Accumulate capital, prevent future problems

Tax avoidance may be shortsighted strategy

A costly but much-needed computer upgrade, the untimely death of a senior partner, and sharply lower reimbursement rates all strike what had been a very successful specialist physician practice within a recent 18-month period.

Now its principals are sequestered in a hotel for a long weekend trying to figure out how they can avoid bankruptcy. One of the doctors breaks into tears complaining bitterly, "I just wish we had not listened to our accountant and attorney when they told us to spend every dollar to avoid paying taxes."

The story is true and it reveals one of the great weaknesses of physician practices all over the country. Few practices have set aside any funds to carry them through a rough period.

For years, many practices have been counseled by their tax advisers not to build up retained earnings. The idea is to avoid double taxation on money set aside as retained earnings.

The possibility of paying tax twice is a very real issue, says Edna Syra Barnes, CPA, of the Owensboro, KY, accounting firm Riney Hancock & Co. "For example, let’s say I have $1,000 of profit in my professional corporation [PC]. If I leave it in my PC, I have to give $350 away to pay my 35% in corporate taxes. That leaves me with $650," she says.

If the physician sells out during the next year, he or she receives a payment in exchange for the physician’s equity in the corporation which includes the $650. "I have to pay tax on that $650 again," says Barnes.

"That’s why people do not like to retain earnings in a professional corporation," she says. There are ways to avoid double taxation, but they require careful tax planning.

Not all administrators see tax avoidance as the biggest reason so many practices have empty retained earnings balances. "Yes, there are tax implications but there is much more to it," said one administrator who would only address the topic under conditions of anonymity.

"Physicians historically have not maintained any retained earnings because they have bled their professional corporations dry. It has all gone to their personal income," says Physician’s Marketing & Management’s source. "They are learning that you can’t do that anymore."

Capital accumulation evolving concept

Call it an evolution of the professional corporation. Physicians find that in today’s environment they have to plan and set aside funds for things like capital expansion and principal buyouts. They are beginning to view their practices the way other corporations have viewed their businesses for years.

Many practices struggling to strike a balance between the tax implications of investing profits back into the practice and keeping practice finances in shape.

"Health care is changing a whole lot. Practices are starting to see a lot more marketing needs than they used to have," says Barnes. Most practices have incurred significant expense in preparing to negotiate managed care contracts, for example.

There are also new risks being accepted by physicians who accept capitation. Prudence dictates that some kind of reserve be established in case the risks happen to have a detrimental financial impact on the practice.

"You really need to have a cushion there," says Barnes. But physician practices typically keep only enough cash in the bank to pay next week’s bills. "You just can’t do that anymore," she says.

Because practices are so capital-poor, many have sold out to big entities like Nashville-based PhyCor. "They have the capital. They can afford to pay for the equipment. They can afford to take on the risk of these capitated contracts," Barnes says. "They can afford to do marketing. They can afford to put some manpower behind going out and writing these managed care contracts. Capital gives you a lot of power."

Practices that intend to remain independent need capital. For some, that may mean retaining income in the practice and biting the bullet on taxes. One way to look at it is as an insurance policy that protects against practice insolvency. It’s just a cost of doing business.

Having cake and eating it

For practices that plan wisely, it is possible to set funds aside for future use while avoiding double taxation.

What a lot of practices do is distribute income in the form of bonuses at the end of the year like they always have but then make capital contributions back into the business.

The key point is that the capital contributions have to be designated for a specific purpose, says Barnes.

Capital contributions could be designated as funding for future buyout obligations, for instance. That is a legitimate business objective. "It is a way to give the company that operating reserve that people really need," she says.

From a technical standpoint, this kind of capital contribution is not treated as retained earnings even though it makes its way to the capital section of the PC’s balance sheet.

It’s the equivalent of buying stock in the corporation. Go back to the earlier scenario in which the corporation generates $1,000 in profits. If the practice tries to retain the $1,000 in the PC, 35% in taxes is due immediately so only $650 remains.

Alternatively, a physician can take the $1,000 in the form of a bonus. The money is subject to personal tax rates, which Barnes estimates would be 40%. That leaves $600 for reinvestment.

"If you put that $600 back in the business [as a designated capital contribution], you come out roughly the same as you would have retaining the profit in the business — except for the back-end tax effect," says Barnes.

At the time the corporation is dissolved, the $650 retained would be taxable income. The $600 capital contribution is not taxable at dissolution, however. "I have already paid tax on that money. I have got basis in it. There is no back-end tax effect, no double taxation," Barnes says.

Plan exit strategy

The bottom line is that most professional corporations now realize the need for some sort of capital accumulation. To determine the best way to accumulate capital, physicians need to sit down with their strategic advisers, their tax advisers, and legal counsel.

Every circumstance is different, says Barnes. Some physicians have partners whom they know are going to one day buy them out. They can put agreements in place that protect them from double taxation.

"There is no right or wrong way. It depends on when you want to get out of this business and how you plan to get out of it," says Barnes.

New practices should check on their state’s laws with an attorney to decide what form of practice is most conducive to capital accumulation. In some states, there is a trend away from professional corporations in favor of limited liability corporations.