The risks of self-financing your practice

Key Points

Money you invest in your practice may be withdrawn, with a tax on any profits from the sale of that capital investment. A loan you make to your practice, on the other hand, can be repaid without incurring a tax bill-provided the Internal Revenue Service (IRS) accepts it as a bona fide, arm's-length transaction.

Similarly, when taking money from your practice, you incur a risk of the IRS viewing any movement of funds from the practice to you, as the principal/shareholder, as a taxable event. As one Texas neurosurgeon recently discovered, a loan from a practice, disguised or not, can be labeled as compensation, a bonus, or as a dividend-all taxable to the recipient.

Under the trust agreement, the employer and employee trustees had discretionary authority to make loans on a nondiscriminatory basis to anyone participating in the plan. Upon application and written evidence of an emergency or serious financial hardship from the eligible employee, the trustees could make a loan up to the amount of the present value of the death benefit.

The doctor subsequently took out a loan for $400,000 for "unexpected housing costs." Although a note evidenced the loan, the doctor made no payments on it. The IRS claimed there was no loan, only a distribution from the plan. In addition, the IRS claimed that the loan was taxable.

The tax court agreed, finding no evidence of a bona fide loan. In addition, the court found the doctor liable for a 20% penalty for failure to report the receipt of the funds and underpaying his taxes.

DRAWING THE ATTENTION OF THE IRS

When lending to or borrowing from the practice, keep in mind that the transaction must be a legitimate, interest-bearing loan. Below-market interest rates or the lack of evidence of an arm's length transaction are likely to draw the attention of the IRS. The IRS is particularly interested in (1) gift loans, (2) corporation-shareholder loans, (3) compensation loans between employer and employee, or between independent contractor and client, and (4) any below-market interest loan in which the interest arrangement has significant effect on either the lender's or borrower's tax liability.

Should the IRS re-characterize a money-in or money-out transaction, the result usually is an interest expense deduction when none was previously claimed by the borrower, and unexpected taxable interest income on the lender's tax bill. Often dating back several years, the lender's higher tax bills usually are accompanied by penalties and interest on the underpaid amounts.

Fortunately, the rules allow a $10,000 de minimis exception for compensation-related and corporate/shareholder loans provided that they do not have tax avoidance as one of the principal purposes. Although this transfer of taxable income between entities may appear to be offsetting, it can have a significant tax impact on the reallocation, depending on the relative tax benefits to the borrower and to the lender, and the deductibility of the expense deemed paid.

When the IRS examines loans from shareholders and the common stock accounts of a medical practice, it often encounters thin capitalization, meaning the practice has little or no common stock and a large loan from the shareholder. Section 385 of the Internal Revenue Code specifically considers whether an ownership interest in a corporation is stock or is indebtedness.