Tax Implications of a Practice Sale

 Intro: [00:00:01] Broadcasting from the studios of Business RadioX, it’s time for Advisory Insights. Brought to you by Oberman Law Firm, serving clients nationwide with tailored service and exceptional results. Now, here’s your host.

Stuart Oberman: [00:00:20] Hello everyone and welcome to Advisory Insights Podcast. Well, today, we’ve got two special guests with us. There is a lot going on in the health care field for the mergers and acquisitions, whether it’s dental, vets, eye, it is all over the place. So, I got two of our great, great partners at the Oberman Law Firm today, and I want to introduce them, Lauren Mansour and Danielle McBride. Both of them do a tremendous job on mergers and acquisitions.

Stuart Oberman: [00:00:51] And I want to talk to Lauren a little bit first. And the key thing is letters of intent. I know if you’re an attorney, you do transactions, you always get, it seems, a signed letter of intent before you really, really have a chance to drill down on it. So, Lauren’s going to talk a little bit about letters of intent. And then, Danielle is going to talk about tax items that are really, really critical in a health care transition, whether it’s a private equity company or it is a private sale.

Stuart Oberman: [00:01:25] So, let’s start off, Lauren, tell you what, I want you to take me through some steps that our listeners need to know regarding LOIs. I mean, we’ve got stuff on holdbacks, real estate matters. I want you to drill down a little bit. Before I start, last year we did as a firm about 135 transactions totaling about 350 million. So, we’ve seen a lot of stuff come under the bridge, if you will, last year. And I think we saw a lot of things we don’t want to see happen again. So, Lauren, tell you what, talk to the audience, tell me a little bit about letters of intent, what you run into and your problems. And, hopefully, our listeners can pick up a couple of pointers.

Lauren Mansour: [00:02:12] Of course, happy to jump into this topic. So, a letter of intent kind of varies. Sometimes we see letters of intent that are a paragraph long, maybe half-a-page max, and sometimes they’re ten pages. And so, there’s definitely a lot of variance depending on the transaction.

Lauren Mansour: [00:02:31] I would say I was speaking with a buyer yesterday, even for just a simpler doctor to doctor transaction, I think it’s important to have a little bit more than half-of-a-page because you do want to flash out certain important concepts and just make sure that you and the seller or you and the buyer are on the same page, and you’re not both spending money on attorneys and bankers and CPAs, and spending time going through this process of negotiating a transaction, and you are never really on the same page to begin with.

Lauren Mansour: [00:03:08] So, I think that we don’t necessarily have to spend a whole lot of time on the letter of intent. But I think it’s important to make sure certain key items like, obviously, the purchase price, possibly even purchase price allocations, what does any post sale employment look like for the seller restrictive covenants, can we agree on those at the LOI stage, is there any real estate involved, and have terms been agreed upon. And if so, let’s include that.

Lauren Mansour: [00:03:39] For a buyer, it’s very important to have exclusivity language in the letter of intent, because you do want to make sure. Again, you’re kind of investing your time and money into the process and you want to make sure that the seller is not continuing to speak with other interested parties. And then, you also want to make sure there’s language that is clear that this document is not binding. I think most letters of intent will say that. But we have had clients in the past sign an LOI before we reviewed, and it was binding. And when they decided after diligence they wanted to walk away, they were facing legal action.

Lauren Mansour: [00:04:20] So, some important tips, I think that in larger transactions, so when our clients are selling, especially to a large group, these letters of intent can be very complex. And I was just looking at one the other day for a client that’s selling a group of practices, and she was looking at restrictive covenants that were not just around her practices, but statewide for any practice that the buyer group owned in any state, that entire state was wiped out for her.

Lauren Mansour: [00:04:56] And so, I think it’s important to kind of go through and make sure that you’re comfortable and you’re aware of the terms kind of before you move forward. Because with sellers, and if they’re talking with big group practices, you’re often courting several buyers. And so, if you can kind of flash out a lot of these concepts and make sure that you understand them, it’s more than just the purchase price. There’s now holdbacks and earnouts and equity involved.

Lauren Mansour: [00:05:31] And so, what do these holdbacks look like? So, sometimes we’ll have a very large transaction and it will briefly mention a holdback or the earnout, and what does that mean? Or the equity won’t be clearly spelled out, and so we have to ask questions. And it’s my opinion, better on the frontend to say, are there going to be any ties to any of this? Is the equity subject to forfeiture if employment terminates before a certain period? Or the earnout, what is it tied to? Do we have to just be employed or do we have to have certain collection levels that we have?

