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  • taxes on offered PE equity

    Hello all,

    I am at a bit of a crossroads in my career. I have been working as an associate in a 2 person practice for the past 10 years. The plan was to buy in already but for various reasons that did not happen. The owner has decided that he wants to sell to PE and is 5 years from retirement. I am 20 years from retirement. The PE firm wants to keep me as part of the deal because I am over 40% of collections of the practice. As such, they are offering me cash as well as equity in the holding company. I will be making significantly less going forward with the PE group than I do now.

    I am trying to think of ways where I would not have to pay full income tax on the total of the cash + equity right now, considering I wouldn't get to monetize the equity until the next liquidity event in several years. My CPA has suggested a contemporaneous buy in, whereas I buy in to my current practice and then when it is sold (at the same time) my equity in my current practice rolls into the equity in the PE firm. That way it would be tax deferred.

    I have heard Jim mention several times in podcasts that in EM there is often not a set purchase price to buy in to be a partner, but rather, sweat equity. I've been working for 10 years and it seems that could qualify as "sweat equity," so that I wouldn't have to actually pay the current owner out of pocket to buy-in. Does anyone have any experience with these "sweat equity" buy ins?


    Any thoughts would be appreciated.

  • #2
    Many ppl on here have experience with sweat equity buy-ins, rather popular in the physician world. You’ll pay taxes on it at some point if you are selling your interest. For most doc’s, it simply means you are paid less for your work in the early years and the “equity” gives you the right for you to be paid more for your work as a partner/shareholder. Few doc’s are able to sell to anyone else at retirement for more than a fraction of what they worked in exchange for the original “buy-in”. You make it up in higher pay, dist’s, etc as a partner or s/h.

    In your case, this isn’t going to reality work in your favor unless you can talk the owner of the practice to give you a piece of it for “free”. You’ll either make an election to treat the value of the sweat equity as wages or treat it as a capital investment that you will pay taxes on when you later sell.

    Actually, this is getting a little complicated and I think it would require going into too many rabbit holes to really explain. Can’t blame you for trying, though!

    However, I also don’t know that I agree with your CPA. You are not allowed to exchange ownership interest in a partnership or corporation (“stock”) via a tax-deferred 1031 exchange because the ptrship interest is “personal property” and the stock is an investment, neither of which qualify for 1031 deferral treatment. If the entity owns the underlying real estate, you can structure a (VERY complicated) maneuver called a “drop and swap” but that’s not my understanding of what’s going on here. So, in the end, I believe you’re going to pay taxes. At best, you may get LTCG treatment if you could get the owner to “share” part of his practice (I’d say fat chance) but then you’d have to hold it for at least 1 yr + 1 day.

    Your CPA is the authority (and maybe this specialty is all he does for a living), and your CPA is obviously NOT ME.
    Our passion is protecting clients and others from predatory advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

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    • #3
      Thank you so much for your insight!

      I figure I've been paid less than partner wages for 10 years and could make an argument that I deserve some "sweat equity." The equity being provided is from the PE's service company, so if he gave me some equity in my current practice "for free" it wouldn't affect his package. I guess I would treat that "sweat equity" as a capital investment so the taxes could be deferred. There would also be an understanding that if this PE buyout doesn't go through that I don't have any equity.

      I guess I'm hoping that if I get x dollars in sweat equity in my current practice and I end up with 4x dollars of equity in the PE's service company, that I wouldn't have to pay (LTCG) tax until the next liquidity event in 3-5 years.

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      • #4
        Private equity equity?

        It would be a lot simpler if you had bought in as an equity partner prior to now. At least you're not getting cut out of the deal completely. If the deal does not seem to be in your favor, you do have the option of walking away, though, which is something you wouldn't necessarily have as a minority partner.

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        • #5
          Originally posted by PhysicianOnFIRE View Post
          Private equity equity?

