In an effort to recruit new radiologists to their group, 10 existing shareholders of a practice had agreed to exclude the accounts receivables from the new radiologists’ buy-in formulas. The existing shareholders, who had bought in at a price of approximately $100,000 with after-tax dollars, would continue to have a buy-out using the same approach and dollar amount that they had bought in with.

The issue became apparent when it was recognized that as the 10 original radiologists retired, the corporation would repurchase the stock from them with non-deductible dollars. This meant that approximately $1 million ($100,000 x 10 radiologists) would leave the corporation in a nondeductible manner and thus the corporation would incur a tax liability of approximately $400,000 in federal and state income taxes. In the past, the corporation had new radiologists buying into the corporation with monies that were not taxable to the corporation to offset the nondeductible buy-out payments. Since this no longer was going to incur, the corporation was somewhat in a quandary. It certainly could not afford to incur the $400,000 tax liability associated with the nondeductible buy-out.

To discuss the buy-ins and buy-outs for radiology groups, we need to break the practices into their two natural components;

  1. The professional entity. This entity builds and collects the revenue from professional fees only, and
  2. The technical entity. This entity does global billing and pays for the professional read. It employs all imaging center staff. This entity owns all the imaging equipment.

The second important aspect to emphasize when discussing valuation of radiology practices is whether the transaction being discussed is between radiologists who will be joining a practice or another party such as a hospital system or independent third party. This article focuses on transactions between radiologists who have been working together.

VALUING PROFESSIONAL ENTITIES

The major issues related to professional entities valuation include the following;

  • Recruiting and retaining radiologists.
  • Keeping the calculation and the method simple.
  • Allowing the transaction to be fair between the buyers and the sellers.
  • Doing it in a tax efficient manner.

When designing the buy-in and buy-out agreements for a radiology group, it is always important to keep in mind that what is good for the corporation, is good for the individual shareholders within these agreements. Of course, the opposite is also true. Individuals can push for a big buy-out, but if the corporation cannot afford to pay it in the years to come, it does not do the individuals any good.

The buy-in/buy-out agreements of a professional entity can be broken into three components.

  • Stock methods
  • Accounts receivable/deferred compensation
  • Income distribution formula (compensation)

Common methods for the valuation of the stock related to the professional entities are as follows:

  • The “easy in/easy out” method
  • Book value method, and adjusted book value

Easy In/Easy Out . The easy in/easy out method is simply a fixed amount to buy into the corporation and the buy-out is the same. This can be $1,000 or $50,000. The advantages to this approach are that it is very simple and there is no cost to calculate the buy-in and buy-out. In addition, it can serve as a recruitment incentive if the buy-in price is low enough. Groups that use this method believe that the radiologist earns his income during his career and that no individual should profit from the buy-in of a colleague.

The disadvantage is that there is no incentive for radiologists to invest into the practice as they near retirement. To invest in any equipment or a new location merely reduces the individual physician’s compensation, and there is no hope to recoup the investment in the form of a buy-out.

Book Value and Adjusted Book Value Methods . Figures 1 and 2 show the calculation associated with the book value and the adjusted book value methods. These are fairly simple methods in that there is little cost to calculate. It does provide some opportunity to reflect the value of equipment purchases.

Figure 1. The book value method of valuing the practice provides the opportunity to reflect equipment purchases.
Figure 2. The adjusted book value method of valuation provides the ability to reflect the fair market value of the technology.

Two important things to note are:

  1. Patient accounts receivables are not included in this calculation. Some groups are finding it difficult to charge new radiologists for the accounts receivable (A/R), so they have ceased doing it in order to make recruitment easier. Other groups handle the A/R buy-in through a separate calculation and do it through compensation reduction as discussed later in the article.
  2. Note that the buy-in price is different if the payment goes to the practice for new shares versus the payment going to the existing shareholders (a cross purchase). The buy-in is greater because the new shareholder will own part of the cash that he is contributing. If the practice was to distribute or bonus out the cash, the new shareholder would share in it and thus should pay more. If the buy is structured as a cross purchase, the practice does not increase in value and thus the lower price. It is highly recommended that the payments on a buy-in go to the practice as opposed to the existing shareholders. It serves as long-term capital for the practice and helps fund the buy-outs as physicians retire. If the pay out in payments go to the individual radiologists, then the incoming radiologist should individually buy-out radiologists as they retire (very tough to do!)

The difference between the adjusted book value method and the book value method relates to the value of the equipment. These methods are chosen when the group believes that the value of the equipment is greater than what shows on the tax return or financial statements (due to rapid depreciation methods), so it adjusts them to be a better approximation of fair market value. The adjusted book value method indicates that a piece of equipment will never be valued at below 50% of cost if it is still being used. It is a simple method, but it may result in overvaluation of the equipment.

Another method is to keep separate depreciation schedules that choose longer lives for some of the equipment. Using a 10-year straight line with a 20% residual value is one method that has gained acceptance for many groups.

High-technology assets could use a shorter timeline.

These methods can get complex as a practice grows and it adds large amounts of equipment and leasehold improvements. It is important to emphasize that any method is just an approximation of the value and you should try not to treat it as a science. Rounding the value to the nearest thousand can help reinforce this concept.

There are many methods that could be used in determining the valuation of a buy-in and a buy-out. Some groups go through a process related to calculating the book value or adjusted book value and adding a goodwill component to that. It appears that there are very few practices that are able to warrant a goodwill component to the valuation of their practice in today’s marketplace. If it does happen, it seems to be in a practice where the income levels are extremely high.

