Protecting Your Practice’s Accounts Receivable
Since a medical practice’s Accounts Receivable (AR) is typically its largest and most vulnerable asset, one would think that most Doctors would focus on protecting it (Fortress) from the many lawsuit risks that Doctors, medical practices, and any operating business with employees and customers face. Unfortunately, this isn’t the case. Also, since the Doctor earns the right to be paid weeks and often months before the AR is ultimately collected, one might think that most Doctors would try to apply the concept of Leverage to this unproductive asset (Engine) to get more out of the asset. Again, you would be wrong.
In this Chapter, we will explain the exposure of a practice’s AR to claims against the Doctors and employees of the practice. Then we will compare and contrast two options for protecting the AR and leveraging this asset for further wealth creation.
How Doctors Lose Their Accounts Receivable
A medical practice’s accounts receivable (AR) is the Doctor’s most vulnerable asset when it comes to losing wealth in any claim against the practice. These claims can be medical malpractice claims, employment claims, healthcare related suits, or any number of financial risks to the practice. This financial risk exists because every case against a physician or the practice will include the medical practice as one of the defendants in the lawsuit. When there is a successful lawsuit against the practice, attorneys will look to corporate assets to satisfy the corporate debt. What is the biggest (and possibly only) liquid asset that a practice has? The Accounts Receivable (AR).
The accounts receivable has already been earned by your practice. You are only awaiting payment. Most medical practices “turn over” their AR every 60-90 days or so. This means the creditor only needs to wait 2 or 3 months, at most, to get access to your AR. It doesn’t matter that the AR is used to pay salaries and expenses. Once there is a lien against the AR, it becomes the property of the creditor and you have to find other ways to pay salaries and expenses.
Protecting Accounts Receivable
It is important to understand how you can protect your AR. Basically, what you need to do is find a way to “encumber” the AR to protect them. In both of the techniques we will examine, there will be a loan to the practice where the AR will become the collateral or “security” for the loan. In this way, the AR will be encumbered. This means that the AR is owned by the lender until the debt is repaid. By implementing one of these two accounts receivable financing strategies, you may not only shield your AR, but you will turn a non-productive asset (the AR balance) into a productive asset that can be immediately invested. This can lead to financial Leverage that may result in greater retirement income for you and death protection for your family. This is another example of how the practice can help build assets (Engine) while protecting existing and future assets from claims (Fortress). Let’s examine the basics of accounts receivable financing and the two different types of strategies you can use.
Accounts Receivable Financing
Accounts Receivable Financing or “AR Financing” is an arrangement where a lender makes a loan to a practice that pledges the AR as collateral for the loan. This way, the practice has a liability (the loan) that offsets the asset (the AR). Typically, the lender will file an official UCC-1 form to give notice to the world that their security agreement exists and that the lender is first in line as a creditor to the AR. This means that any future creditors, including claimants who eventually get any judgments against the practice, would not be able to successfully attack the AR. In this way, the practice can create an arrangement that would successfully dissuade any future creditor from going after the AR that rightfully belongs to someone else. This is an example of an asset protection “debt shield.”
This is similar to what a bank does when it gives you a first mortgage on your home. Once the bank files their security interest, all subsequent mortgages come after their interest. If you have a home worth $1 million with a $1 million previously-filed first mortgage, no creditor (including a lawsuit plaintiff) would see any value in your home. This is because there is no equity for the creditor to attack.
The above description applies to both types of AR financing protection we will discuss in this Chapter. Beyond this basic similarity, there are substantial differences between the two strategies that significantly impact the Doctor’s ability to practically apply the techniques in a cost effective manner. Let’s consider the nuances of the two strategies so that you can make up your mind as to which might work best for you and your practice.
AR Financing Type 1: Unrelated Lender
In the unrelated lender AR financing structure, an outside lender (typically, a bank) makes a loan to the practice and takes the security agreement against the AR. There are a number of vendors for this type of AR financing in the U.S. While these programs are not ideally suited for California physicians, you may have friends and colleagues in other states who have implemented them so we will describe them here. Most of the programs we have seen work the same way, although there may appear to be significant differences among them. Let’s examine a number of factors involved in these types of programs:
1. Protection of the AR
As above, because the lender is an unrelated bank, the protection of the AR will be at the highest (+5) level of protection. However, this assumes that all the formalities are respected and followed. The most important formalities are that the collateral and security agreement make the AR the primary collateral for the loan and that the proper UCC filings are made. While all promoters of these techniques claim that they “do it right,” we have reviewed many of these arrangements where we disagree with both the structure and the method of following the formalities.
In most of the properly structured arrangements, the borrower is the medical practice. In some, the individual Doctors are the borrowers. It’s a “facts and circum-stances” determination.
