By Christopher R. Jarvis, MBA & David B. Mandell, J.D., MBA
There has never been a greater need for physicians to shield assets from potential lawsuits, as malpractice premiums have soared along with lawsuit judgments, forcing many doctors to reduce their insurance coverage.
In this article, we will discuss a strategy for shielding the most valuable of all practice assets: its accounts receivable (AR). Obviously, this is an important objective for any medical practice. We will also deliver a stern warning, as most of the ways doctors have been implementing this strategy is very troublesome. In fact, this is one area where you must “do it right” or risk extremely costly negative tax consequences.
Why Leverage Your AR?
Most physicians have significant AR balances that sit on the practice’s balance sheet as an exposed asset. These AR balances are, in fact, the most vulnerable asset to a malpractice (or other type of) lawsuit, as any type of claim against you or any of your partners could threaten the entire practice’s AR. For this reason, the AR must be shielded, even before you engage in any asset protection of personal assets. If not, you risk losing all of your AR in one claim against any physician.
What if you could asset-protect your AR in a way that actually made you more money for retirement without any more work? Without any call or time in the office? Surely, you would be very interested, right? And, if you could also provide protection for your family in case you passed away, or provided a way to buy out older physicians – both, again, without forcing you to earn any more money – would this get you to focus hard on this opportunity? If you are like most doctors, these combined benefits make the AR leveraging idea a very attractive one.
What is AR Leveraging?
From the many programs we have reviewed for clients, we can say with experience that not all programs are the same. In fact, nine out of ten such programs make false promises with respect to the tax implications of the program. They put the physician at a serious tax risk by telling him/her that there is no present year taxation when the reality is that very sizeable present year tax liabilities may occur. Below we will briefly describe what to look out for when evaluating such a strategy, in order to tell the good ones from the bad. Nonetheless, the first part of the transaction is always the same: the practice gets a loan on its AR, pledging the AR as collateral. With the funds in hand, the practice must invest them in a way that is asset-protected and grow in a tax-advantaged manner, but not be exposed to the practice’s creditors. It is in this effort that nearly all of the programs in the market fail. Let’s examine how these risky programs work.
AR Leveraging the Wrong Way
While there are many variations on the theme, the typical “wrong” AR financing strategy works like this:
• The practice takes the loan proceeds and funds a “deferred compensation plan” for the physicians. The interest on the loan is allegedly tax-deductible, making the financial “cost” of the loan 40 to 50 percent less.
• As part of the deferred compensation plan, the practice buys annuities or a life insurance policy on the physician’s life. The lender takes a security interest in the policy/annuity also.
• The practice either transfers the annuity or policy to the physician, retaining some nominal rights in the annuity/policy (or allows the doctor to take loans out of the annuity or policy directly).
• When the physician retires, he/she liquidates the annuity or policy, pays the practice the loan principal back and the practice then pays off the lender. The doctor takes the remaining balance and pays tax only at retirement.
While this article is not meant to be a tax treaty, let us say here, in short, that we do not believe this type of arrangement works for tax purposes. We are not alone: other tax attorneys we know have issued memoranda coming to similar conclusions. Although thousands of physicians have implemented such plans after being “sold,” it is only a matter of time until the IRS makes these doctors pay when these plans unravel.
The biggest risk of such plans is that the IRS will see through the nominal rights the practice has in the annuity/policy and treat the transfer as taxable income to the doctor in year one (under section 83, its regulations and constructive receipt principles). If a physician finally pays tax on retirement in year 20 and the IRS takes this position, that doctor could be liable for taxes, interest and even penalties going back 20 years!
In addition to the tax problems inherent in such plans, it is also likely that these plans do not work for asset protection purposes either. This is because the legal documentation supporting the plans will likely not stand up to a creditor challenge. The key issue here is: Does the loan document securing the AR really protect the AR as primary collateral, or is it focused more on the annuity/policy? In all of the plans we have reviewed, the AR is not primary collateral and thus, not adequately protected.
AR Leveraging the Right Way
Essentially, AR financing done right works like this:
• The practice takes the loan proceeds and invests in an LLC, along with the participating physician, who also invests after-tax dollars into the LLC (that has been created with a legitimate business purpose, not just to own life insurance).
• That LLC purchases the life insurance policy on the physician member. If the LLC is drafted correctly and the actuarial assumptions in the policy are properly substantiated, there is no taxable transfer of value between the practice and the physician at any time.
• Under the LLC agreement, the physician owns cash value position in the life insurance policy and the practice owns the death benefit.
• When the physician retires, the LLC takes a loan from the policy and pays the practice the loan principal back. The practice then pays off the lender.
• The doctor owns the remaining cash balance in the policy through the LLC. He can take tax-free loans from the policy paying throughout retirement.
• The practice will get the death benefit when the physician dies, which can be used effectively in a number of buy-out scenarios.
This structure satisfies all of the deferred compensation, risk of forfeiture, Section 83 and other issues in which the current financing programs are so deeply mired. Further, when implemented with the right type of security agreement, all the asset protection benefits will also be enjoyed.
In today’s malpractice environment, physicians need to squeeze as much financial value out of their practice as possible. In this case, that means protecting your practice’s most valuable asset – your AR, and doing so in a way that gives you more retirement income. Nonetheless, as with any sophisticated planning, you must do it right to gain the financial benefits and sidestep potential tax landmines. Certainly, it is worth your time to investigate whether or not this makes sense in your practice.
David B. Mandell, J.D., MBA and Christopher R. Jarvis, MBA are with the firm, Jarvis & Mandell, LLC, in New York City.