Weighing the Risks Heed These Guidelines for Ownership of Medical Office Space

Owning your own medical office space can be a financially rewarding experience. However, there are risks in ownership that should be carefully weighed, as enumerated in the May article, “Decisions, Decisions — Medical Office Space: Buy, Lease, or Walk Away?”This article is intended to provide some guidance in determining ownership, entity structure, and financial and operational management.

Ownership and Entity Structure

Attorneys and accountants generally recommend the real estate be placed in a legal entity separate from the medical practice, with a lease arrangement between the two. There are several reasons for this. First, separating the two can limit financial loss resulting from lawsuits or financial failure against either the medical practice or the real-estate entity.

Second, it provides flexibility of ownership. Some doctor owners of the medical practice may not want to assume the risks of real-estate ownership. This is particularly relevant to senior doctors approaching retirement and younger doctors, burdened with educational loans, who can’t afford to buy into real estate at the present time.

Third, when real estate is housed in the same entity as the medical practice, it can complicate doctor buy-in and buy-out arrangements that would require an independent (and often costly) real-estate appraisal every time a doctor retires or a new doctor owner is recruited in the medical practice.

Finally, from an income-tax point of view, if the medical practice is a corporation, the ultimate disposition of the real estate could result in higher taxes paid on the realized gains and possible double taxation.

The legal entity for housing the real estate can be one of the following: limited-liability company (LLC), limited-liability partnership (LLP), S corporation, general partnership, individual ownership, or C corporation.

The most recommended entity of choice is either the LLC or LLP. Both are taxed as partnerships, but afford owners greater personal liability protection than a partnership. They also allow income and deductions to be passed through to owners on their individual tax returns, which enables owners to take advantage of lower capital-gains rates as well as other tax advantages.

An S corporation is the second-most-preferred choice of entity. S corporations are taxed similar to partnerships and afford the same liability projection as C corporations, but are not as flexible as LLCs and LLPs.

General partnerships or individual ownership also have the same tax advantages of LLCs and LLPs, but they expose the owner(s) to personal liability.

Straight C corporations provide better protection from personal liability but are the worst choice from an income-tax point of view. The gain realized on the eventual sale of real estate is first taxed at the corporate level at ordinary tax rates and may then be taxed again to shareholders upon distribution of the proceeds.

Financial Considerations

Most lenders require some down payment of 10{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} to 20{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of the price of the real estate. It could be more depending on the condition and location and may be less in some cases. It is generally recommended to obtain financing of 15 to 20 years. A shorter term and larger down payment usually translate into a lower interest rate. Loans beyond 20 years tend to cost more in total interest paid in return for the lower monthly payments.

Lenders may require personal guarantees of the owners but may be willing to accept limited guarantees based on ownership. Try to avoid cross-collateralization between the real estate and the medical practice, especially if there is a difference in ownership.

The real-estate entity should have a written lease with the medical practice. The rental amount should be based on two calculations: a taxable income projection and a cash-flow projection, prepared by an experienced accountant. The taxable-income projection shows the amount of income the owners will have to report for income-tax purposes. The cash-flow projection shows the level of rent necessary to meet ongoing expenses, debt service, and distributions to owners necessary to pay income taxes.

Most rental arrangements between doctors who own and lease to their own practices are written on a ‘net-lease’ basis. This means the rent is calculated to be sufficient to cover debt service, insurance (building and liability), depreciation, real-estate taxes, and legal and accounting fees.

The medical practice (lessee) is usually responsible for leasehold improvements, utilities, small ongoing repairs and maintenance, contents insurance, janitorial, and other occupancy expenses. The real-estate entity is responsible for expenditures such as HVAC, roofing, and other major building and ground expenditures. The rental structure may be more complicated for larger professional office buildings that rent to several medical practices.

If the real-estate entity limits its cash distributions to owners to only that amount required to pay income taxes, it will minimize occupancy costs to the medical practice while increasing equity in the real estate by reducing debt.

The increase in equity is critical for three reasons. First, it enables the entity to obtain additional financing when needed for major structural repairs and maintenance. Second, it provides a built-in mechanism for buying out retiring partners. Third, it enables the entity to keep its rent competitive, hence, keeping occupancy costs of the medical practice in check.

Doctor-owned real-estate entities that get into financial trouble can usually trace the cause to excessive distributions to the owners. As soon as equity builds up, the doctor owners refinance up to the maximum limit and distribute the cash to themselves. Then the unexpected happens, i.e., the roof needs replacing or real-estate taxes go up, or the HVAC system fails, or market values in the area drop, and the bank wants the owners to kick in additional cash.

When this happens, the medical practice rent can skyrocket above fair market value. The lenders then look to additional collateral, such as the accounts receivable and other assets of the medical practice. This can become particularly divisive if some of the doctor owners of the medical practice aren’t owners of the real estate. Now you have doctor owners of the medical practice protesting excessive rental costs to bail out the real-estate entity, and rightfully so.

There is also a tax issue that comes into play here. If the entity borrows money or refinances existing debt solely for the purpose of making distributions to owners, the interest paid on the new debt would be considered personal indebtedness interest and would not be deductible by the entity or the owners.

Eventually this can create problems in recruiting new doctors in the medical practice who see this scenario as encumbering on their future compensation. Also, retiring physicians may find out that not only do they get nothing for their interest in the real-estate entity, but they may still be on the hook for the outstanding debt. The result is a medical practice in serious trouble.

Buy-in and Buy-out Arrangements

Medical practices have buy-in and buy-out arrangements that can vary substantially, depending on the practice. Real-estate entities, however, may not be so flexible. Real estate is an appreciable asset that can fluctuate dramatically with market conditions. Therefore, the formula for buying into and redeeming ownership interest needs to incorporate this feature. Buy-in and buy-out agreements for a real estate entity should mirror each other.

The most common (and most workable) methodology used generally takes the form of the following:

  • An independent appraisal of the real estate is obtained;
  • This value is added to the cash on hand and other tangible assets of the entity;
  • From the above is deducted all liabilities of the entity; and
  • The result is then divided by the units of ownership currently in place, such as total shares, to arrive at a value per share.

The buy-in price also depends on whether the new shareholder is paying into the entity by issuance of new stock or equity interest, or whether the new shareholder is buying stock or equity interest outside the entity by paying the shareholders themselves.

For example, if the total value of the entity is $100,000 and there are four equal owners, the buy-in of a new owner would equal 20{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} or $20,000 if purchased directly from the existing owners (i.e., $5,000 each). This is because he or she is buying one-fifth of each owner’s 25{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} interest.

If, however, the interest is purchased by paying the entity, the purchase price would be equal to a 25{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} equal interest or $25,000, to avoid dilution to the existing owners. The buy-out of a 25{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} retiring owner, given the same $100,000 value, would be $25,000, since it would most likely be paid by the entity redeeming the retiring doctor’s interest.

If the ownership of the real estate entity is greater than two individuals, it is recommended that interests be purchased through the entity rather than directly from existing owners. Since retiring doctors’ interests are usually repurchased by the entity, interests purchased by new doctor owners should be purchased from the entity to prevent erosion of capital.

If the finances and operations of the real-estate entity are properly managed, it should be able to comfortably buy out retiring owners by refinancing the existing debt. Buy-out agreements should be carefully worded and should avoid fixed-price clauses that do not reflect current market value.

Conclusion

Following these guidelines in managing the financial and operational aspects of a real-estate entity will increase the prospect of achieving the objectives of real-estate ownership, the most important of which is cost containment for the medical practice. Experience has shown that deviations from these will most assuredly result in a price to be paid down the road by all parties.

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

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