Jump to content
Sign in to follow this  
Guest Stuartt

409A and Sale of Stock in a Professional Corp

Recommended Posts

Guest Stuartt

I'm looking at the 409A issues regarding the sale of stock in a professional corporation. Let's assume it's a medical practice.

As part of his semi-retirement, the senior doctor in the practice agrees to sell his stock back to the corporation. The buyout price for his stock will be, for example, $300,000 and 50% of the accounts receivable collections from his work that is received within 12 months after the sale.

A. Assuming he no longer provides any services to the practice after the date of the sale, could the variable portion of the proceeds from the accounts receivable collection fall under IRC 409A? If so, this could mess up the capital gains treatment on the sale.

B. Let's also add to the example that the doctor sells his stock and works part-time as an employee for the medical practice. Would this change your response?

Any comments?

Share this post


Link to post
Share on other sites
Guest Stuartt

33+ views and no comments ?

Share this post


Link to post
Share on other sites

I haven't studied all the details yet - so some one correct me if I am way off here.

This is sale of stock and receipt od receivables. Not ISO or other stock incentives. Receivables are not deffered income - but way of doing business.

Would be stretch for situation A to be under 409A.

For B - I don't think would be much different from A.

Share this post


Link to post
Share on other sites

Presumably, you have spent a good deal of time thinking about this, whereas I have not. Give us a little help: what is it that you think could possibly cause this to be treated as "deferred comp." subject to 409A? I'm not being a wise guy, but I'm not grasping the issue (even though I recognize that the 409A definition of "deferred comp." is very broad).

Share this post


Link to post
Share on other sites

You can't "gussy up" deferred comp to look like a stock sale. I guess if the stock is really worth $300,000 plus the AR then you might be o.k.. (BTW, I don't see this as a sale of AR by the Doc, the corp. not the Doc owns the AR.)

In my view, the payment of trailing AR in many professional practices would typically be treated as deferred comp. Indeed the final regs specifically speak to this point. Here is the portion from the preamble:

Commentators requested guidance on payment schedules contingent on

the receipt of certain payments by the service recipient. For example,

commentators requested clarification whether a plan requiring an annual

payment equal to a percentage of certain accounts receivable collected during

the prior 12-month period would qualify as a fixed time and form of payment.

The ability to schedule payments based upon the time the service recipient

receives a customer’s payment raises issues regarding the ability to, in effect,

create an impermissible event-based payment through characterizing the

payment as a schedule (for example, a payment “schedule” that pays an amount

every year if a specified transaction occurs in that year actually pays based on

whether and when the transaction occurs, which is not a permissible payment

event under section 409A). In addition, these arrangements raise issues

regarding the ability of the service recipient (or service provider) to control the

timing of the payment of deferred compensation through an ability to influence

the timing of the payment by the customer. Accordingly, the final regulations

generally provide that a schedule based upon the timing of payments to the

service recipient is not a fixed schedule of payments. However, the final

regulations also provide certain parameters under which such a plan may qualify

105

as having a fixed time and form of payment. First, if the service recipient is

comprised of more than one entity, the payments must be due from a person that

is not one of such entities (for example, not a payment due from a subsidiary

corporation to a parent corporation). Second, the payments must stem from

bona fide and routine transactions in the ordinary course of business of the

service recipient, and the service provider must not at the time such payments

are due retain effective control over the service recipient, the person from whom

the payments to the service recipient are due, or the collection of the payments.

Third, the payment schedule must provide for a nondiscretionary, objective

method of identifying the customer payments to the service recipient from which

the amount of the payment is determined, and a nondiscretionary, objective

schedule under which payments of the nonqualified deferred compensation will

be made (for example, a payment every March 1 of 10 percent of the accounts

receivable collected during the previous calendar year). Finally, the sales to

which the payment relates must be of a type that the service recipient is in the

trade or business of making and makes frequently, and either all such sales must

be taken into account or there must be a legitimate, nontax business purpose for

limiting the sales taken into account.

Share this post


Link to post
Share on other sites
Guest Stuartt

"You can't "gussy up" deferred comp to look like a stock sale."

I think that this is what is generally occurring. Professional practices never get any type of appraisal on the sale of the stock and they zero out the profit every year. The corporate assets are generally owned by a different entity comprised of shareholders and leased to the corporation.

