Tax Strategies for PPM Transactions
Tax Strategies for PPM Transactions
In many areas of the country, Physician Practice Management Companies or PPMs are major competitors with local hospitals and Managed Care Organizations (MCOs) for physician practice acquisitions. PPMs are both publicly-traded and venture capital funded, the latter generally looking for an Initial Public Offering (IPO) in their future. These non-public PPMs commonly use a significant amount of their own stock as part of the purchase price for the physician practice. The presence of stock allows for potential tax structures that may be either detrimental or advantageous. For C corporations in particular, the goal of the advisor is to avoid double taxation. Where stock is part of the consideration given, the goal is to avoid current taxation and hopefully qualify the proceeds for capital gain treatment when the stock is sold.
PPM's typically "acquire" physician practices based upon a multiple of "created" excess earnings ranging from 4 to 7. The excess earnings are created by taking a percentage of the net income before physician compensation; physicians thus earn less compensation after selling to a PPM. The term of the PPM relationship typically runs from 20 to 40 years, supported by non competition agreements. Note that these long-term agreements are critical for a publicly traded PPM or one contemplating an IPO as the stock market is paying for earnings in perpetuity.
Example
In order to understand the variants of these transactions, a hypothetical sale transaction is described below. Your client (described as the "Target" below) is a 10 person primary care practice generating $4.0 million in annual receipts and $2.0 million in net income before physician compensation and fringe benefits or Pre-distribution Earnings (PDE). It operates as a C corporation for tax purposes. A non-publicly traded PPM has made the following offer: The PPM will charge a management fee equal to 20% of the current PDE, plus 50% of any increase in PDE. In exchange for the 20% of PDE or $400,000, it will pay a multiple of 7 times, or $2.8 million. The physician are offered several structures, but are inclined to take 50% in cash and 50% in PPM stock, valued at $4 per share, or 350,000 shares. The hope is that the PPM will execute a successful IPO with a value of at least $10 per share, resulting in the transaction having a value of $1.4 million in cash plus stock of $3.5 million. Compared to the typical range of values in a cash sale of 50% to 70% of receipts, this value is more than 120% of receipts.
Clearly, the ultimate structure of this transaction will be driven by many things in addition to tax considerations. The presence of potential malpractice liabilities in the seller, qualified plan issues and state law may impact the willingness of the buyer to consider tax favored alternatives. The discussion which follows explores the possible alternatives for accomplishing the sale.
Key Concepts
Corporate Practice of Medicine Doctrine - This refers to the status of state law and whether or not, or to what extent, physicians can be employed by business corporations or entities as opposed to professional corporations or entities. A state with a strong corporate practice of medicine doctrine, e.g., Texas, will preclude business corporations from employing physicians directly.
"Friendly PC" - A device employed to avoid the corporate practice of medicine. A physician affiliated with a hospital or PPM, perhaps employed in a nonclinical capacity, owns all of the stock of the 'friendly' PC. The stock is subject to a variety of restrictions on transfer, voting and other rights in favor of the hospital or PPM. Physicians whose practices are 'acquired' by the hospital or PPM are employed by the friendly PC, which executes a management contract with the Acquirer.
Bulk Transfer Theory- A provision of many states' laws which provides that an Acquirer of all or substantially all of a Target's assets may have engaged in a defacto merger. In this case, Acquirer would be exposed to certain of Target's creditors. This is one reason, for example, why buyers require sellers to obtain certificates of good standing or similar documents from governmental authorities indicating that all taxes have been paid.
Reorganizations
Federal tax law specifies the types of corporate reorganizations in section 368(a)(1) A through G, thus the reference to A Reorgs, C Reorgs, etc. Note that these provisions only apply to transactions involving two or more corporations and their shareholders. They do not apply to transactions between an LLC taxable as a partnership and a corporation, for example.
