Physician Recapitalization Transactions: Three Common Business and Legal Issues

25 January 2023 Health Care Law Today Blog
Author(s): Roger D. Strode

With the pace of health care transactions showing no signs of slowing, we, at Foley, regularly counsel both investors and sellers of physician practices. 

The typical physician practice transaction involves the sale of all the nonclinical assets of the practice to an administrative services organization (MSO) designed to provide administrative and management services to the practice. The physician owners of the practice receive cash and certain amounts of so-called “rollover equity” in the MSO. The physicians remain employees of the practice and sign long-term employment agreements. The purchase price for the practice generally translates into some multiple of projected earnings before income taxes, depreciation, and amortization (EBITDA). If the practice is a “facility-based” practice, such as cardiology, gastroenterology, or orthopedics, as an example, the buyer often will acquire an interest in those facility(ies) owned by the practice or its physicians.

These transactions raise myriad issues. Recently, we’ve seen a spate of three unique business and legal issues that present challenges during these transactions, both for buyers and sellers.

Issues Regarding Allocations of Purchase Price

Physicians, especially those in private practice, tend to own equal, or nearly equal, shares of equity in the practice. They also tend to compensate each other based upon their production relative to each other and generally there is very little, if any, correlation between their compensation and their percentage ownership in the practice.

As noted above, purchase price in these transactions is generally expressed as some multiple of EBITDA, which is calculated through a discounted cash flow model. EBITDA is created by the physicians agreeing to take a “scrape” off, or reduction to, their post-closing compensation, often 20-30% of pre-closing compensation. Because physicians compensate themselves based upon their relative production, a 30% compensation scrape by one physician (Physician A) may result in the creation of much more EBITDA than a 30% scrape by a physician who historically has made much less money (Physician B). Thus, Physician A will take the position that since he has created more value than Physician B because he has given up more compensation (at a 30% reduction) Physician A is entitled to a larger share of the purchase price than Physician B.

As noted above, the owners of the practice, including Physicians A and B, generally own their equity in the practice in equal (or nearly equal) percentages. Here is where the fun starts: to make the transaction tax efficient the physicians will want capital gain treatment for the cash portion of the purchase price, and they will want tax deferred treatment for the rollover equity they will receive. To receive the above tax treatment, the cash purchase price and rollover equity must be distributed to the physician owners in exchange for their equity in the practice, yet they generally own that equity in equal percentages.1

To accomplish the economically equitable allocation of cash while maintaining, to the greatest extent, tax efficient treatment, it is necessary for one or more physicians (in this instance, Physician B) to give up their claims to certain of the purchase price in favor of those physicians with claim to greater compensation (in this instance, Physician A). When the physicians do this, however, they will change the characterization of certain of the purchase price cash from capital gain income to ordinary income, thus increasing the tax payable on such cash. In that instance the amount Physician A receives in excess of his percentage interest in the practice likely will be treated as compensation (and thus, ordinary income) and the payment thereof becomes a deduction for the practice.2

Changes in the tax characterization of the cash proceeds, while more expensive, can be more easily handled because there is cash available to pay the excess tax triggered by the reallocation of those proceeds. The same is not true with respect to rollover equity. Reallocating rollover equity—like the reallocation of cash—can trigger additional tax to certain physician owners (as a rule, the receipt of rollover equity should be tax deferred) but without the cash necessary to pay that excess tax.  One solution to that problem, which can be employed under the right circumstances, is for the physicians to sell their “personal goodwill” which is an asset that each physician may own and can be independently valued and sold to the buyer outside of the confines of the practice entity. However, to engage in such a sale, the physicians cannot be subject to covenants not to compete between each other or the practice at the time of the sale, otherwise the strategy is likely fatally flawed.

Anti-Referral Issues

Depending upon the nature of the practice—for example orthopedics, cardiology, dermatology, and gastroenterology—there are likely to be ancillaries associated with the practice, many of which implicate the Federal Physician Self-Referral Law, commonly known as the “Stark Law.”

The Stark Law is a complex statute and set of regulations that make illegal referrals by physicians to certain (primarily) Medicare-reimbursed ancillary services—such as imaging, inpatient and outpatient hospital services, physical therapy, outpatient prescription drugs and certain other enumerated services—if the physician has a financial relationship with those services, unless an exception (found in the statute or rules) applies. 

Given the complexity of the Law, it is not uncommon, during diligence, to uncover historical breaches of the Stark Law by the target practice. These breaches can range from not meeting the definition of a “group practice” (a “must” if a physician is an owner of a practice and is referring Medicare patients to office-based ancillaries), a failure to understand what constitutes an ancillary that is covered by the law (there are 11 such ancillaries), compensation between a physician and an entity that exceeds fair market value, etc.

Once a Stark Law violation is uncovered it is necessary to disclose the violation within a period dictated by the Centers for Medicare and Medicaid Services (CMS). That disclosure is mandated by the CMS’s Self-Referral Disclosure Protocol (SRDP). Most sophisticated buyers will insist that any SRDP disclosure be completed prior to closing of the transaction.

Given that most SRDP disclosures involve the repayment of some portion of the amounts billed to the Medicare program, it is common for the transaction parties to escrow monies, or agree to offsets of deferred payments or rollover equity, to give the buyer comfort that the funds to be repaid will be available. In that instance, a well-counseled seller will want—and generally will be granted—a sufficient level of control over the drafting of the SRDP disclosure and the resolution of the matter with the CMS. Thus, it is important that the parties reach agreement as to how that level of control will be maintained and under what circumstances control should be shared with, or ceded to, the buyer.

Joint Ventured Facility Issues

Physician owned ambulatory facilities, such as cardiac catheterization labs, ambulatory surgery centers and endoscopy facilities, often provide lucrative returns for their physician owners and are a source of great interest to investors. Often, in conjunction with the practice purchase, an investor will acquire an interest in these ambulatory facilities along-side the physician owners (to maintain economic alignment between buyer and sellers).

It is not uncommon for these facilities to be jointly owned by the physicians with hospitals/health systems or traditional developers who manage and invest in such businesses. Often the arrangements between the owners require the physician sellers to seek approval from their then-current partners to allow for the transfer of equity to a third party, such as the buyer.

Any seller considering a sale should address these consent issues early in the deal cycle. It isn’t unusual for the hospital or development partner to be wary of, or concerned by, co-investment by a private equity investor. This concern can slow down the deal process as these partners may seek concessions in exchange for their consent to the transfer of equity. Moreover, they may want to put limits on the ability of the new investor to exit the investment, which can be a deal killer. Buyers and sellers alike should treat these consent issues as gating items.

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Physician recapitalization transactions are complex. The issues described above are but a few of the hurdles sellers and buyers face in getting to closing. However, they tend to be among the most critical issues faced by parties to these arrangements.

Foley is here to help you address the short- and long-term impacts in the wake of regulatory changes. We have the resources to help you navigate these and other important legal considerations related to business operations and industry-specific issues. Please reach out to the authors, your Foley relationship partner, or to our Health Care Practice Group with any questions.



1 Note that when the selling practice is taxed as a Subchapter S corporation or a Subchapter C corporation, rollover equity is generally not distributed to the individual physicians but to a holding company vehicle owned by those physicians.

2 The same can also be accomplished if the practice is a limited liability company taxed as a partnership by reallocating the share of sale payments via an amendment to the LLC’s operating agreement.

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