Income Taxes and Tax Receivable Agreement
Income Taxes
The Company uses the asset and liability method to account for income taxes. Under this method, deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. If a net operating loss ("NOL") carryforward exists, the Company makes a determination as to whether that NOL carryforward will be utilized in the future. A valuation allowance is established for certain net operating loss carryforwards when their recoverability is deemed to be uncertain. The carrying value of the net deferred tax assets assumes that the Company will be able to generate sufficient future taxable income in certain tax jurisdictions, based on estimates and assumptions. If these estimates and related assumptions change in the future, the Company may be required to adjust its deferred tax valuation allowances.
The Company, or one or more of its subsidiaries, files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal income tax examinations for years prior to 2014 or state income tax examinations for years prior to 2013.
The Company and certain of its subsidiaries file a consolidated federal income tax return. The partnerships, limited liability companies, and certain non-consolidated physician practice corporations also file separate income tax returns. The Company's allocable portion of each partnership's and limited liability company's income or loss is included in taxable income of the Company. The remaining income or loss of each partnership and limited liability company is allocated to the other owners.
The Company made income tax payments of $0.5 million and $0.6 million for the four months ended December 31, 2017 (Successor) and eight months ended August 31, 2017 (Predecessor), respectively. Income tax payments were $0.7 million and $1.1 million for the years ended December 31, 2016 and 2015, respectively.
Income tax expense (benefit) is comprised of the following (in thousands):
|
| | | | | | | | | | | | | | | | | | |
| | Successor | | | | Predecessor |
| | September 1 to
December 31, | | | | January 1 to
August 31, | | Year Ended December 31, |
| | 2017 | | | | 2017 | | 2016 | | 2015 |
| | | | | | | | | | |
Current: | | | | | | | | | | |
Federal | | $ | (111 | ) | | | | $ | — |
| | $ | (31 | ) | | $ | — |
|
State | | 990 |
| | | | 614 |
| | 244 |
| | 909 |
|
Deferred: | | | | | | | | | | |
Federal | | 77,472 |
| | | | (17,288 | ) | | 7,326 |
| | (132,311 | ) |
State | | (6,712 | ) | | | | (1,415 | ) | | (444 | ) | | (17,580 | ) |
Total income tax expense (benefit) | | $ | 71,639 |
| | | | $ | (18,089 | ) | | $ | 7,095 |
| | $ | (148,982 | ) |
A reconciliation of the provision for income taxes as reported in the consolidated statements of operations and the amount of income tax expense (benefit) computed by multiplying consolidated income (loss) in each year by the U.S. federal statutory rate of 35% follows (in thousands):
|
| | | | | | | | | | | | | | | | | | |
| | Successor | | | | Predecessor |
| | September 1 to
December 31, | | | | January 1 to
August 31, | | Year Ended December 31, |
| | 2017 | | | | 2017 | | 2016 | | 2015 |
| | | | | | | | | | |
Tax expense (benefit) at U.S.federal statutory rate | | $ | 24,485 |
| | | | $ | 4,315 |
| | $ | 32,263 |
| | $ | (26,648 | ) |
State income tax, net of U.S. federal tax benefit | | 1,685 |
| | | | (456 | ) | | (86 | ) | | 1,059 |
|
Change in valuation allowance | | 529 |
| | | | 1,324 |
| | 354 |
| | (137,721 | ) |
Net income attributable to non-controlling interests | | (13,872 | ) | | | | (14,731 | ) | | (26,470 | ) | | (24,996 | ) |
Changes in measurement of uncertain tax positions | | (191 | ) | | | | 20 |
| | (262 | ) | | (10 | ) |
Stock option compensation | | 306 |
| | | | 37 |
| | (200 | ) | | — |
|
Differences related to divested facilities | | (429 | ) | | | | (1,708 | ) | | — |
| | — |
|
Nondeductible transaction costs | | 2,058 |
| | | | (977 | ) | | — |
| | 3,442 |
|
Tax return reconciling differences | | — |
| | | | (316 | ) | | 1,635 |
| | (1,574 | ) |
Change in effective tax rate | | 64,343 |
| | | | (825 | ) | | — |
| | (2,143 | ) |
TRA liability | | (7,404 | ) | | | | (4,782 | ) | | (327 | ) | | 39,428 |
|
Other | | 129 |
| | | | 10 |
| | 188 |
| | 181 |
|
Total income tax expense (benefit) | | $ | 71,639 |
| | | | $ | (18,089 | ) | | $ | 7,095 |
| | $ | (148,982 | ) |
The components of temporary differences and the approximate tax effects that give rise to the Company’s net deferred tax asset are as follows (in thousands):
|
| | | | | | | | | | |
| | Successor | | | | Predecessor |
| | December 31,
2017 | | | | December 31,
2016 |
| | | | | | |
Deferred tax assets: | | | | | | |
Medical malpractice liability | | $ | 3,236 |
| | | | $ | 4,194 |
|
Accrued vacation and incentive compensation | | 2,125 |
| | | | 1,112 |
|
Net operating loss carryforwards | | 137,794 |
| | | | 158,796 |
|
Allowance for bad debts | | 2,545 |
| | | | 8,343 |
|
Capital loss carryforwards | | 3,024 |
| | | | 2,785 |
|
Deferred rent | | — |
| | | | 1,371 |
|
Depreciation on property and equipment | | — |
| | | | 530 |
|
Deferred financing costs | | 17,004 |
| | | | — |
|
TRA liability | | 1,042 |
| | | | 4,542 |
|
Other deferred assets | | 4,961 |
| | | | 4,879 |
|
Total gross deferred tax assets | | 171,731 |
| | | | 186,552 |
|
Less: Valuation allowance | | (11,032 | ) | | | | (7,358 | ) |
Total deferred tax assets | | 160,699 |