Stuart Oberman: [00:06:08] Can you explain, so you just hit really on a couple of points. One, have you seen a request on a national non-compete? Two, take our listeners through the process of what exactly is an earnout and a holdback.

Lauren Mansour: [00:06:26] I don’t know that I’ve seen a national non-compete. These are usually groups that are in several states that they’ll kind of limit to a region, but it definitely can be several states, and a lot of times it’s tied to equity. So, if you invest with the buyer group, they’ll tie you to think, “Okay. You need to be loyal to this group. Right now you’re invested with us, and so now, because of the equity, you have to not compete with us, not only around your practices, but around any practices we own. We don’t want you to work there.”

Lauren Mansour: [00:07:02] And so, sometimes there’s circles around every practice they own and sometimes there’s just statewide restrictions. If we own in this state, you cannot operate there. Which is sometimes not problematic when our clients are looking to retire. But other times it is, our clients are younger, they still want to work, there’s never any guarantees. And I think we have to look at things from the worst case scenario, just planning it. And so, it can be problematic.

Lauren Mansour: [00:07:32] With respect to your question on holdbacks or earnouts, in some occasions, a purchase price, let’s say, 80 percent of the purchase price is paid at closing, maybe there’s 20 percent that’s paid in an earnout. And that could be part of a purchase agreement or it could be part of an employment agreement.

Lauren Mansour: [00:07:53] But the earnout means, let’s say, it’s 100,000 a year for three years. And each year, in order to get $100,000, your practice has to continue to collect a certain level or it has to grow by a certain percent. And so, in order to get your 100,000 for the first year, your practice has to be at a certain collection level. And if it’s not, you do not receive that amount. Sometimes those earnouts are only tied to continued employment. So, as long as you’re working there, you would receive it. And we will try to negotiate things like, “Okay. Well, what if there’s death or disability? Would we get it in those events?” But that’s what the earnout looks like.

Lauren Mansour: [00:08:35] And then, holdbacks are similar. Sometimes holdbacks are just based on operating liability expenses to make sure that the seller didn’t leave anything unpaid that the buyer has to pay for. Other times they’re longer term holdbacks, they’re tied to either employment or some revenue metric, and you would receive that amount as long as the goal is met.

Stuart Oberman: [00:09:01] So, you mentioned a couple of things. One, invest in a group, is that where, let’s say, we’re talking about $100,000 deal, doctors will take $200 and invest that back into the private equity company?

Lauren Mansour: [00:09:21] Correct.

Stuart Oberman: [00:09:21] Let’s put that on $1,000,000 scale. So, the doctors are going to take $800,000 to put it in their pocket, and they are percentage. And the equity companies want to have the investment back into groups that are doctors putting in, essentially, $200,000 back into their pockets, if you will, whether it’s what? A or C shares you’re seeing, A or B share stock?

Lauren Mansour: [00:09:51] Right. So, there’s a portion of the purchase price that instead of you receiving that in cash at closing, you will invest it in an entity. And a lot of times with these groups, it may not be the actual buying entity. It may be a group that they formed where all of the doctors are investing into that specific entity. There’ll be an operating agreement. You’re governed by the terms of the existing agreements in place. There’s never any guarantees. Sometimes there’s discussion on the frontend.

Lauren Mansour: [00:10:22] I’ve actually seen it a couple of times recently and spoke with some of my colleagues about how it was actually in writing from a buyer that they expected it to be X amount. But, usually, they may tell you how much you may receive on a return or what they’re expecting. But, again, never any guarantee. The buyers will usually give you some timeframe that they are expecting to roll, so it may be, “We’re expecting within the next year or in two years. That’s when we’re going to do our equity event and you’ll be able to see some of this investment back.” But it’s generally variable, economy and what’s going on in terms of what the buyer pool will look like.

Stuart Oberman: [00:11:04] I mean, just great information. So, literally in 15 minutes, you’ve hit on some amazing topics, purchase price, holdbacks, earnouts, length of terms of employment contracts, real estate, restrictive covenants, equity earnouts, real estate exclusivity binding. I mean, this is a seven day conversation that we’re putting in to, like, 15 minutes. So, you did an enormous, enormous job outlining everything. Is there anything else you want to add that may be of importance to buyers or sellers on any kind of transaction regarding an LOI until we jump into our tax side of the sale?

Lauren Mansour: [00:11:49] I mean, I just think overall, regardless if you’re the buyer and you’re looking at terminating employment, maybe even before you sign a purchase agreement, which I think you need to be cautious about, I think it’s very important for a buyer to have a LOI that’s clearly spelled out so that you know both parties are on the same page with respect to most of the major terms.

