This article is written by John Genz, CPA, and was originally published in EndoEconomics. The article is republished here with permission.
When the opportunity to sell your ambulatory surgery center arises, follow the scout motto – "Be Prepared." The sales process can be long, time-consuming, expensive and intrusive. Proper preparation can help make it more efficient and less costly, so it is never too early to plan for the exit, due diligence process, after tax net cash and post-closing issues.
Planning for a sale
Engaging an attorney and accountant with ASC transaction experience is highly recommended to help you evaluate the following planning opportunities and guide you throughout the process to ensure a successful outcome.
Choice of entity
Selecting an efficient tax structure for your ASC is critical to maximizing after-tax dollars upon sale. There are several types of entities to select from with the most common including corporation, S corporation and limited liability company (LLC). The legal protections for an ASC under each type of entity are similar, but differences include tax rates at the corporate level or owner level, applicability of Social Security and Medicare tax, double taxation when a dividend is paid to corporate shareholders, and certain state fees and taxes such as franchise tax.
When operating as a corporation, the active shareholders may be able to minimize double taxation by providing compensation to the professional owners, thus minimizing corporate level of tax. However, this may not be manageable when a transaction occurs, as there are special rules that limit tax deductible compensation to a "reasonable" level. To avoid this, the pass-through tax treatment of an S corporation or LLC is generally preferable when the ultimate goal is selling the business.
If you are a corporation and not an S corporation, it may not be too late to select S status – minimize the double level of tax exposure. Making an S election for a corporation may not eliminate the double tax, but it freezes the potential double taxation exposure (referred to as the Built-in-Gain [BIG] tax) at the time the election becomes effective.
Estate planning considerations
Establishing an ASC may be an opportune time to move assets out of your estate. This can be accomplished in many ways and timing is critical. Gifting assets when they are at their lowest value is usually the most tax efficient. Therefore, transferring an ownership interest in your ASC during its infancy state to a trust may accomplish moving a highly appreciable asset out of your estate at a relatively low gift value to the beneficiaries of trust. Your current operating agreement should address this.
Alternative sales options
You may be selling your entire ASC interest or a portion thereof. With a complete sale of your interest, proper succession planning should be in place providing the ASC with recurring cash flow, making it an attractive acquisition candidate. Many sales today are for a percentage interest where the buyer acquires 51 percent interest in the ASC and is involved with managing it after the sale. This keeps the doctors involved at a significant level so both parties are motivated to maximize profitability and cash-flow.
There are many options with how a sale is structured – a sale of assets, deemed sale of assets, sale of corporate stock or LLC member units. With a corporate stock sale, the buyer typically reserves the right to treat the stock sale as an asset sale for income tax purposes. This gives the buyer a step-up in the asset basis with a future tax write-off. Bearing in mind, if the entity is structured as a corporation or has BIG, double taxation may apply.
Since buyers vary from private equity firms, public companies, private companies or hospitals, the surviving entity may not be the same type as what you previously owned. You have owned an S corporation or LLC and the surviving company may be a new corporation or new LL.
Valuation of the ASC
Valuing your ASC and timing the exit are critical to maximizing the proceeds upon sale. A common way to value a business is a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). The ASC value can fluctuate significantly based on market conditions. Accordingly, a formal valuation may be prudent when the owners believe the current market conditions are appropriate.
Discuss the potential sale with experienced ASC brokers who can provide support with negotiating the deal, developing a sales strategy, identifying prospective buyers and distributing sales prospectus to interested buyers in an effort to maximize your multiple of EBITDA.
Due diligence
Due diligence is the most intrusive part of the sale. This is not your basic rectal exam or sigmoidoscopy; this is a full blow colonoscopy of your ASC with no anesthesia. Preparation for this phase of the transaction will expedite the timing of the sale, minimize adjustments to the purchase price and avoid hidden issues that could make a potential buyer walk away.
Due diligence teams from the accounting or law firm will examine the ASC from all angles, looking for potential legal or accounting issues, undisclosed liabilities, etc. To help expedite their work, the books and records, including fixed assets, of your practice and the ASC should be properly segregated.