          It would be a lot simpler if you had bought in as an equity partner prior to now. At least you're not getting cut out of the deal completely. If the deal does not seem to be in your favor, you do have the option of walking away, though, which is something you wouldn't necessarily have as a minority partner.
          Read between the lines here. You are correctly focused on the after tax proceeds, both current and IF you stay on. The IF has value to the owner and the PE buyer. One or both might be willing to what I call adjust.
          Gross up of the upfront payment.
          Gross up of the comp for the length of continued employment or a fixed amount over a fixed period.
          They may have agreed, but you have not. You not staying changes the valuation for the owner and the PE buyer. Sometimes an adjustment for you (due to the tax impact) leads to a split between the other two parties. Key man signing may actually be a condition of the deal. This is a delicate negotiation in process, not a done deal.
          I have seen the responsibility for signing the key employee 100% on the seller. Whatever it costs, comes out of the pocket of the seller’s proceeds.
          You need to figure out who to negotiate with and what it takes for you after tax. No idea how firm the owner or PE buyer is.

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          • #6
            Originally posted by Tim View Post

            Read between the lines here. You are correctly focused on the after tax proceeds, both current and IF you stay on. The IF has value to the owner and the PE buyer. One or both might be willing to what I call adjust.
            Gross up of the upfront payment.
            Gross up of the comp for the length of continued employment or a fixed amount over a fixed period.
            They may have agreed, but you have not. You not staying changes the valuation for the owner and the PE buyer. Sometimes an adjustment for you (due to the tax impact) leads to a split between the other two parties. Key man signing may actually be a condition of the deal. This is a delicate negotiation in process, not a done deal.
            I have seen the responsibility for signing the key employee 100% on the seller. Whatever it costs, comes out of the pocket of the seller’s proceeds.
            You need to figure out who to negotiate with and what it takes for you after tax. No idea how firm the owner or PE buyer is.
            My CPA has suggested grossing up my equity payment, if I have to pay current income taxes on it. I'm a little concerned about how the current owner will react if I ask for that much in cash. That's why I'm hoping they can come up with some kind of tax deferred arrangement so the equity I'm getting at least will be tax deferred. I'm planning on just paying the income tax on the cash payment.

            He has said basically what you have said here. Anything I get in comp going forward reduces his sales price by that amount times the multiple. I think the owner stands to make more money if I'm involved, even if he has to pay me more cash, than if the practice is valued with just one physician (5 years from retirement).

            Thank you for the info!

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            • #7
              Originally posted by PhysicianOnFIRE View Post
              Private equity equity?

              It would be a lot simpler if you had bought in as an equity partner prior to now. At least you're not getting cut out of the deal completely. If the deal does not seem to be in your favor, you do have the option of walking away, though, which is something you wouldn't necessarily have as a minority partner.
              Yeah, no kidding it would have been simpler! There's a lot of backstory but suffice it to say I wanted to buy-in and the owner said he wanted a partner but I think over time I've come to realize that the owner didn't ever really want to give up control. This is the third potential buyer for the practice (4th if you count me as the first) so I'm not convinced this will go through either due to his control issues.

              I've thought about walking away. I would have to work 2 years somewhere else farther away because of my noncompete, but then I thought about starting my own practice near where I live. I think I am certainly underestimating the amount of work it would take to start my own practice, however.

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              • #8
                Originally posted by Senator View Post

                Yeah, no kidding it would have been simpler! There's a lot of backstory but suffice it to say I wanted to buy-in and the owner said he wanted a partner but I think over time I've come to realize that the owner didn't ever really want to give up control. This is the third potential buyer for the practice (4th if you count me as the first) so I'm not convinced this will go through either due to his control issues.

                I've thought about walking away. I would have to work 2 years somewhere else farther away because of my noncompete, but then I thought about starting my own practice near where I live. I think I am certainly underestimating the amount of work it would take to start my own practice, however.
                Your non compete is with the owner not the PE. If you leave when he sells without agreeing to work for the PE, I cant see how it will stay valid- unless your contract states it is transferable to the new entity.

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                • #9
                  Originally posted by billy View Post

                  Your non compete is with the owner not the PE. If you leave when he sells without agreeing to work for the PE, I cant see how it will stay valid- unless your contract states it is transferable to the new entity.
                  I've thought about that as well but my attorney has said that it would transfer.

