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AHLA Tax & Finance Practice Group Member Briefing

My article Converting Physician Practices to Tax-Exempt Status: Is There an Upside to the Downturn? was published earlier this week as a Member Briefing by the American Health Lawyers Association. I would like to thank the editors, who included Travis Blaisdell at Mintz Levin, for their efforts in translating my submission into a form appropriate for the AHLA audience.  After my Journal of Accountancy article and ABA Health Lawyer article with Reed Tinsley, this is the third most edited article I have had published. The article contains some observations that are particularly important in the current environment.  Among these are the

1. Import in an appraisal of considering the tax impact of a liquidation when a taxable practice converts to exempt status

2. Continuing importance of the DCF method in determining whether and to what extent a practice has Intangible Value. I continue to believe that absent extraordinary circumstances, the Cost Approach should not supplant the Income Approach as the appropriate reference point in Healthcare Valuation.

3. Valuing the Transaction reflected in the transaction documents as required by the Derby case discussed elsewhere in this BLOG

4. Considering local law as to the enforceability of noncompete and similar provisions

5. Considering limitations on obtaining both debt and equity capital in the current environment on the discount rate and/or the consideration of marketability.

See this earlier Post: http://cpanet.typepad.com/cpanet/2009/03/exempt-organization-cpe-text.html

Managed Care and Taxation in the UK

I have been in London where I’ve had the chance to meet and consult with representatives of the burgeoning private practice physician organizations to discuss the progression of American-style managed care and regulation and what the stages might look like – and none too soon it would appear.  I was also granted the opportunity to give a seminar on valuation of physician practices for tax purposes and describe the significant differences between US and UK tax policy and how it might affect value – notably, there is no equivalent to IRC section 351 and the transfer of goodwill to a corporation by an unincorporated individual in the UK is a taxable event.  The taxation and value of physician goodwill have become quite important as the number of private physician practices has climbed in response to the partial move away from National Health Service (NHS) to a mix with private health insurance. Many doctors have begun private practices in addition to their weekly commitment as employees of the NHS. There are quite a few private hospitals in London as well, some owned by large American companies, notably HCA. Private health insurance and the related export of American-style managed care is somewhat surprising, particularly in light of present trends here in the US.

 

I have been invited to write an article for the leading physician trade magazine on managed care and its stages of progression and once it is published, I will post excerpts of it here.

Exempt Organization CPE Text

My October 10, 2007 discussed the several IRS CPE Texts that are relevant to valuing physician practices for purchase by hospitals or Integrated Delivery Systems. I should have mentioned an obvious one there, the 1996 EO CPE Text Valuation of Physician Practices (eotopicq96.pdf). Look at the discussion beginning at the bottom of page 22 and particularly that on page 23 with respect to Medical Records. This is where the IRS first made it clear that you had to have intangible value under the income approach before the cost approach became relevant. In my view, that is true anyway but particularly so in light of Derby, discussed elsewhere on the BLOG.

You can obtain eotopicq96.pdf at http://www.irs.gov/pub/irs-tege/.

Observation on Reasonable Comp

A colleague and I had an exchange on reasonable compensation today and it reminded me of a point I often see missed in valuation of small businesses and professional practices: the compensation assumption in a CCF or Excess Earnings Model is PERPETUAL and increases at the growth rate used to determine the cap rate. As such, any measure of reasonable comp based on entry level salaries is likley not relevant for a capitalization model and can also lead to significant error. This is due to the fact that professionals can experience a fairly rapid increase in salary from their intial year as they "ramp up" and reach a normal level of productivity in the workplace.

For physicians, some of this difference can be gleaned from the Merritt Hawkins Annual Survey as well as the difference in reported salaries in the MGMA data using All Physicians, Partner/Shareholder Physicians and Physicians with 1-2 years experience.

Similarly, a low initial salary followed by a "low or no" buy-in and high partner income can also be explained by a combination of recruiting demand and higher-than-entry-level long-term compensation expectation. The low buy-in price reflects the new professional's high perpetual income expectation and as such a lower level of profit or excess earnings from ownerhship.

Health Lawyers Weekly

My article with Greg Anderson of Horne on WRVU Conversion Factors and the Fair Market Value of Physician compensation appeared in the November 15, 2008 edition of Health Lawyers Weekly from the AHLA. You can download it here.

Download HLW_article_Anderson_Dietrich.pdf

Derby et al v. Commissioner

My article on the above case, What Goes Around Comes Around, is in the current (Fall) edition of the AICPA's CPA Expert. I described it in a post to the BLOG back in May.  http://cpanet.typepad.com/cpanet/2008/05/index.html

You can download it at the link below.

Download fall_expert_what_goes_around_comes_around.pdf

Fair Market Value and Income for Support: NOT the Same Thing

Today I am reminded again that the income of a practice in the hands of the hypothetical owner of the fair market value standard is not the same thing as the income from that practice to the existing owner for purposes of support.  For example, if industry-normal overhead is say 60% and the subject practice has overhead of only 40%, the appraiser may well need to normalize expenses to determine what the fair market value of the practice is. On the other hand, if the practice is operated by the existing owner at a low overhead because, for example, he does his own office cleaning, supply purchasing, grounds maintenance and the like and intends to continue to do so, support income will be greater than the income in the hands of a hypothetical owner - who, based on industry-normal practice, will pay someone else to clean toilets and cut grass.

Post-Transaction Compensation

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 http://www.irs.gov/pub/irs-tege/. 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.

Enterprise and Personal Goodwill

In preparing for my recent course on the topic of this post, I came across a Technical Advice Memorandum from the IRS - 200244009 - dealing with a Physician Practice Management Company Transaction that cited Martin Ice Cream as the basis for part of the decision - which was highly favorable to the taxpayer. Well worth the read if you happen to be structuring such a transaction, or in any event if you have an interest in the area.

In connection with an upcoming piece (TBA)  I have also been giving some thought to the implications of the 8th Circuit's decision in Exacto Spring on reasonable compensation under an independent investor test. At least for medical practices, service businesses in general and many small businesses, reasonable compensation is the key factor in determining the value of the business. The difference between personal and enterprise goodwill should be a key factor in reasonable compensation; it is also a key factor (Martin Ice Cream and Norwalk) in allocating sale proceeds. An Exacto Spring reasonable comp analysis should also consider who owns the underlying goodwill - the corporation or the key employee.