How to appraise a physician practice

Be rigorous in assessing fair market value

By Roy Bossen, JD

Hinshaw & Culbertson

Chicago

Tax-exempt hospitals that are purchasing medical practices must ensure that they pay no more than fair market value. Determining the fair market value generally requires an appraisal. In performing an appraisal, several methodologies can be used.

The Internal Revenue Service in Washington, DC, has defined "fair market value" as:

* a price at which a willing buyer and a willing seller will agree;

* neither the seller nor the buyer being under any compulsion to buy and sell;

* both the seller and buyer having reasonable knowledge of the facts.

The Internal Revenue Service Exempt Organizations Technical Instruction Program for 1995 indicates that appraisals are pivotal in determining if the price represents fair market value.

The Exempt Organizations Technical Division has indicated that fair market value is determined within the framework of the Business Enterprise Value (BEV), with the BEV consisting of the total value of the assembled assets that comprise the entire going concern.

Methods to determine business value

Three common methodologies are used to estimate the BEV:

* The income approach.

The income approach is thought to be the most comprehensive and the most relevant, because it includes the excess-earnings methods described in earlier revenue rulings.

This approach also does not place a substantial value on intangible assets, because they are difficult to measure real value and often are used to inflate the valuation for impermissible private benefit or inurement purposes. The income approach focuses on a cash-flow analysis, determining what cash flow can be taken out of the practice without impairing operations or profitability. The cash flow available for distribution would then be discounted at present value of the specified discounted rate.

* The market approach.

The market approach is based on the purchase price paid for similar assets in the market. This creates difficulty in determining whether one practice is similar to another. The fact that the receipts of one practice are the same as another may not mean that the value of the practice is the same.

* The cost approach.

The cost approach involves determining the cost to replace or reproduce the practice while using the fair market value of the individual corporate assets as its starting point. The value of the corporate assets are estimated and subtracted from the book value of liabilities. The resulting number is the value of the business.

The IRS recognizes that all three methods will be used. It has been suggested that to ensure a correct evaluation, the results of the income approach be tested against the other approaches.

In determining what the correct evaluation is, it must be remembered that all tax-exempt organizations purchasing practices:

* must be organized and operated exclusively for charitable purposes;

* must have no part of the net earnings inuring to the benefit of any private shareholder or individual.

In addition, private individuals, such as the seller, may not receive value in excess of the fair market value for the assets. In such a situation, not only must there be no more than fair market value paid, but the benefit the physician-seller receives must be balanced against the benefit to the public.

How to demonstrate fair market value

To guard against tax-exempt concerns, Section 501(c)(3) hospitals should be able to demonstrate that:

* Their relationship with potential insiders has been negotiated at arm's length.

* The physician does not have an opportunity to exert undue influence on the transaction.

* The purchase price for assets was at fair market value.

* Payment is at reasonable compensation if there is payment for services.

Tax-exempt entities, when purchasing practices or any business, can best protect themselves if they obtain a qualified appraisal using the above methodologies to ascertain fair market value.