| | | | 179,194 |
|
Deferred tax liabilities: | | | | | | |
Deferred financing costs | | — |
| | | | (8,797 | ) |
Depreciation on property and equipment | | (12,098 | ) | | | | — |
|
Amortization of intangible assets | | (12,441 | ) | | | | (15,241 | ) |
Basis differences of partnerships and joint ventures | | (2,399 | ) | | | | (68,160 | ) |
Deferred rent | | (717 | ) | | | | — |
|
Other deferred liabilities | | (725 | ) | | | | (3,203 | ) |
Total deferred tax liabilities | | (28,380 | ) | | | | (95,401 | ) |
Net deferred tax assets | | $ | 132,319 |
| | | | $ | 83,793 |
|
The Company had federal net operating loss carryforwards of $507.4 million as of December 31, 2017, which expire between 2025 and 2037 and state net operating loss carryforwards of $619.6 million as of December 31, 2017, which expire between 2018 and 2037. The Company had capital loss carryforwards of $12.6 million as of December 31, 2017, which expire between 2018 and 2022. The Company had federal and state credit carryforwards of $1.1 million as of December 31, 2017. The federal credits do not expire, and the state credits expire between 2018 and 2029.
The Company has recorded a valuation allowance against deferred tax assets at December 31, 2017 and 2016 totaling $11.0 million and $7.4 million, respectively, which represents an increase of $3.6 million. The valuation allowance continues to be provided for certain deferred tax assets for which the Company believes it is more likely than not that the tax benefits will not be realized, which are primarily certain state net operating losses and capital loss carryforwards.
Included in the increase in the valuation allowance for the year ended December 31, 2017 was an increase of approximately $0.4 million that was recorded to additional-paid-in-capital as the result of the tax effect of the disposals of shares of non-controlling interests. Also included in the increase in the valuation allowance was an increase of approximately $0.3 million that was recorded to goodwill related to certain deferred tax assets acquired during the year. Approximately $1.8 million of the valuation allowance as of December 31, 2017 is recorded against deferred tax assets that, if subsequently recognized, will be credited directly to contributed capital.
A reconciliation of the beginning and ending liability for gross unrecognized tax benefits for the years ended December 31, 2017 and 2016 is as follows (in thousands):
|
| | | | | | | | | | |
| | Successor | | | | Predecessor |
| | December 31,
2017 | | | | December 31,
2016 |
| | | | | | |
Unrecognized tax benefits at beginning of year | | $ | 1,061 |
| | | | $ | 1,403 |
|
Additions for acquired positions | | 36 |
| | | | — |
|
Additions for tax positions of prior years | | — |
| | | | 60 |
|
Reductions for tax positions of prior year | | (407 | ) | | | | (398 | ) |
Settlements | | — |
| | | | (4 | ) |
Unrecognized tax benefits at end of year | | $ | 690 |
| | | | $ | 1,061 |
|
The Company recognizes interest and penalties related to uncertain tax positions in its provision for income taxes in the consolidated statements of operations. For the years ended December 31, 2017 and 2016, the Company had approximately $0.1 million and $0.2 million, respectively, of accrued interest and penalties related to uncertain tax positions. The total amount of accrued liabilities related to uncertain tax positions that would affect the Company's effective tax rate, if recognized, is $0.2 million and $0.3 million as of December 31, 2017 and 2016, respectively. The reserves are included in long-term taxes payable and long-term deferred tax assets in the consolidated balance sheet as of December 31, 2017.
The Tax Cuts and Jobs Act was enacted on December 22, 2017. The Act reduces the US federal corporate tax rate from 35% to 21%, allows for 100% expensing of certain capital expenditures, and will limit interest expense deductions beginning in 2018. As of December 31, 2017, the Company has not completed its accounting for the tax effects of enactment of the Act; however, in certain cases, as described below, the Company has made a reasonable estimate of the effects on existing deferred tax balances. In other cases, the Company has not been able to make a reasonable estimate and continues to account for those items based on existing accounting under ASC 740, and the provisions of the tax laws that were in effect immediately prior to enactment. In all cases, the Company will continue to make and refine its calculations as additional analysis is completed. In addition, estimates may also be affected as the Company gains a more thorough understanding of the tax law.
The Company remeasured certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21%. However, the Company is still analyzing certain aspects of the Act and refining its calculations, which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The most significant component of the uncertainty relates to the state tax impact of the federal changes and how the states will or will not adopt federal changes. The effect on the Company will primarily be related to its state net operating losses and related valuation allowances. The provisional amount recorded related to the remeasurement of the deferred tax balance was $64.0 million, which is included as a component of income tax expense.
