E.8 Professional Practice Structures

E.8.1 Overview

Depending on the jurisdiction in which a professional practice legal entity operates, a licensed professional practitioner (e.g., physician, dentist, accountant) may be required to own the equity of the professional practice legal entity while nonpractitioners may not be permitted to own an equity interest. In some cases, nonpractitioners may have variable interests in the professional practice legal entity in forms other than equity, most commonly through a fee arrangement. The professional practice legal entity generally enters into various agreements that may affect the consolidation analysis and governance. Common agreements include, but are not limited to:

Management services agreements.
Shareholder, limited liability company, or partnership agreements.
Professional practitioner employment agreements.
Credit agreements.

It is essential for a reporting entity to take a complete inventory of all agreements and understand how they affect the consolidation analysis of professional practice structures. The discussion below provides considerations related to assessing such structures for consolidation under ASC 810.

E.8.2 Variable Interests in a Professional Practice Structure

In determining whether it is required to consolidate a professional practice, a reporting entity must identify all agreements and assess whether they represent a variable interest. While the agreements listed in the previous section are commonly associated with professional practice structures, their names may vary, or there may be other relevant agreements.

E.8.2.1 Fees Paid to Decision Makers or Service Providers

A reporting entity will often enter into a management services agreement with a professional practice legal entity that delegates certain administrative and managerial services that are not related to the professional practice (e.g., nonmedical or dental services). Generally, the agreement (1) designates the entity responsible for various services, including, but not limited to, billing services, marketing services, legal services, human resource services, information management services, equipment and supply services, and financial services and (2) gives that entity the right to manage the related personnel and execute those services. The agreement(s) may also give the entity the ability to make decisions about the scope of professional practice activities provided by the legal entity (e.g., operational activities), such as establishing fees charged for services, hiring and firing professional practice personnel, setting policies and procedures, and performing other general operations of the legal entity.

As compensation for its services, the entity will receive a fee. If all of the following conditions are met, the fee will not represent a variable interest (see Section 4.4):

The fee is “commensurate” under ASC 810-10-55-37(a).
The arrangement is at market under ASC 810-10-55-37(d).
The decision maker or service provider does not have any other interests (direct interests or indirect interests through its related parties) in the legal entity that absorb more than an insignificant amount of the potential VIE’s variability (ASC 810-10-55-37(c)).

Generally, the fee arrangement is the most common form of variable interest in a professional practice structure. The fee structure may vary by agreement, and the fee may be designed to absorb the variability of the operational activities of the legal entity (e.g., the initial fee may be based on the initial expected cash flows and subject to future adjustment). Similarly, the fee arrangement may expose the reporting entity to risk of loss as a result of the obligation to fund operating losses (see Section 4.4.1.3).

Note that while a fee arrangement is commonly included in a management services agreement or equivalent, other types of agreements may contain one. Fee arrangements should be scrutinized in the determination of whether a reporting entity that is acting in a servicing capacity holds a variable interest in a professional practice legal entity through the servicing agreement. For example:

A reporting entity should carefully assess whether to evaluate the unit of account of the risk of loss and the fee arrangement as (1) a single (combined) interest under which the reporting entity may be exposed to risk of loss in the professional practice legal entity through the fee arrangement in accordance with ASC 810-10-55-37C or (2) substantively separate interests and therefore view the credit enhancement as an “other interest in the VIE,” as described in ASC 810-10-55-37(c). In making this determination, the reporting entity may consider the interpretive guidance in Section 5.3.1.1.2, by analogy.
If the risk of loss (1) is an interest that is substantively separate from the fee arrangement and (2) exposes the reporting entity to first-dollar losses in the professional practice legal entity, the reporting entity should closely evaluate whether such exposure would, individually or in the aggregate with its other interests, result in the reporting entity’s absorption of more than an insignificant amount of the professional practice legal entity’s expected losses under ASC 810-10-55-37(c).

E.8.2.2 Debt

A reporting entity will often enter into a credit agreement with a legal entity to provide the necessary capital for the legal entity’s operations. The form of debt can include, among others, a revolving facility, promissory note, or term debt. Debt instruments that represent financing instruments of a legal entity are almost always variable interests, even if such instruments are the most senior in the capital structure of the legal entity (see Section 4.3.2). As liabilities, these instruments are designed to absorb variability in the performance of the legal entity’s assets because the debt holder is exposed to that legal entity’s ability to pay (i.e., credit risk) and may be exposed to interest rate risk, depending on the legal entity’s design.