Section 481 Adjustment - The cash method of accounting is typically used by physician practices while the PPM-buyer will utilize the accrual method. Acquisition of the Target's assets in a transaction subject to IRC section 1060 and/or section 381(a) (such as (A), (C), (D), (F), and (G) Reorg transactions) will require the Target to convert to the accrual method if the combined receipts of both exceed $5.0 million (see section 448). The result is that the difference between Target's accounts receivable and accounts payable is recognized as income at the transaction date. Accounts payable for this purpose do not include accrued items such as compensation to stockholders subject to section 267. This recognition can be mitigated by "bonusing" the receivables themselves to the Target's shareholders as compensation for past services as of the transaction date or by spreading it out over four to six years under applicable IRC provisions. If the collected receivables are paid to the sellers as compensation subsequently, a deduction will result which could offset any short-term adverse tax effect.
Issues Affecting Structure of Transaction
In addition to the various tax issues which are the subject of this article, a variety of other issues may influence what the buyer and the seller desire to do and are willing to do. The transferability of contracts held by the seller may influence whether or not the buyer is willing to purchase stock. The type of specialty practiced by the physicians may influence the buyer's willingness to purchase stock also. The risk of an unrecorded malpractice claim is much higher for an obstetrician or orthopedist than for a general internist.
Asset Sale
This would be the typical, least complicated approach to the transaction. The PPM would transfer the cash and stock to the selling corporation in exchange for its tangible and intangible assets. The seller would recognize gain on the difference between the tax basis of the assets sold and the fair market value of the consideration. Since most of the value will be intangible, the gain is likely to be high.
Seller
The physicians can use the available cash to pay bonuses or other deductible items with the risk that the compensation will be challenged as unreasonable. It may be possible to have a portion of the cash paid to the physicians in exchange for individual covenants not to compete. The non-cash portion of the transaction may be structured as an installment sale, with the stock not payable until the time of the IPO.
Buyer
The buyer may be desirous of the asset purchase, since it will be entitled to a step-up in tax basis equal to the purchase price. This results in larger depreciation deductions.
Stock Sale
Clearly, an outright purchase of the stock of the seller from the selling physicians will result in capital gain treatment. This is the most advantageous structure from the sellers' standpoint.
Buyer
In addition to the risks associated with the assumption of liabilities of the seller, the buyer may encounter other problems. Section 481 may impact the transaction depending upon how it is structured.
Use of options
There are two kinds of options under the tax code, incentive stock options and nonqualified options. Nonqualified options are not taxed until they are exercised. At the time of exercise, the spread between the exercise price and the fair market value is taxed as ordinary income. Any future appreciation post-exercise is taxed as capital gain. Due to the need to raise cash to pay the taxes at the time of exercise, coupled with investment risk, many individuals exercising options simultaneously sell their stock.
The selling physicians in the example could be granted nonqualified options, as additional consideration in the transaction, to acquire stock of the PPM at $4 per share. In the event of an IPO at $10 (or likely any number over $4) the physicians would exercise the options, and recognize ordinary income of $6 per share, or $2.1 million. Federal taxes would approximate 40% of this total. Due to SEC restrictions on "insider" sales in the post-IPO period, the sellers might be unable to raise sufficient cash to pay the taxes.
Restricted stock
The receipt of restricted stock generally coincides with the recognition of taxable income. The income realized is the value of the stock, reduced by the impact of the restrictions. (In order to avoid current taxation under section 83, the stock must be BOTH nontransferable AND subject to a substantial risk of forfeiture.) Taxpayers can elect under section 83(b) to include the value of the stock absent the restrictions at the time it is received. The advantage of doing this is that all future appreciation will be taxed as capital gains, whereas the difference between the value of the stock with the restrictions and the value without the restrictions would be taxed as ordinary income when the stock is sold without the 83(b) election.
A Reorganization Or Tax Free Asset Acquisition
In this variant, the PPM (or a controlled subsidiary) acquires the Target via a statutory asset merger. The criteria for a statutory merger is generally determined under state law. If the governing state law does not permit the PPMs to own stock of professional corporations - the Corporate Practice of Medicine Doctrine - the Target must convert to regular business corporation status immediately before the merger.
