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Strategies for Partnership Buy-in
By Thomas L. Snyder, D.M.D., M.B.A.
Many practitioners who have built successful practices
in their mid careers need associates. After several years
of employment a common strategy to take is to offer your associate
the opportunity to become a partner. This is typically the
beginning of a two-step process toward your retirement.
The partnership typically lasts anywhere from seven to fifteen
years with an eventual buy-out of your remaining half of the
partnership interest.
Once the purchase price has been decided, the next and most
important step is to determine how the funds will be paid
to the "senior" partner. There is more than one
way to structure a buy-in. If not properly designed,
the buy-in can become a very costly venture for the associate.
Let's examine several different buy-in strategies.
1) Cash Buy-in.
Based on the financial needs of the host doctor, the associate
can pay for the partnership interest in cash. This is typically
funded by a bank loan. The practice's assets are used as collateral
and often times the senior partner co-signs the note. The
senior partner gets the cash and after taxes, can invest the
proceeds. This provides an immediate return on investment.
In this instance, if the entire partnership interest was paid,
the Junior Partner immediately receives all rights and privileges
of ownership. A potential downside for the associate may be
the manner in which the transaction was structured, from a
tax point of view. If, for example, the associate purchases
stock in the professional C Corporation, this transaction
will be very tax inefficient for the associate and maximally
tax efficient for the senior partner. The senior partner receives
capital gains treatment on the sale of the stock and the associate
will get no write off since he/she purchased stock. Therefore,
the after-tax consequences can be severe based upon the personal
income tax bracket of the associate and also the state in
which the transaction occurs. This could mean that the junior
partner may have to earn 40-45% more income to pay for the
buy-in since payments are made in after tax dollars.
2) Senior Partner Loan.
Another approach to providing funding allows the senior partner
to provide a loan to the associate for a buy-in over a period
of years. Historically, Senior Partners would function as
a bank, charging an interest rate and receiving principal
and interest payments. A potential downside for the Senior
Partner is giving the new partner 50% of the profits before
they have paid their full share for that interest. Often times
in this scenario, the senior partner really sees no appreciable
growth in income, rather just the opposite! The senior partner
is sometimes getting paid back with the very profits he/she
just gave the new partner via a loan funding the entire partnership
interest!
We suggest a more conservative approach funding a 50% buy-in
over a five to seven year period. In essence, you purchase
what you can afford. This approach works with younger associates
who want the security of becoming a partner but are financially
unable to handle a 50% cash buy-in or who are still growing
in their annual clinical production. For example, 10% of interest
is offered annually for five years. Each year the associate
receives an additional 10% ownership interest. In this approach,
the junior partner takes no financial risk and just receives
the benefit of partnership interest through Seller financing.
The junior partner gets limited deductibility for a seller
loan as principal is not deductible. However, if the seller
accepts the allocation as goodwill, the junior partner will
be able to write off that portion allocated over a 15-year
period.
3) Management Fee.
Another strategy, which really benefits the associate, is
having a portion of the buy-in paid through a management fee.
This approach allows for an income transfer enabling the associate
to pay for a majority of the ownership interest in "pretax"
dollars. Effectively, pretax dollars allows for a reduction
in income with the income differential going to the senior
partner. However, the management fee is considered as ordinary
income and taxed accordingly. The senior partner receives
considerably less from the sale of ownership interest than
if it were structured as a capital gain. The approach to "soften
the blow" of ordinary income tax is to calculate the
differential between the capital gains rate and the seller's
personal income tax rate and increase the payment to the seller
for that differential. This charge is a consideration to allow
the selling doctor to have additional funds to pay the taxes
due as ordinary income. This still is a more effective approach
than having the associate pay for this transaction in after-tax
dollars.
4) Qualified Pension Plan.
The most innovative and tax efficient approach to structuring
a buy-in for both parties is to use a qualified pension plan
for a buy-in strategy. First, you need to conduct a pension
study to determine the most effective pension plan that will
factor in staff and doctor age and income. The junior partner's
buy in is the pension plan contribution over a specified time
frame. Since a dental practice can have more than one pension
plan, your current plan may still be maintained with an additional
pension plan or perhaps a complete plan redesign. Be advised
that all "qualified" pension plans are termed "qualified"
because they are approved by the Internal Revenue Service.
This is again a tremendous benefit for a junior partner since
he/she can pay their ownership interest in pretax dollars.
A significant benefit for the senior partner, if funds are
not currently needed, is to allow the buy in proceeds to accumulate
on a tax-deferred basis in the pension plan with no taxable
event occurring until retirement or the age of 70 ½!
Of course, there is always the risk of paying higher taxes
in the future, but to allow your buy-in proceeds to grow in
a tax sheltered mode is the most efficient way to get a return
on investment for selling an interest in your practice. As
always, when these transactions are structured, appropriate
tax and accounting advice is required. We recommend using
advisors who have worked with other dental professionals in
this fashion.
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