them.
Is the original position of the OIG still relevant? Although the physician to physician standard has faded into the background there are areas of the country where exempt hospitals continue to maintain that they cannot purchase goodwill for regulatory reasons. At the monument, this does not appear to be true. The government, however, always has the benefit of hindsight in enforcement actions. One need look no farther than the PATH (Physicians At Teaching Hospitals) program for proof. Here, HCFA attempted to apply regulations promulgated in 1995 retroactively for six years, collecting $30 million from the University of Pennsylvania in the process. The current investigation of Columbia/HCA and its physician joint ventures may yet again call attention to the issue of goodwill. Conservatism dictates that valuators consider the possibility of future changes in the OIG's attitude about past transactions.