E.8.2.3 Equity

Equity interests are almost always variable interests because they typically represent the most subordinated interest in the legal entity’s capital structure. However, as discussed above, a variable interest in the form of equity in a professional practice structure is less common given the nature of these structures and the potential jurisdictional requirement that the equity of the legal entity must be owned by a licensed professional and that nonpractitioners may not own such equity. If a jurisdictional restriction does not exist, an entity may have an equity interest in the legal entity.

E.8.2.4 Implicit Variable Interests

As discussed in Section 4.3.10, an implicit variable interest involves the absorption or receipt (or both) of variability indirectly, rather than directly, from the legal entity. Identifying an implicit variable interest involves determining whether a reporting entity may be indirectly absorbing or receiving variability of the legal entity, which may be contractual or implicit. For example, an entity will often have an implicit obligation to absorb the losses of a professional practice legal entity, including funding any shortfalls in working capital needs. Often, the entity with the implicit obligation to absorb losses of a professional practice legal entity is also the entity that enters into a management services agreement with the professional practice legal entity (Section E.7.2.1). The equity held by the professional practitioner is often not considered “at risk” if an entity has an implicit obligation to absorb the losses of a professional practice legal entity. Additional considerations are discussed below.

E.8.3 Determining Whether a Professional Practice Legal Entity Is a VIE

The determination of whether a professional practice legal entity is a VIE generally focuses on whether (1) the legal entity has sufficient equity at risk (see Section 5.2) or (2) the equity investors, as a group, lack the characteristics of a controlling financial interest (see Section 5.3). In general, this is because (1) the equity held by the professional practitioner is not “at risk” or, if the equity is at risk, is not sufficient to finance the legal entity’s operations without additional subordinated financial support or (2) the equity investor (typically the professional practitioner) does not have the power to direct the most significant activities of the legal entity. If the professional practitioner is the sole equity holder, a reporting entity should consider whether a nonequity holder has the right to remove the professional practitioner (i.e., the equity holder) from the legal entity (i.e., a substantive kick-out right) in the assessment of whether the equity investors, as a group, lack the characteristics of a controlling financial interest. See Chapter 5 for further discussion of how to determine whether a legal entity is a VIE.

E.8.4 Determining the Primary Beneficiary of a Professional Practice Legal Entity

ASC 810 requires a reporting entity to identify the primary beneficiary of a professional practice legal entity that is a VIE on the basis of whether the reporting entity has both (1) the power to direct the activities that most significantly affect the VIE’s economic performance and (2) the obligation to absorb the VIE’s losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. Only one reporting entity is expected to control a professional practice legal entity. Typically, the primary-beneficiary assessment of a professional practice legal entity focuses on the power criterion and determining which party has the power to direct the activities that most significantly affect the economic performance. See Chapter 7 for further discussion of identifying the primary beneficiary of a VIE.

E.8.4.1 Power Analysis — Identifying the Activities That Most Significantly Affect the VIE

In a professional practice structure, the activities that most significantly affect the economic performance of the legal entity are typically the operational activities of such entity. Accordingly, the entity that has the power over the operational activities of the legal entity, or the entity that holds a substantive kick-out right to remove the decision maker (if such right exists) would generally meet the power criterion. As described above, one or more agreements will often give an entity power over the operational activities.

Further, in some situations, a decision maker may be acting as an agent on behalf of other parties because the decision maker does not have a variable interest (e.g., if the fee arrangement was determined to not be a variable interest). In instances in which a reporting entity absorbs essentially all of the variability of a VIE, we would expect the reporting entity to consolidate the VIE. This is consistent with the guidance discussed in Section 7.2.7 and with prepared remarks by Christopher Rogers at the 2014 AICPA Conference on Current SEC and PCAOB Developments.

E.8.4.1.1 Kick-Out Rights

In professional practice structures, while the professional practitioner often has the ability to make decisions about operational activities, a legal entity (often the service provider) may hold a kick-out right to remove the professional practitioner. A reporting entity must assess whether a kick-out right exists and, if so, whether such right is substantive. For a kick-out right to be substantive, there cannot be any significant barriers to its exercise. We would also expect the holder of the kick-out right to have a variable interest. See Section 7.2.11.1.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.