Lauren Mansour: [00:12:11] And then, a seller, especially with these very complex group LOIs, I think it’s also important, one, just to understand everything and sometimes to flash things out a little more fully than they even are in that group. LOI, just because, again, I feel like at times you have more negotiation power at the LOI stage. So, once you’ve signed something, if you didn’t understand it or we think, “Oh, this isn’t really market, let’s see if we can change it,” it sometimes becomes more difficult.

Lauren Mansour: [00:12:41] And so, I think it’s a good idea to have that letter of intent reviewed and to fully negotiate it at that stage while the buyer is basically courting you versus after you’ve already signed. So, I think that would be my advice is definitely to pay attention, not to disregard the LOI and to make sure that you’re comfortable with all of the terms.

Stuart Oberman: [00:13:01] Yeah. That’s just great information. Like I said, this is a seven day conversation and we’re trying to boil it down into a relatively short period of time, if you will. Lauren, thank you very much on that.

Stuart Oberman: [00:13:12] And now I want to jump over to Danielle McBride, who does an enormous amount of transactions as does Lauren on a national basis. And Danielle is our resident tax attorney, also extraordinaire, she’s got a master’s in tax. And I know that this could be a 75 day conversation on tax, but there’s so many things that can really go sideways regarding tax issues in a merger and acquisition. And, Danielle, I want you to touch on a few of those sort of landmines, if you will.

Stuart Oberman: [00:13:49] And then, Lauren said to two things. I want to know the tax consequences on earnout and what that looks like. And, again, I know there’s so much information you can provide. But I want you to to discuss some of the tax issues that you run into through your training and experience. And you’ve been on both sides of the fence. You also done state planning for tax issues. So, you’ve got a well-versed bullpen, if you will. So, Danielle, take it away. I want to hear some things that our listeners want to hear about.

Danielle McBride: [00:14:27] Sure. I would just start off by saying I completely agree with Lauren, though, about consulting with your advisors on the letter of intent on some of these concepts, because if you don’t get them flashed out, you don’t understand them. And then, especially with a corporate sale, it becomes sometimes impossible to negotiate off of those things that are in the letter of intent with them.

Danielle McBride: [00:14:51] So, I do agree with her. It’s really important to look. Just because people tell you letters of intent are nonbinding, don’t skip that step in having it reviewed by your advisor because it makes the our job a lot more difficult and it could really change some of the tax consequences for you.

Danielle McBride: [00:15:10] So, as far as tax implications, there’s sort of some basic tax implications on these deals, whether it’s a private party or a corporate sale. You know, it gets more complex when you’ve got the corporate sales and the DSOs that are buying these, and you’ve got the rollover equity, and earnouts, and holdbacks, and those sorts of things. So, your basic tax consequences, you’re got a sale of assets, tangible assets, your fixed assets, and you’ve got your goodwill.

Danielle McBride: [00:15:43] The goodwill can be a big deal and there can be some tax traps there as far as is this professional personal goodwill, is it corporate owned goodwill, and how is that allocated. You know, there can also sometimes be some negotiation as to how much is allocated on the side of the goodwill versus the tangible assets. And there are a few differences between those tax implications and whether buyers and sellers, whether it’s private party or a corporate sale, how much are you going to allocate to either transaction.

Danielle McBride: [00:16:23] So, the complexity comes from the corporate sales and when you’ve got these holdbacks and rollover equity. So, a private party is pretty much going to pay you cash at closing. So, you’re going to have your tangible assets and your goodwill allocation. You’re going to have a portion that’s taxed at ordinary rates. You’re going to have a portion that’s taxed at capital gains rates. Usually, the bulk of that is capital gains for your goodwill allocation.

Danielle McBride: [00:16:48] But on a corporate deal, you’re not getting all cash at closing. You’re usually getting maybe 70 to 80 percent as cash at closing. And the rest is in these earnouts, holdbacks, and rollover equity, like Lauren mentioned.

Danielle McBride: [00:17:02] So, that rollover equity piece, earnouts, and holdbacks, those are usually taxed. They’re usually tied to compensation, performance triggers, and things like that. They’re paid over time. And a lot of times those are paid as compensation, and you get taxed at compensation rates, at ordinary income rates for those.

Danielle McBride: [00:17:22] Your rollover equity, though, you can get tax deferral on that rollover equity. So, you’re investing in a parent company or a holding company that one of these corporate buyers has. And so, you’re contributing assets in exchange for goodwill often. And so, you’re getting a tax deferral on this rollover equity under Section 721. And you don’t recognize any tax on that until you sell it later, until that company has what they call a liquidity event, or they bring in a new private equity buyer, or they sell the entire company.

