A Buy-Sell Funded for a Practice That Has Since Doubled
Three dentists own equal shares of a practice recently appraised at 2,400,000 USD. Their 2019 cross-purchase buy-sell fixes each share at 300,000 and is funded by term policies: each partner owns a 250,000 policy on each of the other two. Partner A is 58; 18 months ago he completed treatment for prostate cancer and his PSA is now undetectable, so new underwriting on him is uncertain. The practice has no disability buy-out clause. Group long-term disability pays 60% of income to a maximum of 8,000 a month after 90 days, with an any-occupation definition after 24 months; the practice pays the premiums. Each partner earns 320,000 and bears one third of practice overhead of 46,000 a month. Personal after-tax spending is 11,000 a month. The partners are asking whether their protection is adequate and whether the agreement is enforceable if a partner dies or becomes disabled.
1. Quantify the buy-sell funding gap and evaluate the funding options given Partner A's health history.
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The agreement is underfunded by roughly 2.7 times. Each share is worth 2,400,000 / 3 = 800,000. On A's death the other two each collect 250,000, so 500,000 is available against an 800,000 obligation - a 300,000 shortfall per partner, and the same shortfall exists whichever partner dies. Worse, the agreement still prices each share at 300,000, so the survivors are contractually obliged to buy at 300,000 while the policies pay 500,000; the excess is taxable to the survivors and the seller's estate receives far less than fair value. That mismatch is a dispute waiting to happen.
Options, in order of priority:
- Replace the fixed price with a formula or a biennial appraisal, with a floor and a dispute mechanism. This is free and removes the main source of litigation.
- Add 300,000 of permanent or long-term term cover on B and C, who are insurable. Increase cover on A only if underwriting permits; after prostate cancer, offers may come with a table rating or exclusion, so obtain quotes before relying on it.
- For A's uninsurable exposure, use an installment note: the estate sells A's share with 20-30% down and the balance over five to seven years at a stated rate, secured by the practice and backed by a sinking fund of about 50,000 a year.
- Consider a wait-and-see or entity-purchase structure so the practice, not the individuals, holds the obligation, but check that this does not create a transfer-for-value problem.
A cannot self-insure his own death, but the practice can pre-fund through reserves.
2. Quantify Partner A's disability exposure and specify the coverage changes needed.
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Monthly need if A is disabled: personal spending 11,000 plus his one-third share of overhead 15,333 = 26,333. The group plan pays at most 8,000. Because the practice pays the premium, the benefit is taxable; at an assumed 35% combined marginal rate that is about 5,200 net. Shortfall: about 21,100 a month, or roughly 253,000 a year - the group plan covers under 20% of his real exposure.
Definition risk is as serious as the amount. After 24 months the test becomes any-occupation, so a dentist who cannot do clinical work but could review charts or teach may lose the benefit entirely. The 90-day wait also means the practice funds three months of overhead and personal costs from reserves.
Recommended changes:
- An individual own-occupation disability policy with residual/partial benefits, a benefit period to age 65, and a future-increase option; target 60-70% of income after tax.
- An overhead expense policy in the practice's name covering 100% of monthly overhead for 12-24 months, so staff and rent are paid during the waiting period.
- A disability buy-out clause in the buy-sell with a 12-24 month qualification period and lump-sum or installment funding; this is the missing piece that turns an indefinite partner into a clean exit.
- A written practice continuation plan covering patient handover and locum costs.
Given A's age and history, obtaining individual cover may be difficult, so the practice also needs a reserve equal to at least three months of overhead.
3. The partners ask whether the agreement itself is sound. What governance and drafting failures should be flagged?
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Enforceability and fairness issues to fix:
- Valuation: a 2019 fixed price with no update mechanism is the biggest defect; the practice has moved from 900,000 to 2,400,000. Use a formula tied to revenue or EBITDA with an independent appraisal every two years, and define what happens if the partners cannot agree.
- Funding mismatch: policies total 500,000 against an 800,000 share; either buy more cover or write the note mechanics explicitly.
- Disability: with no buy-out trigger, a disabled partner keeps drawing profit share and blocks decisions indefinitely. Add a defined trigger, a valuation adjustment (often a discount for disability), and a timetable.
- Structure: cross-purchase means each partner must be insurable and premiums are paid with after-tax dollars; entity purchase is simpler administratively but concentrates policies in the practice and can create alternative-minimum-tax and creditor issues. Whichever is chosen, check transfer-for-value rules when policies move between the two.
- Administration: named beneficiaries on policies, a funded escrow, annual certificates of insurance, and a requirement that any partner who becomes uninsurable discloses it.
- Exit terms: death, disability, retirement, divorce and bankruptcy should all be addressed; currently only death is covered, and even that incompletely.
The adviser's role is to put the numbers behind each gap and insist on legal review; drafting the agreement without a lawyer is outside scope.