Avoiding the Spiral Retention of Profits Is Key to Long-term Success

Oak Grove Associates, P.C., a practice group of five physicians, had a long-standing practice of stripping all the cash out of the practice at year end through bonuses, to avoid paying any corporate income taxes.

The practice had a significant amount of bank debt from previously buying out former shareholders in large stock redemption transactions. The practice also had recurring non-deductible items of expense that required them to bonus out amounts that gave rise to net losses and which exceeded available cash balances.

As a result, the physicians had to borrow on the bank line of credit year after year to enable them to pay the bonuses. Over time, the bank debt became so large they couldn’t pay it back; then they started to loan back their net bonuses to the practice until they couldn’t repay the shareholder loans.

Eventually, the accumulated deficit of the practice exceeded even the value of outstanding accounts receivable. This all came to a head when one of the retiring physicians wanted repayment of $100,000 in prior-year bonuses loaned back to the practice, and the practice had no cash to do this and had no collateral available for additional borrowings. The practice was insolvent.

It is common practice for physicians and dentists to strip out most, if not all, of the cash in their practice bank accounts before year end, thinking this is necessary to avoid paying income taxes. Some doctors see it as their money and fear that, by leaving it in, someone else will get it. Tax accountants feel as though they are not doing their job properly if the practice owes income taxes on year-end profits, however small they may be. Practice managers, on the other hand, are tearing their hair out, worrying whether there will be enough cash to meet the next payroll and scheduled debt payments.

The most stable and successful practices combine tax planning with good business sense. They recognize the need to retain cash and earnings in the practice for stability and growth, like any other business.

We recommend two rules of thumb. First, maintain a cash balance equal to two weeks of annual operating expenses. This is in addition to special accounts used during the year to accumulate cash for funding the practice’s annual retirement plan contribution. Second, leave a taxable profit equivalent to 5{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of net income before doctor compensation.

Reasons for Retaining Cash and Profits

Most practices are undercapitalized from the beginning. In forming a new entity, doctors are reluctant to make an adequate level of capital contributions. Depending on the practice, we recommend $10,000 to $20,000 per doctor as an investment in return for their original issue of capital stock or equity interest. This investment is generally returned to the doctor at retirement, as provided for in the practice stock redemption or partnership agreement.

This is necessary to maintain some reasonable level of working capital and to fund certain start-up costs. Doctors who contribute less than this will either have to retain a larger portion of future earnings or be saddled with ever-increasing bank debt.

Practices make certain expenditures that are not tax-deductible, such as key person life insurance, disability insurance, certain meals and entertainment, redemption of stock or equity of retiring doctors, and memberships in IPAs, to name a few. Since these are non-deductible, they have to be paid in after-tax dollars.

Practice managers should not have to struggle every payroll and accounts payable cycle to find enough cash because the practice is operating on a shoestring. This is crisis management. It is stressful and a waste of resources that should be spent in more productive ways.

Maintaining a reasonable cash balance gives the practice a cushion to withstand unexpected interruptions in cash flow resulting from payer problems, doctor absences, systems failures, etc., without having to rely 100{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} on bank financing.

Most group practices that are in financial trouble are there because they were undercapitalized from the beginning and/or the doctors did not retain an adequate level of earnings in the practice.

The Myth of Taxes

Tax planning is a very important element of running any business, and we as accountants and tax advisors are ever-cognizant of ways to reduce income taxes. However, there is a misconception among doctors that, by drawing out all profits, they are avoiding income taxes. This is simply not true. Income taxes will be paid in any event, whether at the individual level or entity level.

Granted, there are some rate differences, and there is the possibility of some double taxation with professional corporations. However, most of this can be avoided with proper planning and isn’t as big a financial issue as some would believe. If the entity is an S-corporation, partnership, or LLC, there is virtually no income-tax reason to strip out all cash and profits. The tax cost of retaining an adequate level of operating cash in a practice is even less significant if you factor in the alternative costs of bank financing.

Bank Financing

Borrowing is a necessary element of running a practice. Generally, practices that incur no bank financing are either heavily capitalized by the owners or not making the necessary expenditures to grow and stay current with technology. However, like consumer credit, it should be used wisely with a plan to repay over an appropriate period, and should not be used to finance physician compensation on a continuing basis.

Debt financing is a means to pay for growth and technology over a period commensurate with the use of the related resources. For example, financing a new information system costing $80,000 with a five-year installment loan enables the practice to even its cash flows over the period that the equipment will be depreciated. After five years, the practice will have paid and deducted the costs and can then be in a position to finance a new system or needed enhancements. Similarly, financing office improvements with a repayment schedule extending the life of the lease results in a better matching of cash flows with costs recognized.
Every practice should also have a revolving line of credit to meet temporary cash shortfalls due to the unexpected. This debt is usually required to be repaid within a year or shorter period.

Balancing the Mix

Doctors that strip all cash and profits out of their practices every year will get caught in a spiral of ever-increasing deficits and debt service.

In the long run, this will be the costliest way to finance their practice and will limit their ability to grow and keep pace with their industry peers. Eventually it will impact their own compensation and could impair their ability to recruit new doctors.

Practices that use the appropriate mix of retaining profits and debt financing will experience a more cost-effective use of resources and a more stable and predictable cash flow pattern, and they will be better-positioned for growth and technological advancement.

James B. Calnan, CPA, is partner-in-charge of the Health Care Services Division of Meyers Brothers Kalicka, P.C. in Holyoke;             (413) 536-8510      .