Nearly one in five AAOS members is in solo practice, according to the 2012 Orthopaedic Surgeon Census. More than half of AAOS members are part of a private group practice. And the average age of AAOS members is 55 years. Based on these statistics, many members may be wondering what will happen to the practice when a partner retires, becomes disabled, or dies?
Some practices may already have strategies for acquiring a partner’s share and redistributing it or transferring it to a new partner. But many practices may not. Implementing a properly structured and funded buy/sell agreement can not only help protect the business owner and his or her family, it can also ensure a practically financially painless transfer of the practice.
Buy/sell agreements are generally triggered by one of three events: death, disability, or retirement of one of the partners. Many physicians, especially those who are younger or new in practice, don’t take the time to prepare for future unknowns. However, beginning buy/sell preparation earlier not only helps to protect the practice throughout a career, but may result in overall lower costs. Proper preparation by partners can help alleviate the stresses if one of the three triggering events occurs unexpectedly.
Types of agreements
The two most common types of buy/sell agreements are the cross-purchase agreements and the entity purchase agreements. Determining the type of strategy that’s best for a particular practice depends on many factors, and it’s wise to work with both a qualified financial advisor and an attorney.
A cross-purchase agreement typically works well for a small partnership. Under this arrangement, the owners of a practice agree that, on the death of either partner, the survivor will buy the other’s share of the practice for a specified amount of cash.
Life insurance may be used to fund this arrangement, with each partner purchasing and owning a policy on the other partner. Each partner pays the premiums and is the owner and beneficiary of the policy on the other partner. When one partner dies, the survivor receives a tax-free death benefit from the policy that can be used to buy the business shares from the decedent’s estate or family. The surviving partner then becomes the sole owner of the practice.
An entity purchase agreement works in the same way, except that the practice owns the insurance and is the beneficiary of the policy. Entity purchase agreements are typically used for larger groups with more than two owners.
Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender periods. Policy loans and withdrawals may create an adverse tax result in the event of a lapse or policy surrender and will reduce both the cash value and death benefit. Depending on actual policy experience, the policy owner may need to increase premium payments to keep the policy in force.
Buy/sell arrangements are advantageous for several reasons, including the following:
- Guarantees a buyer: A buy/sell agreement provides a guaranteed buyer of the business—at fair market value—upon an owner’s death, disability, or retirement.
- Creates liquidity for deceased/disabled owner’s family: Buy/sell agreements can require the business or surviving owners to purchase the ownership interest of the deceased or disabled partner, allowing liquid assets to be distributed to the family.
- Avoids conflict of interest between the surviving owner(s) and the family of the deceased or disabled owner: The family of a deceased or disabled owner may want income from the business, while the surviving owners may want to reinvest all excess profits back into the business. The buy/sell agreement will prevent outsiders from interfering in the business.
- Avoids valuation difficulties: Typically, a buy/sell agreement includes a method of estimating the value of the business and can also be used to help determine the value of the business for estate tax purposes.
- Solves lack of marketability issues: In general, closely held stock has no established market and finding a third party who would be willing to purchase an interest, particularly a minority interest, in a closely held business immediately after the death, disablement, or retirement of an owner-employee may be difficult. The buy/sell agreement, as noted above, guarantees a buyer.
Funding buy/sell arrangements
Buy/sell agreements may be funded in several ways. Under an unfunded or installment purchase arrangement, the surviving owners or business purchase the ownership interest of the deceased, disabled, or retiring owner with periodic payments. This method may put a strain on the cash flow of the business and may drastically affect the business’s profits.
Alternatively, the business or the owners may begin to set funds aside to buy out a deceased, disabled, or retired owner. The downside of this strategy is that the business may not have enough time to accumulate the assets necessary to fund the purchase. Additionally, if the business is a C corporation, retention of assets can trigger accumulated earnings taxes.
Another option is to use third-party financing to fund the buy-sell. Third-party financing can be difficult to secure after the death of an owner and may restrict the practice’s ability to secure additional loans for other business needs, such as expansion or working capital.
Life and disability buy-out insurance can also be used. As previously explained, the business or the owners can purchase life insurance on the lives of the owners to fund the buy/sell arrangement. If a permanent policy is used, owners may access the cash value through policy loans or withdrawals to help assist in a retirement buyout. The facility and ultimate cost of this option will depend on the health of the owners.
In the event of a disability buy-out, disability insurance can be used to fund the buy/sell plan. If an owner is out of work due to a covered disability for a specified time, such as 1 year, the insurance policy will begin payments to the other owners. Based on the legal agreement, the other owners can buy out the disabled owner for a previously agreed-upon value.
Practices interested in buy/sell agreements should pay particular attention to the legal contract. Funding the agreement properly is important, but precisely written and prepared legal documents are crucial. The practice’s attorney and financial advisor should work together to obtain the strategies best suited for the practice.
Because this article is written broadly, it cannot cover all the factors that should be considered in establishing the proper buy/sell strategy. It is extremely important that practices work with a professional, because errors in the process can result in unfunded plans, negative tax consequences, credit liability, and bad feelings among the partners. As with all estate considerations, being proactive is crucial.
Brian Carlson, CFP®, CLU®, CLTC, is vice president, insurance and investment services, for GCG Financial in Bannockburn, Ill.
Disclosure: Securities and advisory services are offered through Securian Financial Services, Inc. (SFS), member FINRA/SIPC. GCG and SFS operate under separate ownership.
Editor’s Note: This article is for general information purposes and should not be construed as providing financial advice. Individuals who need tax or legal advice should contact a duly licensed professional.