Asset mergers are risky for the Acquirer since liabilities, including those unknown, go along with it. This, in turn, exposes the Acquirer's assets to the claims of the seller's creditors. For this reason, Acquirers typically use a wholly owned subsidiary to effect an asset merger. Note that the continuity of business principal is maintained since the assets of the Target remain inside a corporation and the Target's shareholders continue to own stock in the Acquirer.
The PPM pays the selling physicians for their stock, generally with shares of PPM stock. The Target and the selling shareholders do not recognize gain or loss, unless there is other property ("boot') received as part of the transaction. Up to 50% of the consideration can be in cash or other property without disqualifying the transaction for A Reorg status. Any such boot received is taxable to the selling physicians as capital gain.
Steps in an asset merger
1. Target converts from PC to Business Corp.
2. Target retains all assets, except those precluded by loss of PC status
3. Target merges into Acquirer or subsidiary
4. Acquirer gives Target stock and/or cash. Target makes liquidating distribution to shareholder-physicians
5. Acquirer gives Target shareholders stock of Target and or cash in exchange for their stock and liquidates Target
6. Physicians establish own PC which contracts for services with Acquirer
If the transaction does not qualify as an A Reorg, there will generally be a taxable asset sale with gain recognized by Target, followed by a liquidating distribution with gain recognized by Target shareholders
C Reorganization: "Stock For Assets"
Despite the repeal of the so-called General Utilities doctrine (old section 337) in 1986, the reorganization provisions contained in section 368 provide limited opportunities for avoiding corporate level tax on appreciated assets. The Target corporation can receive up to 20% of the consideration for its assets in cash or assumption of liabilities and still qualify for a C Reorg. The PPM in our example would need to increase the portion of the purchase price payable in stock from 50% to 80%. The Target would recognize gain to the extent of the "boot" or cash received and/or liabilities assumed. The PPM stock could be distributed to the physicians in redemption of their shares in the Target. The physicians will not recognize gain upon the receipt of the PPM stock in exchange for their own shares pursuant to the liquidation.
A C Reorg differs significantly from an A Reorg in that there is no merger. The Acquirer therefore avoids assumption of the Target's liabilities. The maximum of 20% of consideration receivable by a Target in cash can be used to discharge liabilities. This type of a structure works best when the Target has few liabilities and the selling shareholders desire to own significant voting stock in the Acquirer. Unlike an A Reorg, the stock in a C Reorg must be voting stock.
Steps in a C Reorg
1. Target transfers "substantially all" of its assets to the Acquirer
2. Acquirer exchanges voting stock plus no more than 20% of total consideration in cash or assumption of Target liabilities
3. Target liquidates and distributes Acquirer stock and remaining assets to its shareholders
4. Shareholders recognize gain to extent of cash or other assets ("BOOT") received
D Reorganization
This provision applies to "spin-off" and "split-off" transactions. After the repeal of former section 337 in 1986, taxpayers attempted to avoid the impact by use of D reorganizations. In a valid D Reorg, a single corporation splits into two or more separate corporations based upon separate lines of business or a division of a single business in two or more units. It is commonly used where several incompatible businesses exist in the same corporation. In PPM transactions, it may be used to attempt to separate the management operations of the Target practice from the clinical operations. The management operations would then be acquired by the PPM. Such a transaction is highly complex and often warrants a Private Letter Ruling from the Internal Revenue Service.
Conclusion
Adequately representing a client in a transaction involving PPM stock can require expert knowledge of provisions of the Internal Revenue Code commonly known only to the few who work with them on a regular basis (which does not include this author). Nonetheless, familiarity with the basic opportunities and pitfalls afforded by use of such devices as reorganizations, restricted stock and stock options can give the CPA-negotiator the chance to enhance the economics of a transaction for his or her client. The "experts" can be called in to structure the transaction properly to achieve the desired results. The author advises that you "not try this at home" without proper supervision.
The author acknowledges the assistance of Michael L. Blau, Esq., McDermott, Will and Emory, Boston in developing the material for this article.
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