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                  • #10
                    Originally posted by Senator View Post

                    I've thought about that as well but my attorney has said that it would transfer.
                    If the contract transfers, then the obligations transfer as well, they want your agreement. They want a new one that has been offered, the issue is a benefit for which they (PE and owner) have gains to be made. You have no obligation to split tax benefits with them. You can. Someone wants you was the point.i
                    Tax protecting is a concept that is formula based if the concept is accepted. Your CPA can give you that number. I would suggest you consider "emotional", from your perspective you have "earned" a share of the pie. Net cash in your pocket is valid.

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                    • #11
                      Why would you want to stay with the PE if you are going to make significantly less than you are now ?

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                      • #12
                        Originally posted by Tim View Post

                        If the contract transfers, then the obligations transfer as well, they want your agreement. They want a new one that has been offered, the issue is a benefit for which they (PE and owner) have gains to be made. You have no obligation to split tax benefits with them. You can. Someone wants you was the point.i
                        Tax protecting is a concept that is formula based if the concept is accepted. Your CPA can give you that number. I would suggest you consider "emotional", from your perspective you have "earned" a share of the pie. Net cash in your pocket is valid.
                        Thank you for your input, I'm trying to follow best I can. You're saying that they don't want the obligation of my old employment contract so they want me to sign a new one, right?

                        What do you mean by "I would consider "emotional", from your perspective you have "earned" a share of the pie."

                        I will ask my CPA about tax protecting.

                        Comment


                        • #13
                          Originally posted by Random1 View Post
                          Why would you want to stay with the PE if you are going to make significantly less than you are now ?
                          In theory I will be busier which will make up for some of the lost comp. In theory I will also participate in the "second bite of the apple" at the time of the next liquidity event in 3-5 years.

                          Hopefully there will be more of my specialty in the future in the group so call will be shared by more people.

                          If I were to leave, there would be no guarantee I would make as much as I do now, either. I could start my own group (once my noncompete is over) but again, I assume that would be at least 1-4 years until I'd be busy enough to make my current comp. Or I could join another group as an associate and restart the process.

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                          • #14
                            Originally posted by Senator View Post

                            In theory I will be busier which will make up for some of the lost comp. In theory I will also participate in the "second bite of the apple" at the time of the next liquidity event in 3-5 years.

                            Hopefully there will be more of my specialty in the future in the group so call will be shared by more people.

                            If I were to leave, there would be no guarantee I would make as much as I do now, either. I could start my own group (once my noncompete is over) but again, I assume that would be at least 1-4 years until I'd be busy enough to make my current comp. Or I could join another group as an associate and restart the process.
                            This has almost never happens in PE takeovers- they will run the business to tight margins once your servitude contract is up, so expect your calls to get busier/more often, not less busy. Unless you are somehow bringing in so much volume that they are forced to hire more people. At least that is the anesthesia model. They will keep their costs as tightly controlled as they can.

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                            • #15
                              Originally posted by Senator View Post

                              Thank you for your input, I'm trying to follow best I can. You're saying that they don't want the obligation of my old employment contract so they want me to sign a new one, right?

                              What do you mean by "I would consider "emotional", from your perspective you have "earned" a share of the pie."

                              I will ask my CPA about tax protecting.
                              “As such, they are offering me cash as well as equity in the holding company. I will be making significantly less going forward with the PE group than I do now.”

                              If you continue to bring in 40% of revenue, how are you making less going forward? Sounds like comp is changing. Cash up front and equity in the holding company? Someone is changing contract terms is certainly implied.

                              You expressed concern about the owner. No concern for the PE firm? That is an emotional reaction. He can refuse to accept a lower amount or PE can raise it. Or the deal gets trashed. Your after tax is the only consideration. This deal is between the owner and PE.

                              They will require new terms for cash up front. You actually need to compare this deal to other opportunities. Pay is changing, employer is changing, new rules, this is a new job. Stay or leave.

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