Many buy/sell agreements for these types of entities base the payout on a percentage of the receivables collected from past services of the selling physician. In addition, the employment agreements and/or past payroll practices base the compensation of the physician on a percentage of collections.

The problem in these cases is if the physician sells out and takes capital gains treatment on the sale. The IRS could come back and say the payment is subject to 409A, treat the income as ordinary income and hit them with the 20% penalty. The more they tie the buyout price to the receivable collections derived from the services of the selling professional, the closer the move to 409A.

I appreciate the comments from all of you.

Share this post


Link to post
Share on other sites

KJohnson, the excerpt from the preamble which you quoted presupposes that the payments in question represent deferred comp. subject to 409A, and the issue tackled is how contingent payments may comply with the 409A payment rules.

I was assuming that the scenario described by the original poster was a legitimate buy-out/redemption of an equity interest in the professional corporation. In fact, the shoe is almost always on the other foot: the corporation would prefer to characterize the contingent payments as deferred comp. in order to claim a tax deduction. Obviously, however, or at least so it appears, the parties agreed that the contingent payments represent payment for the stock, so why should we doubt that? That gets back to my original question: what is it in 409A or the regs. that causes the original poster to have a concern about the contingent payments being treated as deferred compensation?

Share this post


Link to post
Share on other sites
Second, the payments must stem from bona fide and routine transactions in the ordinary course of business of the service recipient, and the service provider must not at the time such payments are due retain effective control over the service recipient, the person from whom the payments to the service recipient are due, or the collection of the payments.

In additional to jpod's comment, please note the bolded phrase. This refers to income that becomes due to the company after the provider ceases to have control over the practice. An example of this would be an insurance agent who sells a practice and gets paid based on future years' premium payments.

In the orginal scenario, the AR that the doctor is getting payment from is for services performed and payment due while the doctor was still an owner-member of the practice. Therefore we have to go back up to an earlier sentence in the excerpt which says "Accordingly, the final regulations generally provide that a schedule based upon the timing of payments to the service recipient is not a fixed schedule of payments."

Share this post


Link to post
Share on other sites
Guest Stuartt

JPOD:

Let's assume we have 2 doctors that each own 50% of the corporation. Dr. A generally has $500,000 a year in receivables and Dr. B generally has $1,000,000 in receivables. The physician compensation is generally based on a percentage of billings and collections throughout the year.

Dr. B decides to retire. The agreement between the shareholders provides that a selling shareholder will receive $300,000 plus 50% of the accounts receivable collected in the following 12 months generated from the services of the physician.

Since they both own 50% of the company, if Dr. A sells out he would receive for his 50% interest the $300,000 base and $250,000 for the receivables (50% of his receivables of $500,000), for a total of $550,000.

Dr. B, owning the same equity interest would receive $800,000.

Assuming the 50% interest is worth $300,000 (doubtful) since the corporation never shows a profit and no dividends are ever paid, the excess amount could be treated as disguised compensation and subject to 409A.

Share this post


Link to post
Share on other sites

I agree that it "could," but if the corporation includes the A/Rs in its gross income and does not take a deduction for the A/Rs when they are paid out to the selling s/h, instead treating them as part of the redemption proceeds, the IRS is not likely to disturb that treatment. It never did in the past and it is not likely to do so in the future just for the sake of playing "gotcha" with 409A.

If the original poster's characterization was incorrect and the corp. is treating the contingent payments as compensation, then we would not be having this conversation. Anything that is compensatory raises 409A issues.

Share this post


Link to post
Share on other sites

I can't think of any reason why the IRS wouldn't try to argue that some portion of the payout is compensation for services rendered. I have a similar situation involving limited partners who also performed services for the company. The difference is their contract specified the amount of compensation, so obviously you can't re-characterize the payment as capital gain. When they sell their interest, what leg do you have to stand on for full capital gain treatment if part of the payout includes an amount that would have been paid as compensation for past services?

Share this post


Link to post
Share on other sites

Can anyone show actual precidence where the IRS took a basic fact pattern like this (which has no appearance of being abusive) and ruled that payment received for realized AR as part of a stock transaction was compensation?

I guess if the stock is really worth $300,000 plus the AR then you might be o.k.

