Tax Considerations in Selling a Medical Practice in Today's Market

As seen in Crain's New York Business

The Affordable Care Act (ACA) passed in 2010 has brought a wave of consolidation to the medical practice industry. Driving this trend are the significant new demands placed on medical practices because of the ACA’s ‘triple aim’ to improve the patient care experience, improve the overall health outcomes for patients, and reduce the per capita cost of healthcare. Medical practices have been forced to make a significant investment in electronic health records and shift their reimbursement model from a fee-for-service model that ties payment to volume, to a new, fee-for-value model tying payment to meeting cost and performance thresholds. With these new demands, more medical practices are finding it difficult to stay independent.

Compounding the issues noted above has been the deep and widespread impact of the coronavirus pandemic. Patient volumes have declined precipitously, while patient demand for comprehensive telehealth and other virtual health options has skyrocketed.  

According to the Healthcare Financial Management Association’s (HFMA) Health Care 2020 Report, M&A growth for medical practices has surged in the past few years and will stay strong in 2020. While M&A activity in the first and second quarters of 2020 has been well below expectations, it is anticipated that an even larger wave of deals will hit the industry over the next 12 months as medical practices feel the sustained financial impact of the coronavirus pandemic. The two primary acquirers of medical practices have traditionally been health systems and private equity investors.

Health System Acquisitions

Health systems are typically interested in acquiring medical practices for two primary reasons. First, in order to spur success under the fee-for-value reimbursement model, health systems have attempted to align themselves with a sufficient number of providers, across the continuum of care, to take on significant risk with patient populations. Second, health systems are interested in shoring up downstream referrals into their hospitals —particularly as the number of hospital-based services continues to decrease due to price pressures and the increasing ability to provide care in an ambulatory setting.

When a health system acquires a medical practice, the physician owner (“PO Seller”) typically sells 100% of their ownership interests and becomes a health system employee. The value in the practice is typically created because the PO Seller’s post-acquisition compensation as an employee is directly related to the provision of medical services as opposed to the profit of the business.

Private Equity Acquisitions

Private equity firms believe the consolidation of medical practices can offer a strong investment return for numerous reasons, including current market fragmentation, insufficient capital invested in medical practices, and an aging population. This combination of increasing demand and current inefficiencies in the market is attractive to private equity firms that have a driving imperative to put investors’ capital to productive use.

When a private equity (“PE”) firm acquires a medical practice, it generally purchases a majority of the medical practice’s equity, while the PO Seller retains the remaining equity. After a holding period that typically ranges from three to seven years after the sale, the PE firm will look to sell the medical practice to another buyer, in what is referred to as a “second bite of the apple” transaction.  

Many medical practices are structured as a pass-through entity (“PTE”) such as an S-Corporation, partnership, or limited liability company. The biggest advantage of a PTE, as compared to a C-Corporation, is the single level of taxation on income generated by the PTE. In general, the sale of a PTE ownership interest by a PO Seller produces tax results similar to the sale of stock in a C-Corporation. However, an asset sale by a PTE results in one level of tax paid by the PO Seller verses the double taxation of a C-Corporation.

While a PTE only has one level of tax, the character of the assets sold by the PTE will determine the tax rate attributed to each class of asset. For example, the sale of accounts receivable, furniture and fixtures, and other tangible property are typically taxed at the ordinary income rates, while intangible assets (such as goodwill) would generally receive favorable capital gains tax treatment.

In addition to the federal income tax burden PO Sellers face, state taxes can potentially reduce the amount of net proceeds to a PO Seller by eight percent or more. Similar to federal income tax, the form of the sale and type of legal entity play an important role in determining the state tax costs of a transaction. However, the state of residency (for purposes of this article, residency and domicile have the same meaning) of the PO Seller can have the most significant effect.

In general, the sale of the stock in a C-Corporation or equity interest in certain PTEs should only be taxed by the PO Seller’s state of residency. For example, if a PO Seller’s state of residency is New York State, the PO Seller will pay up to 8.82% on any gain from the sale of stock as compared to zero if the PO Seller was a resident of Florida. The state tax costs can go up substantially if the PO Seller is a New York City (12.7%), New Jersey (10.75%), or California (13.3%) resident. Alternatively, if the PTE sold its assets, the gain from the sale of such assets will typically be taxed by the state(s) where the medical practice does business.

While changing the state of residency for a PO Seller is not always possible, if the PO Seller is contemplating retiring after the transaction and is considering living in a no-tax or low-tax state (Florida, Texas, Nevada, etc.) post retirement, proper planning before the transaction happens could result in significant state tax savings.

Conclusion

It is critical that PO Sellers pay appropriate attention to the tax considerations of a potential sale. Proper tax planning takes time, and therefore, should be considered when the possibility of a sale first arises.