Contract analysis

I. Executive Summary Calderwood & Harkness LLP has been engaged by Ardent Capital Partners III LP ("Ardent Capital" or "Fund III") to advise on the tax structuring of its proposed acquisition of one hundred percent (100%) of the membership interests in Pinnacle Health Services Group LLC ("Pinnacle" or "PHSG"), a Delaware limited liability company currently classified as a partnership for federal income tax purposes,

II. Background and Transaction Overview A. Parties. Buyer/Sponsor. The acquiring party is Ardent Capital Partners III LP, a Delaware limited partnership (EIN: 87-3491520), whose general partner is Ardent Capital GP III LLC, also a Delaware limited liability company. Fund III is a 2022-vintage private equity fund with total committed capital of approximately $3.2 billion, focused on healthcare services, technology-ena

III. Issue Presented This memorandum addresses the following principal question: Whether the earnout payments under the Merger Agreement should be treated for federal income tax purposes as (a) additional purchase price for the Pinnacle membership interests, resulting in capital gain to the selling members under Section 741 of the Internal Revenue Code of 1986, as amended (the "Code"), (b) compensation for post-closi

IV. Analysis A. Capital Gain vs. Compensation — General Framework

1. The Governing Standard. The federal income tax characterization of contingent payments made in connection with the acquisition of a business represents one of the more fact-intensive inquiries in the tax law. The determination carries significant consequences: if the earnout payments are treated as additional purchase price, the sellers recognize capital gain (currently taxable at a maximum rate of 20%, plus the 3

2. Factors Favoring Capital Gain Treatment. The multi-factor test derived from case law, including Klamath Strategic Investment Fund v. United States, 568 F.3d 537 (5th Cir. 2009), Lane Processing Trust v. United States, 25 F.3d 662 (8th Cir. 1994), and the Tax Court's analysis in Peterson v. Commissioner, T.C. Memo. 2013-271, examines the following factors, each of which generally favors capital gain treatment when

3. Factors That Could Support Compensation Recharacterization (Risk Analysis). While we believe that capital gain treatment is the correct and defensible characterization of the Pinnacle earnout, we note the following factors that the IRS could potentially point to in support of a compensation recharacterization: (a) Continuing Employment of Major Sellers. Three of the earnout-eligible sellers — Dr. Carvallo, Dr. Ost

1. Pro Rata Allocation. The single most significant factor supporting capital gain treatment is the pro rata allocation of earnout payments among all pre-closing Pinnacle members. The earnout is not limited to the Continuing Sellers; it is payable to every pre-closing member in proportion to their respective membership interest percentages, without regard to whether the member has any continuing relationship with Pin

2. EBITDA-Based Performance Metric. The earnout targets of $58.0 million (Period 1) and $65.0 million (Period 2) are based on Adjusted EBITDA, a business-level financial metric that reflects the aggregate operating performance of all 42 of Pinnacle's facilities across five states. Adjusted EBITDA is a function of dozens of revenue streams, cost centers, and operational variables that are far beyond the control or inf

3. Absence of Employment-Condition Language. As currently drafted (based on our review of the February 22, 2024 term sheet and the preliminary discussion draft of the Merger Agreement circulated by Harcourt Shaw & DeVries LLP on February 28, 2024), the earnout provisions do not contain any forfeiture-for-termination clause. That is, no seller's earnout right is forfeited or reduced if that seller ceases to be an empl

4. Separation from Non-Compete and Consulting Arrangements. The Merger Agreement and the related transaction documents include separate non-compete agreements with certain of the founders and executives. Specifically, the purchase price allocation prepared by Northmark Advisory Group LLC allocates $17.4 million of the total enterprise value to non-compete agreements, which are classified as Class V intangible assets

5. Arm's-Length Negotiation. The earnout was negotiated at arm's length between Ardent Capital (represented by Meridian Tuck Partners LLC as financial advisor) and the Pinnacle founders (represented by Larchmont & Co. as financial advisor) as a component of the purchase price negotiation. The negotiation history, which we understand to be well-documented in correspondence and term sheet exchanges between the parties'

1. Applicability. Section 483 of the Code provides that, in the case of any payment under a contract for the sale or exchange of property where some or all of the payments are due more than one year after the date of the sale or exchange, the payments shall be treated as including a component of imputed (unstated) interest if the contract does not provide for adequate stated interest. The imputed interest component i