Danielle McBride: [00:18:09] Some of these are scaling up and then they sell the entire business to someone new. That’s when you would wind up with your taxable event and recognize capital gains tax, usually, because your contribution of assets is typically goodwill contribute in exchange for that rollover equity.

Stuart Oberman: [00:18:32] I have one question for you. So, on the capital gains side, you mentioned 721. Now, you’ve got another podcast coming up where we’re actually going to touch even more on 721s, which are critical to the tax consequences. But one thing I want to know is, is investment in shares – our clients get letters of intent and it’s A shares, C shares – what is the difference on the tax consequences, if any, on those particular A shares or B shares or C shares?

Lauren Mansour: [00:19:07] Sure. Well, in most cases with a seller, they’re receiving A or B shares, typically it’s B shares. The A shares will be held by the members who created the entity. Those owners, the directors, the managers of that business, they may hold the A shares, which may mean that they have more authority, more management power. That’s usually the big difference between class A, class B shares. Class A shares can sometimes have a preferred return where money is paid out to those Class A shareholders first before the Class B shareholders, which are usually all your doctors.

Danielle McBride: [00:19:43] You can also have Class C shares where you don’t have a typical equity, but maybe you have an associate. Seller has an associate who they want to keep on board. Buyer wants them to stay on board so they offer some Class C shares that are really a profits interest in the business. And those can be subject to vesting requirements, and continued employment, hitting performance triggers, things like that, and they won’t get a return on those until they hit the four years that they have to work with them.

Danielle McBride: [00:20:21] So, those Class C shares, usually, they don’t share in the existing value of the practice. It’s usually just a go forward thing. So, once those shares vest, they will have a piece of the pie in any growth in the business, not in the existing value of the business, and those can get complicated.

Danielle McBride: [00:20:46] And, now, there’s something called an 83B Election that can come in, so you’re not getting taxed, so you can limit your tax consequences and get a substantial portion of this growth in capital gains versus ordinary income tax like compensation on these amounts. It can get very complicated.

Stuart Oberman: [00:21:06] 83B sounds like another podcast.

Danielle McBride: [00:21:09] Yes.

Stuart Oberman: [00:21:09] I think you just teed yourself up to another at bat here. I got you. I got you. Well, you know, the funny thing, I’m listening to you talking all this information, and it’s amazing to me how many -and I hate to say this – CPAs and financial advisors don’t understand this when they get into these transactions. And then, it becomes very complex when someone like you understands the absolute tax side of this has a financial adviser on the other side and doesn’t explain or can’t explain to the seller why it is so beneficial, yet risky to a certain extent, in the long run.

Stuart Oberman: [00:21:53] So, I’m sitting here listening to all this and these are the questions that our CPAs are asking us – they’re asking you, they’re not asking me.

Danielle McBride: [00:22:05] Yeah. Yeah. Definitely. They’re asking me in.

Stuart Oberman: [00:22:08] They ask me these questions, I’m getting you on speed dial, so we’re good with that. We’re good with that.

Danielle McBride: [00:22:12] Yeah. Yeah.

Stuart Oberman: [00:22:13] I tell you, like I say, we got another podcast coming up with you and I know we’re going to cover 721 and 83Bs. But, Danielle, thank you so much for this information. I think the information that you gave was just enough to let our clients know, our listeners know, or maybe they’re not even doing business with us but, yet, they’re going to get their financial advisors, their CPAs, and their lawyers involved. But, Danielle, extraordinary job. I look forward to our next podcast. And I know Lauren’s going to have some further input later on down the road on some of these podcasts.

Stuart Oberman: [00:22:54] But, folks, we are about to conclude the Advisory Insights podcast. My name has been Stuart Oberman, Oberman Law Firm. So, if you want to reach out to Lauren, please feel free to email Lauren at lauren, L-A-U-R-E-N, @obermanlaw.com. And danielle, D-A-N-I-E-L-L-E, @obermannlaw.com. A phone number for the firm is 770-886-2400.

Stuart Oberman: [00:23:23] Folks, thanks so much for listening in. Danielle, Lauren, thank you so much for your time. And I know it’s invaluable, invaluable information. Ladies and gentlemen, thanks a lot. Have a fantastic day.

Outro: [00:23:37] Thank you for joining us on Advisory Insights. This show is brought to you by Oberman Law Firm, a business-centric law firm representing local, regional, and national clients in a wide range of practice areas, including health care, mergers and acquisitions, corporate transactions, and regulatory compliance.