A/R AND DEFERRED COMPENSATION

Joseph P. White, CPA, MBA

The second component of the buy-in for a radiology practice often relates to the accounts receivable buy-in. A major difference compared to a stock buy-in is that the accounts receivable is commonly done with pretax dollars for the buyer. The buy-in payments are shifted through salary reductions to the original shareholders. It is very important that these and any legal agreements be drafted by an attorney who has a strong understanding of the tax issues associated with these transactions. Documents must be drafted in accordance with appropriate revenue source, codes, and regulations to ensure that they are treated properly.

The common methods related to accounts receivable/deferred compensation are as follows:

  • No buy-in/no buy-out
  • Vesting method
  • Traditional buy-in
  • The frozen accounts receivable method

No Buy-in/No Buy-out . This method has been used as a negotiated arrangement at some point when there was difficulty recruiting radiologists. It also tends to be seen in larger groups. The advantages are that it is simple and it promotes recruitment. The disadvantage is that very often there is a fairness issue as it relates to some of the original physicians who bought into the accounts receivable and/or incurred the cost of the ramp-up of accounts receivables when the practice started. If there is no buy-in, usually there is no buy-out or deferred compensation payment when a physician leaves the practice.

The Vesting Method . This method is similar to the no buy-in method. However, when a physician does leave, the group does share in the accounts receivable. To protect itself, the group puts in a vesting schedule. The vesting schedules range from 10% per year for 10 years or 0% over the first 5 years and then 20% per year. At the end of the vesting period, if a physician leaves the practice during the vesting time frame, they would receive their prorated share of the accounts receivable times their vested percentage.

Once again, this is a fairly straightforward and simple method and aids in the recruitment of radiologists. The disadvantage is that the buy-in does not match the buy-out. The individual physician buying-in did not pay for the accounts receivable, yet is receiving them when they retire or terminate after a period of time.

The Frozen Accounts Receivable Method . In this method there is no buy-in to the accounts receivable, but the radiologist buys-in shares in the increase of the accounts receivable as of the effective date that they became a shareholder. For example, assume the accounts receivable are worth $1 million on the effective date of the buy-in and this is the tenth radiologists to be an active shareholder in the group. If the accounts receivable went to $1.2 million, and the most recent radiologist to become a shareholder left the organization, he would share in 1/10th of the $200,000 increase. A radiologist who had been a shareholder the entire time and left the organization would receive $131,111 (1/9th of 1 million plus 1/10th of $200,000).

This method can get quite complex as the number of shareholders increases and multiple layers are created over many years. In addition, it is very possible for accounts receivable to decrease over time and thus when an individual leaves the practice, in theory, he or she could owe the other partners money related to accounts receivable valuation.

Income Distribution Formulas . Many groups have moved away from exact computations related to accounts receivable buy-ins. Instead, after a period of time (1 to 2 years), the associate goes off salary and receives compensation equal to a percentage of a full shareholder compensation level for a few years. Some examples include the following:

  1. 60% the first year, 80% the second year, and 100% the third year.
  2. 80% the first year, 90% the second year, 95% the third year, and 100% the fourth year.

The deferred compensation payout then tends to be a percentage of the final W-2. This approach is very straightforward, and it reduces the complexities and removes any potential disagreements related to the purchase of accounts receivable. Depending on the percentages used, this amount can be approximately equal to a prorated share of the accounts receivable or potentially greater.

TECHNICAL ENTITIES

Many radiology groups own imaging centers in a separate entity. The valuation methods that can be used “between radiologists” include many of the same methods used for stock valuations. These include:

  • Easy in/easy out
  • Book value and adjusted book value
  • Percentage of the income distributed

In addition, many groups use the book value plus a multiple of earnings. Many radiologists see this as a separate business venture that they believe requires a separate valuation method. In the development of the imaging centers, they took a greater amount of risk and incurred substantial start-up costs. They see the imaging center profits differently than they do the earnings from their professional practice. Some of the earnings from the imaging center relates to the investment of capital and an appropriate return on that capital.

Some groups are using a very low multiple (one to three times) of net income or profits plus book value for calculation of value for buy-ins and buy-outs between radiologists. This method will tend to provide a 20% to 40% annual return on investment for individuals buying into the practice, assuming a consistent profit stream. Returns at this level make it an easy sell to new radiologists joining the practice.

The valuation of imaging centers as it relates to transactions between parties outside the radiology group should have a traditional business valuation completed by a qualified appraiser. This type of valuation or appraisal will cost approximately $4,000 to $10,000, depending on the size and complexity of the entity being appraised but will take into account many intangible variables associated with the business (market share, name recognition, and quality of staff). An appraisal of this type tends to take a futuristic look at the imaging center as opposed to a pure historical calculation.

CONCLUSION

Whenever an organization reviews its buy/sell agreements, it should always keep in mind that the arrangements should be designed to protect the entity. It is good to see provisions that include the payouts over an extended period of time (5 to 7 years) and at interest rates that are at prime or below. Deferred compensation payouts tend to be over a shorter period of time; however, they usually do not include any interest factors associated with their buy-out payments. One final provision to consider limits the number of buy-outs that can occur at any one time and/or as a percentage of net income. This is a wise way to protect the corporation.

The time to review the buy/sell agreements is before somebody leaves the organization. The group with the $400,000 tax problem resolved their issue by shifting a major portion of their stock buy-out to a deferred compensation arrangement. This meant they would lose the favorable capital gains treatment, but it was the best thing for the corporation. The fact that the nearest planned retirement was more than 5 years away allowed the group to reach consensus relatively painlessly.

Joseph P. White, CPA, MBA, is a principal of LarsonAllen, Minneapolis, specializing in serving physician groups and individual physicians in financial planning, auditing, tax, and business consulting.