Let's look at it from this angle... why would the value of the stock not include part of the unrealized value of AR? It is an asset of the corp and therefore the shareholder has some right to the value in it (presuming the AR was excluded in arriving at the $300K). Since Stuart says above that the physical assets are owned by another company and leased to the corp, then the main assets of the corp which have value are 1) the doctor's book of patients (generally valued at a factor of prior years' receipts), 2) current cash/equities on hand, and 3) current accounts receivable. The difference between cash on hand and AR is liquidity and risk of default. What you have is a contingent installment payment on the sale of the stock.

Share this post


Link to post
Share on other sites

I'm probably adding facts here but wouldn't it be reasonable to assume that the physician was also under an employment contract and that upon sale of his interest, the employment contract will also be cancelled? This situation is ripe for savvy taxpayers to roll any consideration received in exchange for cancelling the contract into the stock payment. Under Rev Rul 2004-110 the IRS's position is clear that any such consideration is compensation, which would be ordinary income for a nonemployee or wages for an employee. You cannot get cap gain treatment for such amounts or avoid ordinary income treatment by trying to characterize or recharacterize them as a return of capital.

I guess the physician could agree to forego any compensation, but it would have to be clearly demotrated that such amounts are not included in the buy out payment or that the payment is reduced by the amount of compensation that was erroneously included. I am not an expert on these organizations, but who would believe that the good doctor agreed to work for free that year? Am I missing something?

Share this post


Link to post
Share on other sites

Good point Steelerfan. Stuart might want to review the doc's employment contract, if any to see if/how it pulls the AR into the compensation picture. Also, on that line of thinking, while prior year(s) AR may be considered in determining the doc's salary, does anything in that process tie his new salary to the coming year's AR?

Share this post


Link to post
Share on other sites

The real problem with this is that what the Doc gets for his stock is dependent upon the accounts receivable attributable to his production. If you had it equal to all accounts receivable for the Corp. as a whole, I think you might have a much better argument. Under Sutarrt's scenario one Doc gets $550,000 for his 50% interest while another Doc would get $800,000 for the exact same 50% interest because his receivables were greater. I guess if you look at it logically you would think that the value of the stock would be worth less rather than more upon the departure of the greater producer.

If the IRS looked at this I think that they would conclude that something is going on here other than the sale of stock.

Share this post


Link to post
Share on other sites

You're right, that looks more like a division of income rather than equity.

Higher performing partners usually get more income, otherwise they would leave to avoid propping up underpeforming partners. I worked for an attorney that left a firm for that very reason.

True 50/50 splits of income might not be as common as you would think. But shouldn't the equity division be the same if the agreement is 50/50 as to equity?

The real question I have is how can you just sell your equity interest and claim that you have no income for the year if you performed services?

Share this post


Link to post
Share on other sites
Guest Stuartt

Steelerfan

"True 50/50 splits of income might not be as common as you would think. But shouldn't the equity division be the same if the agreement is 50/50 as to equity?"

This is the issue. It would appear that the purchase price should be the value of the stock and the receivable portion treated as payable under a deferred compensation plan or a bonus. Having different values placed on the equity interests invites ordinary income/409A issues.

By lumping it all together as proceeds from the sale of stock, the seller risks having a portion of the proceeds later treated as ordinary income. This ordinary income could also potentially be treated as subject to 409A.

It would appear that the provisions of the stock sale agreement relating to the collection of the receivables and payments to the selling shareholder should be 409A compliant. This would at least provide some protection if payments relating to the receivables were later treated as ordinary income.

All comments on this issue have been appreciated.

Share this post


Link to post
Share on other sites
By lumping it all together as proceeds from the sale of stock, the seller risks having a portion of the proceeds later treated as ordinary income. This ordinary income could also potentially be treated as subject to 409A.

I'll agree the AR is ordinary income but I still disagree about 409A because of reasons discussed above. See my post on May 23 at 10:56am. The section of preamble that was quoted says amounts from sources like AR are not subject to 409A unless they meet a list of criteria. As noted, I feel your situation fails the second criteria because the AR became due while the doc was still in and had effective control over the practice.