The Company has not made sufficient progress on the analysis of the 100% expensing that may be claimed at certain partnership entities in their 2017 income tax returns for applicable capital expenditures, and the effects that would have on the Company's deferred tax assets and liabilities. The temporary differences related to these amounts would adjust the Company's deferred tax assets and liabilities related to partnership differences and net operating losses, but would likely have an immaterial net effect on the overall deferred tax asset recorded in the financial statements.
Tax Receivable Agreement
On May 9, 2017, the Company and H.I.G., in its capacity as the stockholders representative, entered into an agreement to amend that certain Income Tax Receivable Agreement, dated September 30, 2015 (as amended, the “TRA”), by and between the Company, H.I.G. (in its capacity as the stockholders representative) and the other parties referred to therein, which amendment became effective on August 31, 2017. The TRA was initially entered into in connection with the reorganization undertaken to facilitate the Company’s initial public offering. Pursuant to the amendment to the TRA, the Company agreed to make payments to H.I.G. in its capacity as the stockholders representative pursuant to a fixed payment schedule. The amounts payable under the TRA are calculated as the product of (i) an annual base amount and (ii) the maximum corporate federal income tax rate for the applicable year plus three percent. The amounts payable under the TRA are related to the Company’s projected realized tax savings over the next six years and are not dependent on the Company’s actual tax savings over such period. The calculation of amounts payable pursuant to the TRA is thus dependent on the maximum corporate federal income tax rate. To the extent that the Company is unable to make payments under the TRA and such inability is a result of the terms of credit agreements and other debt documents that are materially more restrictive than those existing as of September 30, 2015, such payments will be deferred and will accrue interest at a rate of LIBOR plus 500 basis points until paid. If the terms of such credit agreements and other debt documents cause the Company to be unable to make payments under the TRA and such terms are not materially more restrictive than those existing as of September 30, 2015, such payments will be deferred and will accrue interest at a rate of LIBOR plus 300 basis points until paid.
As a result of the amendment to the TRA, the Company was required to value the liability under the TRA by discounting the fixed payment schedule using the Company’s incremental borrowing rate. During the eight months ended August 31, 2017 (Predecessor), the Company recognized a reduction in the carrying value of the liability under the TRA of $43.9 million, with $15.3 million of the reduction recorded to a gain on amendment of TRA and $28.6 million recorded as a reduction to the goodwill recorded in connection with the application of pushdown accounting related to the change of control (discussed in Note 1. "Organization").
As a result of the reduction in the corporate tax rate from the Tax Cuts and Jobs Act discussed above, the Company remeasured the value of the liability under the TRA pursuant to the calculation terms as described above. During the four months ended December 31, 2017 (Predecessor), the Company recognized a reduction in the carrying value of the liability under the TRA of $25.3 million, included as a tax receivable agreement benefit in the consolidated statement of operations. Assuming the Company's tax rate is 24%, calculated as the maximum corporate federal tax rate plus three percent, throughout the remaining term of the TRA, the Company estimates the total remaining amounts payable under the TRA as of December 31, 2017 will be approximately $65.1 million. The carrying value of the liability under the TRA, reflecting the discount as discussed above, was $44.3 million as of December 31, 2017.
Prior to the remeasurement at the lower corporate tax rate, but subsequent to the effectiveness of the amendment discussed above, the Company estimated that the total amounts payable under the TRA would be approximately $120.5 million. Prior to the effectiveness of the amendment to the TRA, the amounts payable under the TRA varied depending upon a number of factors, including the amount, character and timing of the taxable income of Surgery Partners, Inc. The Company estimated the total amounts payable would be approximately $123.4 million, if the tax benefits of related deferred tax assets were ultimately realized. The amounts payable were recognized during 2015 in conjunction with the release of the Company's valuation allowance recorded against the deferred tax assets.
On September 8, 2017 (Successor), in connection with the resignation of the Company's former Chief Executive Officer, Michael Doyle, Mr. Doyle entered into a TRA Waiver and Assignment Agreement (the “CEO TRA Assignment Agreement”) with the Company, pursuant to which the Company accepted the assignment of 50% of Mr. Doyle’s (and his affiliates’) interest in future payments to which such parties were entitled pursuant to the TRA, in exchange for an upfront payment of approximately $5.1 million, in the aggregate, as set forth in the CEO TRA Assignment Agreement. On September 15, 2017 (Successor), certain of the Company’s employees entered into TRA Waiver and Assignment Agreements with the Company (collectively, the “Employee TRA Assignment Agreements” and together with the CEO TRA Assignment Agreement, the “TRA Assignment Agreements”), pursuant to which the Company made upfront payments of approximately $4.8 million in the aggregate, in exchange for the assignment of 100% of each such employee’s interest in future payments to which such employee was entitled pursuant to the TRA. During the four months ended December 31, 2017 (Successor), the Company recognized an aggregate gain of $1.1 million as a result of the TRA Assignment Agreements.