Today, the majority of new practitioners are coming out of residency training with significant school related debt.  Because of this and a lack of knowledge about running a business, most want to join a practice as an associate with an option to buy-in.  Many agree this approach gives the associate and the owner the opportunity to evaluate the “fit” and if it is appropriate for an equity offer.

First, we will explore the “Salary Override” or Indirect/Inexact Method. In this approach, the compensation is set below standard levels so that excess earnings (those collections which exceed the cost of direct overhead, an allocation for indirect overhead and their compensation), accrue to the owner.  In this model, the owner receives the benefit of the associate’s production for a period of years (4-8) and the purchase, price is reduced to account for the receipt of these “indirect” payments using this approach. The key in this approach is for the owner to realize the benefits of the associate through greater personal flexibility and higher ordinary income (credited to the buy-in by the associate).

The benefits to the purchaser are:

• Pre-tax dollars used as credit against the eventual buy-in.
• Buy-in over period of time giving him/her a chance to learn the business
• Reduced lump sum payment required (generally at the end of the buy-in period).

The benefits to the seller are:

• Higher income stream for period of years
• Ability to maintain control
• No significant tax “hit” in year of purchase

The weaknesses in this approach for the buyer are:

• Long period of time for ownership and change in control to occur.
• No write-off for goodwill on amounts credited during buy-in period
• Minority position for a number of years

The weaknesses in the approach for the seller/owner are:

• Payments during buy-in period treated as ordinary income and taxed at higher rates
• Based on time value of money- net realizable amount may be reduced
• Taking risk and “playing” role of banker
• Allows associate to buy-in without risk for timely payments

Second, we will explore the immediate buy-in or partial sale method. In this approach the new associate obtains financing (or has it) to purchase a portion of the practice immediately. The associate immediately starts sharing in the operations of the practice.  To the extent purchased, the new associate has a role and voice in the day-to-day operation and decision-making process.

In this approach the benefits to the seller/owner are:

• Immediate sharing of practice duties
• Immediate cash
• Payment treated as capital gains and taxed at lower rate
• A fully committed and vested interest by the associate to a long term business relationship
• No risk for financing

The benefits to the buyer are:

• Immediate sharing of practice profits
• Equal role in decision making and practice operation
• Equity stake in business

The weaknesses in this approach for the seller are:

• Relinquishment of total control
• Lump sum payment and tax hit in one year (generally taxed at 20%)
• Potential drop in compensation and sharing of excess earnings with new partner.

The weaknesses in this approach for the buyer are:

• Ability to obtain financing
• Making debt/buy-in payments with after tax dollars
• Lack of business knowledge requires intensive commitment to learning and understanding practice operation.
• Risk for making debt payments- production pressure.

A third method would be a hybrid of the two combining pre-tax and after tax payments.  In this method an initial payment of 20-25% of the purchase price is required.  Then in years 1-5 (or whatever time frame is agreed upon) the owner takes a salary override from the associates’ production.  Then at the end of the buy-in period a lump sum pay-out is required from the buyer to the seller.

In this approach the benefits to the seller are:

• Initial payment is treated as capital gains (20% tax rate)
• Immediate cash
• A fully committed and vested interest by new partner
• Final lump sum payment also treated as capital gains

(With imputed interest portion treated as ordinary income)

The benefits to the buyer are:

• Equity stake in business
• All monies not required up front
• Clear pathway established for buy-in
• Buy-in with pre-tax and post after-tax dollars.

The weakness in this approach for the seller are:

• Risk of new partner not being as productive
• Relinquishment of total control
• Receipt of payments “during the term” taxed at ordinary rates.

The weaknesses in this approach for the buyer are:

• Making payments on initial down payment (if borrowed)
• Finding funding source.
• Lack of ability to exercise control during term.
• Pressure to generate production at appropriates level

Each method/approach has strengths and weaknesses for the buyer and seller.  The best approach will emerge when the buyer and seller evaluate how the needs of each are met and compromise reached upon a thorough analysis!