2. Applicable Federal Rate (AFR). Under Section 483(b) and Treasury Regulation Section 1.483-1(a)(2), the applicable discount rate for determining imputed interest is the Applicable Federal Rate ("AFR") in effect on the date of the contract. For purposes of Section 483, the "date of the contract" is the date of the Merger Agreement (the signing date), which is anticipated to be March 15, 2024. As of March 2024, the a

3. Computation Methodology. Under Section 483, the imputed interest component is calculated by applying the applicable AFR to the deferred payment amount over the period from the closing date (the date of the sale) to the payment date. The computation assumes annual compounding unless the parties elect a different compounding period. Period 1 Earnout ($15.0 million): Assuming the Period 1 earnout payment is made on a

4. Seller Reporting Obligations. Each seller must separately report the imputed interest component as ordinary interest income on its federal income tax return for the taxable year in which the earnout payment is received. The balance of the payment is reported as additional capital gain. The allocation of imputed interest among sellers is pro rata based on their respective membership interest percentages. For exampl

Section 409A of the Code imposes strict requirements on "nonqualified deferred compensation plans," broadly defined. If a payment arrangement constitutes deferred compensation under Section 409A and fails to comply with the statute's timing and form requirements, the service provider is subject to an additional 20% tax on the amount of deferred compensation, plus an interest charge calculated from the date the amount

1. Terms. Article VII, Section 7.04 of the preliminary Merger Agreement draft provides that, upon the occurrence of a "Change of Control" of Ardent Healthcare Holdings LLC at any time during the earnout period (i.e., prior to the later of (a) the last day of the Period 2 measurement period, May 31, 2026, or (b) the date on which all earnout payments have been finally determined and paid), one hundred percent (100%) o

2. Tax Treatment of Acceleration. The acceleration of the earnout upon a Change of Control does not alter the character of the earnout as additional purchase price. Acceleration is a timing mechanism, not a characterization mechanism. It simply provides for early payment of the full contingent amount based on the occurrence of a specified transactional event. The character of the payment (capital gain vs. compensatio

3. Section 280G Interaction. Section 280G of the Code provides that no deduction is allowed for any "excess parachute payment" made to a "disqualified individual" in connection with a "change in ownership or control" of a corporation. An excess parachute payment is defined as any payment in the nature of compensation that is contingent on a change in control and that exceeds a base amount equal to three times the ind

V. Structuring Safeguards and Drafting Recommendations Based on the foregoing analysis, Calderwood & Harkness recommends the implementation of the following structuring safeguards and drafting provisions to support the capital gain characterization of the earnout. These safeguards are designed to address each of the risk factors identified in Section IV.A.3 above and to create a robust evidentiary record in the event

1. Pro Rata Allocation. The Merger Agreement must expressly provide that earnout payments are allocated pro rata among all pre-closing Pinnacle members based on their respective membership interest percentages as set forth in the Pinnacle Operating Agreement as of immediately prior to the closing. The allocation must include all fourteen (14) minority physician-investors, none of whom has a continuing employment or s

2. No Forfeiture-for-Termination. The Merger Agreement must include an affirmative provision stating that each seller's right to receive earnout payments survives any termination of such seller's employment with Pinnacle or any affiliate, whether such termination is voluntary, involuntary, with or without cause, by reason of retirement, disability, or death. No seller's earnout shall be forfeited, reduced, or otherwi

3. No Employment-Condition Language. The Merger Agreement must not condition any seller's eligibility for, or the amount of, earnout payments on such seller's continued employment or performance of services. No provision of the Merger Agreement should link the earnout to any individual seller's employment status, attendance, performance evaluation, or compliance with employment policies. The earnout provisions should

4. Separate Compensation Arrangements. Any consulting agreements, employment agreements, or non-compete agreements with Dr. Carvallo, Dr. Ostrowski, or Mr. Farnsworth must be (i) independently negotiated between the applicable seller and the buyer, (ii) separately documented from the Merger Agreement (though they may be cross-referenced as ancillary agreements), (iii) independently valued at fair market value, and (i

5. Consistent Tax Reporting. The Merger Agreement must include a provision requiring all parties — the buyer, the sellers, and their respective affiliates — to treat the earnout payments as additional purchase price for the Pinnacle membership interests on their respective federal, state, and local income tax returns, and to not take any inconsistent position on any tax return, tax claim, tax proceeding, or other fil

6. Section 409A Protective Language. The Merger Agreement must include a provision stating that: (a) The earnout is not intended to constitute "nonqualified deferred compensation" within the meaning of Section 409A of the Code. (b) To the extent that any earnout payment is determined to constitute nonqualified deferred compensation subject to Section 409A, such payment shall be made within the "short-term deferral" p