After tax cash
Once the deal is negotiated, the accountants calculated the gross gain, tax and after tax net cash. This is critical, as your ultimate decision may be contingent upon the anticipated cash in your pocket at closing. Several factors impact these complex calculations such as:
• Federal tax: The sale of your ASC may be subject to both ordinary income tax rates and capital gain tax rates. The current federal ordinary income tax and capital gain tax rates increased in 2013, plus another 3.8 percent layer of tax may apply if you are a passive investor in the ASC. (The 3.8 percent layer of tax is called the Net Investment Income Tax, commonly referred to as the Obama Care tax.)
• State tax: If you're ASC is located in and you live in a state that does not have an income tax (Alaska, Florida, Nevada, South Dakota, Texas and Wyoming), you may only need to calculate the federal tax. However, if you are not working and residing in one of these states, the state income tax could substantially reduce your after tax net cash.
• Individual income tax: Each owner's personal tax situation further affects the calculations.
• Purchase price allocation: The buyer and seller will negotiate and settle on the fair value to be allocated to each respective asset in the transaction, commonly referred to as the purchase price allocation, which will dictate the impact of the various tax rates. The tax laws require the allocation of the purchase price be at fair market value, prohibiting much of the wiggle room when trying to shift the purchase price away from higher taxed assets. Some typical items that may be at the higher ordinary income tax rates are unrecognized accounts receivable and recapture on items that have been amortized, depreciated or written off under Internal Revenue Code Section 179 (the 179 Deduction).
Net working capital
Referring to the minimum amount of operating capital needed to run the business after the sale, net working capital is calculated by taking the current assets (e.g. cash, accounts receivable and other current assets) less current liabilities (e.g. accounts payable and accrued expenses). This concept applies to companies operating on either the cash or accrual method of accounting. If there is insufficient net working capital to continue the operations, this usually results in a reduction of the purchase price or sellers will be required to leave a negotiated amount of cash in the business before closing. There is excess net working capital, this could increase the purchase price.
Escrow
Most transactions include an escrow agreement to protect the buyer from undisclosed liabilities not found during due diligence. The escrow cash hold back could be about 10 percent of the total proceeds with a term of about 12 months. Accordingly, that portion of the gain is recognized in the tax year the escrow is received, unless the owners opt out of the installment method and accelerate the tax gain on escrow at the time of sale. This was popular in 2012 when sellers anticipated the Bush tax cuts sun setting.
Closing the sale
You have negotiated the price, completed due diligence and are ready to close. If it is near the end of the year, you may want to consider waiting until immediately after year-end to defer paying tax on the gain. However, you may not want to wait and close as soon as possible before unanticipated external factors potentially change the deal at hand. Other factors may also play into timing, such as pending change in tax rates, expiration of the BIG, or offsetting tax attribute carry forwards (e.g. net operating loss, suspended loss or capital loss carry) available to minimize gain recognized.
Post-closing issues
In many transactions, the sellers stay on as 49 percent owners of the surviving ASC entity after closing. This may result in culture shock for some owners as they are no longer the majority owner and the buyer now has control. Many buyers have substantial back-office operations that eliminate the need for the sellers to maintain certain functions, such as billing, accounting, supply ordering, etc. The buyer can leverage its critical mass to benefit from economics of sale when purchasing goods and providing benefits to employees. However, the sellers should be aware that the buyer will charge back a management fee to offset their cost, plus a mark-up for these services. For tax purposes, the company charging the management fee is required to charge an arms-length price, which would include a mark-up that any independent third-party would charge and a buyer of those services would pay.
The sale of an ASC is a complex endeavor. Proper planning and engaging experienced ASC brokers, attorneys and accountants are critical to achieving a successful transaction. Manage your expectations by understanding your ASC's value, calculating the after-tax net cash from the transaction and understanding what post-closing services the buyer will provide and at what cost. Leverage from this new business partner as they are heavily interested in the process and want it to be as profitable as you do.
John Genz, CPA, is a tax partner at EsinerAmper LLP, a full-service accounting and advisory firm providing specialized expertise to the healthcare industry including ambulatory surgery centers, hospitals and physicians. He is also a colorectal cancer survivor.