Many small practices operate on a pure "pay-as-you-go" basis; they don’t use debt at all. If new equipment needs to be purchased, the practice simply cuts back on distributions to owner-physicians; it finances the entire purchase out of current earnings.

In other practices, debt is used to finance equipment purchases, buildouts for new offices, or acquisitions of other medical practices. Their balance sheets may show hundreds of thousands of dollars of debt.

How much debt should a medical practice have? There are no hard and fast rules here, although at some point the bank may balk at lending more money.

Certainly, less debt is better than more debt. More debt means more potential for legal disputes among the doctors, if the practice ever dissolves or breaks up. More debt also means more of a "drag" on future earnings; this can be discouraging both to members of the group and to associate physicians who are evaluating buy-in.

That being said, some debt can be useful. For some specialties, such as ophthalmology, cardiology or radiology, the cost of acquiring new technology, such lasers or imaging equipment, is simply too great to finance from a single year’s earnings. And in many group practices, there are some (or many) members whose personal debts or tight cashflow will not permit them skip a paycheck (or two or three) as needed for new investments.

Other instances where debt may be desirable or at least unavoidable are:

· Establishing a new office, especially if the property will be purchased, rather than leased.

· Purchase of electronic health records software, the costs of which can be hundreds of thousands of dollars.

· Acquisition of a competing medical practice with substantial goodwill/intangible value.

· Hiring an associate physician with large salary.

· Building an ambulatory surgery center.

· Offering a new product, such as spa services (dermatology practices) or laser vision correction (ophthalmology).

What all these situations have in common is that they involve multi-year investments. The long-term financing is appropriate to secure long-term returns from a new investment.

Judicious use of debt may also make sense for tax reasons. If you pay cash for an expensive equipment item, you may not desire or be able to fully tax deduct all purchase costs in the first year. This means you will have some "phantom" income on which to pay tax. Although the phantom income in the early years will be offset by depreciation deductions in later years, the timing of these tax events may not be advantageous for you. It will be especially problematic in the medical practices that have been formed as "C" corporations; the phantom income in the early years may trigger tax at the corporate level, in addition to the tax at the individual level: a double tax on earnings.

By contrast, if debt is used, the non-deductible portion of the purchase can be financed so that it matches the depreciation deductions on the equipment in the later years, avoiding the phantom income.

If you are going to borrow, what precautions should you take?

Have your office manager or consultant or accountant do a proforma to gain comfort that the debt payments can be comfortably funded from the future profits from the investment being made. Leave yourself some room for error by financing a portion of the investment with personal funds or current year earnings.

Talk with your bank and accountant to see if you can match the term of the loan and the debt payments on principal so that they match the depreciation deductions on the purchased equipment as closely as possible, to avoid phantom income.

Oftentimes the bank will require personal guarantees from the doctors, even if the medical practice corporation is the primary debtor. If this the case, have your attorney draw up a "Co-Guarantor Agreement" or provision, discussed below, to ensure that each doctor pays his or her fair share, if there is a later default.

Make sure that the group’s buy-in and buy-out arrangements for departing shareholders properly reflect any bank debt that exists at the time of buy-in or buy-out. For example, assume a three doctor practice with $300,000 of equipment financed in part with $200,000 of bank debt. The Shareholders’ Agreement says that a departing doctor will be bought out for his "pro-rata share of equipment value." This does not properly reflect the debt. A departing doctor could insist in a payout of 1/3 of $300,000, or $100,000, when what he really should get is 1/3 of the net of $300,000 less $200,000, or $33,333.

If you are using the debt to buy equipment, and you will be repaying the debt over an extended period, be careful about your use of the depreciation tax benefits! Some medical practices in "C" corporations have created major tax problems for themselves by claiming accelerated tax depreciation benefits in the year of purchase and then immediate bonusing out all the resulting tax savings in the first year or so. This is fun while it lasts, but the flip side is that you will have no depreciation deductions left in later years to offset or shelter the non-deductible payments on the debt. This creates the extremely troublesome "phantom income" and double taxation referenced earlier.

For expensive equipment purchases, such as lasers or imaging equipment, you may also want to investigate vendor "finance leases." This is an alternative to financing through ordinary bank debt. Under a finance lease (also called a "capital lease"), the medical practice rents the equipment for several years, and then has the option, at the end of the lease, to buy the item for a nominal amount, such as $1. Since the lessee is not permitted to cancel the lease, the economic risks that the lessee assumes (risk of obsolescence, risk of low profitability) are virtually the same as outright purchase. However, the structure of the transaction as a lease rather than a purchase may facilitate the matching of deductions and cash flow in an advantageous way. In addition, the "red tape" factor is likely to be reduced. The vendor will make it easy for you to lease, so that you will commit to the equipment acquisition. By contrast, the bank credit approval and documentation process will likely be slower.

If you do consider leasing, make sure that you understand what your finance charges are. With a bank loan, interest and other fees are easily identified. But in a finance lease, the effective interest charge may be not be broken out separately from the overall lease payment. Nonetheless, it has been factored into the lease rate, by the vendor, and the vendor can quantify it for you. This way you can compare "apples to apples," in terms of financing costs.

Above we mentioned "Co-Guarantor Agreement." This can be a free standing agreement or merely a provision within the Shareholders’ Agreement. It ensures that each shareholder pays his or her fair share of the debt, if there is any default.
For example, assume that there are five shareholders, each of whom has provided a personal guarantee of a bank debt of $300,000. The practice breaks up; there is a default on the debt; and the bank files suit to recoup its money. The bank happens to know that the founding physician has many assets, after many years of good earnings, and that the younger shareholders are mortgaged to the hilt with medical school debts and new home mortgages. Therefore the bank does not bother to pursue the younger shareholders. It seeks repayment of the entire $300,000 debt from the senior physician. The bank can do this because the personal guarantees furnished by the doctors are "joint and several" guarantees. Each shareholder is on the hook for the full $300,000, even though all of them enjoyed the benefits.

In this situation the Co-Guarantor Agreement states that, if any one shareholder is held responsible for more than his or her pro-rata share of the debt, that shareholder will be entitled to reimbursement from the others, so that in the end the responsibility has been allocated in proportion to ownership. So, instead of being stuck with the entire $300,000 liability, the senior physician only pays 1/5 of $300,000, and each other shareholder chips in the same amount.

Another tip for Shareholders’ Agreement language: many such agreements state that the departing shareholder will be "taken off from" any personal guarantees, or similar language. However, it is not within the discretion of the medical practice to release such a guarantee. Only the bank has this discretion, and generally the bank has no incentive to release any guarantor. The only way the group can assure the departing shareholder that he will be released is to refinance the debt entirely, and this may involve financial concessions, such as "points" and a higher interest rate. It will at least involve substantial hassle in terms of redoing all the bank loan documentation.

A better approach, in the Shareholders’ Agreement, is simply to "indemnify" the departing shareholder against further liability on the guarantee. This involves no paperwork at all. It is simply a promise, by the group, that if the departing shareholder is held liable by the bank, the group will make that shareholder "whole" by reimbursing him for his payments to the bank.