Share this post


Link to post
Share on other sites

Just curious if anybody has further thoughts on these issues and Masteff's last post concerning possibility that AR tied to period during which services were performed would not be deferred compensation. Also, curious if anybody has thoughts on an earlier post (pre final regulations) I've seen that suggested an argument that the risks inherent in trying to collect the AR may work a substantial risk of forfeiture such that the AR might be exempt from 409A if paid to former employee within short term deferral period after it is collected (vests).

I am looking at a physician agreement that provides "severance" pay in the form of a decreasing percentages of the practice's AR for three years following termination. It seems to me the first part of this is more tied to receipt of payments collected for services the doctor rendered or had a hand in but the payments beyond the first year (and I guess even some of the 1st year's payments) really seem to me to clearly be true deferred compensation arrangements. I don't think compliance there is too hard but necessitates making some changes to agreements which seems to open up can of worms.

Anybody else seeing similar arrangements or have other thoughts? Also curious if anybody may point me to an article or more detailed discussion of this issue and typical physician employment agreement issues written post-final regulations. Seems there have got to be a lot of physicians (and others) with similar arrangements.

Share this post


Link to post
Share on other sites

Just wanted to bump this up for reality check and brief revisit of issue as it relates to payment of future accounts receivables (AR) for a departing physician separate and apart from any equity interest or stock interest.

First, I agree with Everett Moreland's post on a similar thread regarding physician agreements when he noted that the risk is just too great to not structure agreements to pay out on some fixed payment schedule per 1.400A-3(i)(1)(iii) when you have accounts receivables trickling in over extended period of time. Although it is not absolutely clear that the contingent nature of ARs would not in some cases give rise to a SRF argument that might let you comply with a short term deferral exemption, the lack of clarity on the issue is just too great to risk that, particularly if compliance can be fairly easily obtained.

I have a physician who is reading the regulations (bad sign already) and has raised similar question to that raised by Masteff below. Namely in the preamble quoted by KJohnson it talks about the need for the physician not to have been in effective control at the time the payment is due. In most situations we would expect payment for a physician's medical services (the services giving rise to the future AR payments) to first be due and payable when the services are rendered and thus at a time the physician was very much employed with (and possibly in control of) the practice group. Of course, all involved realistically understand that actual payment is likely not to happen for an extended period such that the Dr. rendering services could depart and be long gone by time payment is received (or even when normally expected). Thus the preamble language about being in effective control at time payment becomes due is seemingly troublesome. Perhaps it really means though at the time payment is collected?

If I read Masteff's posts correctly, Masteff seems to go beyond simply noting a problem with the timing issue raised in the preamble. He seems to argue that the AR amounts should not be viewed as deferred copensation subject to 409A at all if the physician was in control (or I guess generally connected with the practice) at the time payment was due.

I do not read the preamble provisions KJohnson quoted to really provide or support that sort of interpretation but perhaps I am missing something. I see the provisions quoted as addressing whether amounts subject to 409A (which I guess I think vested but deferred AR payments would be) may be structured to comply with the specified time or fixed schedule payment requirements even if they base timing of payment on the time the service recipient's receives the actual payments. Nothing about the quoted provisions seem to me to say that such amounts would be exempted from 409A, just that they may not qualify as being paid on a fixed schedule.

I suppose if the timing rule were as Masteff notes and the amounts were subject to 409A, this would raise a question of just how you could comply with the payment requirements under 409A while keeping payment contingent on amounts collected / received by the physician practice group. However, the actual regulations in 1.409A-3(i)(1)(iii)(B) seem to me to eliminate this problem or concern by avoiding the somewhat strange "when payment is due" language and instead suggest there should not be an issue as long as the physician is not in controll of the phyisican group or the patient, etc. at the time the payment is received. That would guarantee that the physician cannot control when the amounts are collected or paid and makes sense to me from a policy standpoint.

Just curious if I am missing some aspect of Masteff's argument so that the preamble language might actually prevent complying with 409A by establishing a fixed schedule based on when AR amounts are received when they were arguably first due and payable when the physician was still working with the practice group. Given the differing language in the actual regulations, I'm thinking the preamble provisions are not an barrier to compliance.

(Note, I've generally given up on any argument that the preamble provision would somehow support the notion that AR amounts first payable while physician was still employed would somehow fall outside 409A but if I'm missing something there, I would appreciate any thoughts or help understanding the argument.)

Share this post


Link to post
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
Sign in to follow this  

×
×
  • Create New...