Every day, you work hard to treat your patients and keep them healthy. And if you own a medical practice, you have to work just as hard to keep your business healthy. One way to do that is with a buy-sell agreement.
Buy-sell agreements are a crucial part of protecting the future of your practice — and protecting your family members and the other partners in your practice. Why? To find out, ask yourself these questions:
- Who would take over your part of the medical practice if you died or became disabled?
- How would your death or disability affect the other physician-owners and their families?
- If one of the other partners in your practice died or was disabled, would his or her family then control his or her share of the practice?
- If you wanted to buy the deceased partner’s share of the business from his or her family, would you be able to come up with the capital to do so?
- If you died or became disabled, would your family continue to reap the benefits of all of the hard work you’ve put into building your medical practice?
- If you decided to retire, what would happen to your share of the practice?
As you can tell, if one partner in a medical practice dies or becomes disabled, it affects their families, their partners, their partners’ families, and the business. A buy-sell agreement protects everyone involved.
What is a buy-sell agreement?
A buy-sell agreement is a legal agreement between owners of a medical practice that ensures that the other practice owners have the right, and the resources, to purchase the shares of a practice if a physician-owner dies, is disabled, or wants to retire. Buy-sell agreements are typically funded by life- and disability-insurance policies, which provide capital for the owners to purchase the business shares of the disabled or deceased partner.
Here’s how it works
Dr. Smith, Dr. Jones, and Dr. Peterson have a medical practice together. Each physician owns 33.3 percent of the practice and contributes equally to the bottom line. The business would suffer if any one of them were not working.
After a few years of practicing together, they all agree it’s a good idea to have a buy-sell agreement. The three physicians ask an appraiser to come in and appraise their practice, so they know how much each share is worth. Then, they have an attorney write up a buy-sell agreement. In order to fund the buy-sell agreement, they take out both life and disability policies on each other, so if any of them was to die or become disabled, the other owners would receive the life or disability benefit in order to have the capital to purchase the absent partner’s share. They update the valuation of the business annually to make sure the buy-sell agreement and the corresponding insurance policies are still in line with the value of each partner’s share of the business.
At age 56, Dr. Smith suffers a heart attack and dies. The practice is left reeling. A third of their business income is gone instantly. Dr. Smith’s family is also suffering, because they are suddenly left without their main breadwinner and income. Because of the life-insurance policies taken out to fund the buy-sell agreement, Dr. Jones and Dr. Peterson each receive a lump-sum benefit, which they then use to purchase Dr. Smith’s portion of the business from his surviving family members. Now Dr. Jones and Dr. Peterson are the sole partners, and have the power to determine who they want to hire to replace Dr. Smith. Dr. Smith’s family financially benefit from the sale of his portion of the business.
Because a buy-sell agreement was already in place, the family and partners are spared the unpleasant task of negotiating while they are mourning the death of Dr. Smith.
Two types of buy-sell agreements
The scenario above describes a cross-purchase buy-sell agreement, where each individual owner purchases life and disability policies on the other owners and pays premiums from his or her own personal accounts. The main advantage of a cross-purchase agreement is that there is no taxation on any gain if the partners decide to sell the old owner's shares to a new owner.1 When there are more than two partners in a practice, they can use a trust to stand in for the individual partners when purchasing the policies, in order to simplify administration.
The other type of buy-sell agreement is an entity-purchase buy-sell agreement. In this type of agreement, the life- and disability-insurance policies are purchased through the business (or “entity”) and the benefit goes to the business, which then purchases the disabled or deceased owner’s interest. The advantages of an entity-purchase agreement are that premiums for the life and disability policies are paid for through the business account, instead of personal accounts, and the insurance policies’ cash value is shown as a business asset on the balance sheet.2
Practice owners can also set up a “hybrid agreement,” which is a combination of the cross-purchase and the entity-purchase agreements. A hybrid agreement is also called a “wait and see” buy-sell agreement, because it defers the decision about who purchases the deceased partner’s share of the business — the practice entity or the partners — until after the partner is deceased or permanently disabled.
A financial advisor can tell you which type of buy-sell agreement may work best for your practice. In addition, you will want to consult with an attorney who specializes in buy-sell agreements, an insurance advisor who can help you secure life and disability policies to fund the buy-sell agreement, and an appraisal firm that can help you place a monetary value on each partner’s share of the practice.
With a buy-sell agreement and related insurance policies in place, you and your partners can have peace of mind that your practice will run smoothly for years to come, no matter what challenges its partners may face.
1 The CPA Journal, Understanding Buy-Sell Agreements, by Howard Davidoff, April, 2006, http://www.nysscpa.org/cpajournal/2006/406/essentials/p58.htm. Accessed October 27, 2010.
2ING, Entity Purchase Agreements: Buy/Sell Planning Using Life Insurance. Consumer Overview brochure, August 2004.