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Art of Accounting: Price to pay for a practice

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My practice continuation tool kit has a sample purchase agreement with explanations of each step of the process. I feel it creates a fair arrangement should a solo owner suddenly die or become disabled.

In all, I’ve distributed over 15,000 of these sample agreements for free. You can get your kit by emailing me at GoodiesFromEd@withum.com and just put Practice Continuation as the subject.

I get many calls from practitioners asking, “How much should I pay for a practice?” I speak to them for a few minutes and suggest they use the letter in my kit as a model for the price and terms. However, when you buy a practice from a retiring practitioner, it’s typical for a down payment to be made, which I don’t suggest when it is transferred due to a sudden death. Different circumstances. So I alter that model letter by adding a down payment. The following is a suggested arrangement with all the details to acquire a practice from someone who is retiring:

1. The total price will be based on collections paid over five years, with no guarantees of client retention. To offset the lack of guarantees and the obvious loss of some clients, the seller will share in increased fees that are collected during the five-year period. The buyer’s only risk is the down payment. Further, the purchase will be structured so the seller will get capital gain treatment rather than ordinary income, which would also be subject to self-employment tax. The buyer will forgo current tax deductions on the payments and will amortize the practice purchase cost over 15 years. In my opinion, taken as a whole, this is a fair deal for both buyer and seller.

2. The pricing model works out to 100 percent of “one year’s” collections, but it is a moving amount based on actual collections over the next five years.

3. The total purchase price will be estimated based on 100 percent of the seller’s previous year’s collections.

4. A down payment of 25 percent of that amount will be paid.

5. Monthly payments of 15 percent of actual collections will be paid over five years. These payments will be made by the 15th day of the month following the month of collection.

6. The collections referred to are from the purchased clients and any growth in fees from them and added or increased services to them. It will not apply to any fees from clients referred by them.

7. At the end of the fifth year, the total of the five years’ 15 percent payments based on collections will be totaled and added to the down payment. This gives the total payments on account.

8. The total collections during the five years will be multiplied by 20 percent, and that is the actual and final “purchase price.”

9. The total payments will be subtracted from the purchase price. If there is a shortfall, it will be paid to the seller. If there is an overpayment, the seller will refund that amount. These will be done within 15 days of this calculation.

10. To avoid the need for an overpayment having to be refunded, an estimated calculation can be made at the end of the fourth year, and the fifth year’s monthly payments can be adjusted downward.

11. The five-year payment period is based on collections for services performed during that five-year period, so the collection period will extend beyond the end of the fifth year for late payments.

`12. An estimate can be made for accounts receivable expected to be paid after the end of the fifth year and included in the final calculation, or you could wait until those amounts are received and 20 percent of those collections would then be paid.

13. Note that all of the payments to the seller will be capital gains, except to the extent interest is imputed; and all payments by the purchaser will be applied to the amortizable amount, except for a current interest deduction to the extent interest is imputed.

14. An example of the transaction is as follows:

a. Assume the base year gross collections was $200,000;
b. Down payment of 25 percent is $50,000;
c. Annual collections for years 1, 2, 3, 4 and 5 are $160,000, $180,000, $220,000, $260,000 and $300,000 with a five-year total of $1,120,000;
d. The annual payments at 15 percent are $24,000, $27,000, $33,000, $39,000 and $45,000, or a total of $168,000. Added to the $50,000 down payment, the total paid was $218,000.
e. The total percentage of the payments over the five years was 19.45 percent ($218,000 ÷ $1,120,000).
f. 20 percent of the collections is $224,000 (20% x $1,120,000), so an additional $6,000 would need to be paid to the seller.

A second example where there is an overpayment:

a. Assume the base year gross collections was $200,000;
b. Down payment of 25 percent is $50,000;
c. Annual collections for years 1, 2, 3, 4 and 5 are $140,000, $150,000, $160,000, $170,000 and $180,000 with a five-year total of $800,000;
d. The annual payments at 15 percent are $21,000, $22,500, $24,000, $25,500 and $27,000, or a total of $120,000. Added to the $50,000 down payment, the total paid was $170,000.
e. The total percentage of the payments over the five years was 21.25 percent ($170,000 ÷ $800,000).
f. 20 percent of the collections is $160,000 (20% x $800,000), so there was an overpayment of $10,000 that the seller would need to pay to the buyer. It would have been more appropriate to adjust the fifth year payment so the overpayment would not have resulted.

The above model can be used as a guide. I believe it works and is fair. It also represents a method I have followed when we acquired a practice. The only difference with this model to the suggestion in the practice continuation kit is the down payment. My models are suggestions to be considered in your negotiations. Also, whatever you decide, you would need to use an attorney to draw up the contract.

Do not hesitate to contact me at emendlowitz@withum.com with your practice management questions or about engagements you might not be able to perform.

Edward Mendlowitz, CPA, is partner at WithumSmith+Brown, PC, CPAs. He is on the Accounting Today Top 100 Influential People list. He is the author of 24 books, including “How to Review Tax Returns,” co-written with Andrew D. Mendlowitz, and “Managing Your Tax Season, Third Edition.” Ed also writes a twice-a-week blog addressing issues that clients have at www.partners-network.com along with the Pay-Less-Tax Man blog for Bottom Line. Ed is an adjunct professor in the MBA program at Fairleigh Dickinson University teaching end user applications of financial statements. Art of Accounting is a continuing series where Ed shares autobiographical experiences with tips that he hopes can be adopted by his colleagues. Ed welcomes practice management questions and can be reached at (732) 743-4582 or emendlowitz@withum.com.

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Succession planning Practice management Ed Mendlowitz Retirement planning
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