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Issue #3-1 | August 10, 2012

Owners’ compensation, consulting fees, or distributions?

The recent Mulcahy, Pauritsch, Salvador & Co., LTD. v. Commissioner (T.C. Memo. 2011-74) Tax Court case, speedily upheld by the 7th Circuit Court of Appeals (No. 11-2105 (7th Cir. 5/17/12)), highlights the increasing exposure to challenges in owners’ compensation deductions that a professional firm operating as a C corporation faces. Because this case involves an accounting firm with the same issues inherent in medical practices, it has broad implications in the determination of both deductible compensation as well as fair market compensation in the tax-exempt sector. Analysts untrained in taxation often do not understand that the standards of IRC §162’s “ordinary and necessary” test apply just as fully to tax-exempt entities as they do to taxable companies, with the added burden of meeting the inurement prohibition of §501(c) (3).

The firm in this case made a critical error by shifting what were intended to be compensation deductions into “consulting” payments to shell entities. The firm reported that it had “virtually no income” and owed “virtually no corporate income tax” because its revenues were offset by deductions for business expenses—mostly the “consulting fees” paid directly or indirectly to its owner-employees. The IRS disallowed the firm’s deductions for “consulting fees,” reclassifying them as dividends. Ultimately, the Tax Court and the 7th Circuit Court of Appeals upheld the IRS’s determination finding that the firm could not deduct payments to related entities. The court said that the payments were, in fact, dividends or return on equity, not compensation for services rendered by the firm’s owners. Both courts went on to find that the compensation was unreasonable under several other theories, including the independent investor standard of Exacto Springs, another well-known 7th Circuit case.

Here is the Tax Court’s discussion of what “return on equity” actually means. The firm claimed, in effect, that because such companies are typically valued on the basis of a multiple of gross revenue (which is, in fact, true), the owners received their equity return for each year that firm revenues grew. This is a sound argument from a valuation standpoint because, according to Morningstar/Ibbotson data, for example, it is well established that “return” consists of both income (cash or dividend) return and capital appreciation. However, no valuation that would have offered evidence on the capital appreciation was submitted in the case. Nonetheless, this highlights why the income approach in addition to a “market approach” is useful in addition to such “market methods” as the rule of thumb the firm cited in the case.

The firm contends that the rate of return on equity is equal to its gross revenue for one year minus its gross revenue for the prior year, divided by the gross revenue for the prior year.  This definition is based on the theory that the value of the firm’s equity is equal to the firm’s gross revenue for one year….

We agree with the IRS that the rate of return on the firm’s equity should be calculated by reference to annual net income, not the year-to-year change in gross revenue. It is inappropriate to look at gross revenue (or to changes in gross revenue) to determine if equity investors are receiving good returns on their investment. A corporation’s shareholders do not seek to maximize gross revenue.  They seek to maximize profit….

Using annual net income comports with the approach taken by the Seventh Circuit in Exacto Spring Corp. v. Commissioner....

The firm retained Marc Rosenberg of the Rosenberg Survey as an expert to opine on the owners’ compensation for the case. Both the Tax Court and the 7th Circuit dismissed his testimony in disparaging terms. Here is the critical takeaway from Rosenberg’s opinions: “Even though the $300,000 in payments [to the owners] were nominally labeled by the company as ‘salary,’ the payments could in reality be a return on the owner’s investment in the company….” This is precisely the case with data commonly used from the Medical Group Management Association Physician Compensation and Production Survey to the extent that it comes from owners of private practices! In other words, MGMA data is typically used as if it were straight compensation for services without considering that the private practices distribute profits as well that are counted as compensation. Similar anomalies therefore will exist in other surveys due to reliance on various exempt institutions’ compensation opinions from valuation firms to support fair market value that are in turn based on private practice data that include equity return payments to the owners.

Tips and resources to increase profitability

Becker’s Hospital Review recently profiled Mary Greeley Medical Center’s CFO, Mike Tretina, who led the charge to increase his hospital’s profit margin from 1.5%  to 6% in one year and then to 8% the following year. Describing the secrets to his success, Tretina offers practical tips on how to improve profit margins by monitoring financial metrics closely and embracing today’s new emphasis on quality, safety, and service, and more. Click here for the full article.

A report from Healthcare Intelligence Network (HIN), a BVR partner, supports the benchmarking data and monitoring Tretina suggests. 46 Healthcare Metrics to Boost Profitability: Charting 2012 Trends offers actionable metrics carefully curated from 2011 market research data and explores responses from hundreds of HIN survey respondents on fundamental healthcare metrics. Key findings include the following:

  • 30% of respondents indicate that the patient-centered medical home is the healthcare delivery model with the most potential to reduce costs and improve care quality in 2012;
  • 63.2% of respondents say that to reduce avoidable ER use, the most effective intervention for recently discharged patients is ED visit notification;
  • The top three populations linked to avoidable ER use are avoidable or non-emergent visits, high utilizers and Medicaid;
  • 63% of respondents offer health and wellness incentives for participation in health promotion programs; and
  • Cost is the top challenge to ACO creation, according to 22% of respondents.

HIN Executive VP and COO Melanie Matthews says, "Given the changing landscape of healthcare, executives must identify their population's healthcare needs and available resources, articulate their goals, and structure their network of care around these elements. The metrics found in 46 Healthcare Metrics to Boost Profitability  will support healthcare leaders in accomplishing all of these goals." Use this resource along with Tretina’s tips for profitability to boost your profit margins.  Click here for more information.

Fraud in out-of-network billing practices may affect value

“Healthcare insurers are taking aim at the billing practices of out-of-network (OON) ambulatory surgery centers (ASCs), alleging, among other things, that ASC’s routine waiver of patient financial responsibility constitutes fraud, ” reports the American Health Lawyers Association in its July Fraud and Abuse Practice Group email alert. An example is the February 2012 case in which Aetna Life Insurance Company (ALIC) filed suit in California Superior Court against Bay Area Surgical Management LLC (manager of six ASCs), Bay Area Surgical Group (owner of the defendant ASC), and the three coparticipating provider contracts. According to Bloomberg BusinessWeek, “the lawsuit seeks to stop [ASCs] from waiving the co-insurance payments people are supposed to be charged when they use doctors or facilities that don’t have contracts with their insurers. By not requiring such payments for so-called out-of-network care, the centers illegally lured patients, and then billed Aetna up to 2,500 percent more than what the company pays its contracted providers for procedures, according to the suit.”

The ALIC case is a good reminder for healthcare appraisers to be on the lookout for OON billing that could distort historical results of operations and the value of a healthcare entity. OON refers to a situation in which a physician, ASC, or surgical hospital—to name the more common examples—does not have a provider agreement with one or more insurers in their market area and thus is not subject to that insurer's contracted rates. As a result, if a patient is treated by the OON provider, the provider can charge its "regular" fee, which is usually several times (and sometimes even greater multiples) more than it otherwise would have received. Insurers sometimes feel compelled to pay the charge or more than their normal allowable charge rather than leave the insured patient "holding the bag."

Although not necessarily a national phenomenon, New Jersey, Texas, and Ohio are examples of other states where this has become an issue and law suits similar to the ALIC case have been filed. Waiving co-pays or deductibles can violate state statutes or can be deemed—as in the California suit—to be perpetrating a fraud against the insurers since insured patients who can use OON providers have higher co-pays and deductibles intended to discourage them from doing so.


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Business Valuation Resources, LLC
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