3. Use of loan proceeds
There is a great deal of variability here. In most of the arrangements, the practice gets the loan and then creates a deferred compensation arrangement for the Doctors. If the practice owns the deferred compensation agreement, this may not protect the loan proceeds at all. In other arrangements, the deferred compensation agreement can trigger immediate ordinary income tax to the Doctor, even though the AR has not yet been received (discussed in point #4 below). How the funds get out of the practice, how they are taxed, and what the Doctor does with the funds are all very important considerations. Make sure to discuss this with experts who understand the nuances of tax law before agreeing to participate in such a plan.
In almost all cases, the proceeds of the loan will eventually be invested in some type of cash value life insurance policy. You will learn in Lesson #8 that insurance policies can significantly outperform mutual funds and other brokerage accounts when the investor is a high-income taxpayer. In addition, in the states where cash values in life insurance policies are given the highest (+5) level of asset protection this is a great way to achieve full (+5) protection of the AR. However, as the value that is protected in California is so limited, this technique is not feasible.
A California doctor could invest the proceeds in another type of protected vehicle, such as an FLP, LLC or even a trust.
4. Tax issues
This is the one area where we’re used to seeing claims made by the arrangement promoters that are not well-founded. Some programs have made great strides toward handling this matter properly. However, this is not always the case. The two key tax issues here are the deductibility of the interest paid to the bank and, if there is a deferred compensation plan as part of the arrangement, the tax treatment of that plan. It is imperative that the Doctors get independent review of these issues and not rely solely on the promoter or bank, or any tax attorney or accountant who has a relationship or financial incentive to work with the program promoter or bank.
5. Protection of loan proceeds
As above, in many of the AR financing structures, the loan proceeds are invested in (+5) state-exempt assets like cash value life insurance policies and annuities. In states like California, where such assets are not given (+5) protection, the protection of the proceeds is more challenging and may typically involve (+2) LLCs. Of course, this assumes that the loan proceeds are properly removed from the practice. Any assets that remain in the practice will not be protected.
This is the area where promoters were especially aggressive when initially selling these plans a decade or so ago. The promoters would sell these techniques based on projections of very low interest rates on the loans and very high rates of return in the policies and annuities. For the most part, the reality of the past decade has generated returns that are nowhere near these rosy projections. Nonetheless, there is the potential for some wealth creation in these techniques. Because interest rates and investment returns vary greatly from year to year, there will always be a significant opportunity for appreciation and a substantial risk of lost principal. This needs to be understood before you agree to any such arrangement.
7. Overall cost/benefit
We recommend that you look at the unrelated lender AR financing arrangement more specifically as a protection tool and less as an arbitrage play that will create significant wealth in retirement. We understand that the stock market has outperformed the prime rate over time, but we cannot be sure how these two indices will perform between today and the day you need the money. If the arrangement can be structured to protect the Doctor’s financial downside and shield the AR effectively, we think that would be ideal. The additional valuable insurance protection these programs can afford (which most Doctors and their families need) can become the “icing on the cake.”
AR Financing Type 2: Related Lender
In the related lender AR financing structure, a related lender (often, an irrevocable trust for the benefit of non-physician family members) makes the loan to the practice and takes the security agreement against the AR. Because the trust and family members (spouse and children, typically) are being paid market-comparable interest, the overall family economics are superior to the unrelated lender arrangement.
Let’s examine a number of factors involved in these types of programs:
1. Protection of the Accounts Receivable
As above, because the lender here is a related entity, the protection of the AR will be examined more closely. Nonetheless, if done right, this technique could afford protection at levels of (+3/+4). This also assumes that all of the formalities are fol-lowed correctly. Most important are that the collateral and security agreement make the AR the primary collateral for the loan, that the proper UCC filings are made and that the loan is at a market-comparable rate (at Applicable Federal Rate, or AFR, at a minimum when dealing with family members). Making sure your arrangement follows the necessary guidelines is the job of the attorney who structures the arrangement.
In these arrangements, either the practice or the Doctor could be the borrower.
3. Use of loan proceeds
There is a great deal of variability here. In most of the arrangements, the funds are ultimately invested either directly into some kind of cash value life insurance policy in the states where these policies’ cash values are given the highest (+5) exemption protections or, in California, into an LLC that may then invest into life insurance or some security.
4. Tax issues
If the Doctor is the borrower, there will not be a deferred compensation arrangement. That means that the tax issues are much simpler. If the practice is the bor¬rower, the same deferred compensation tax issues exist as they do with an unrelated lender. In both situations, interest deductibility is still an issue that needs to be addressed with your tax advisors.
5. Protection of loan proceeds
As above, the loan proceeds may be invested in (+5) state exempt assets like cash value life insurance policies and annuities. In states where such assets are not given (+5) protection, such as California, the protection of the proceeds is more challenging and may typically involve LLCs that offer a (+2) level of protection.
Because the trust and family members (spouse and children, typically) are being paid interest, the overall family economics are superior to the unrelated lender arrangement. This is because the practice will pay interest to family members instead of to a bank. This means that the funds stay “in the family.” This technique will work in high or low interest markets, while the previous technique’s success will be contingent on a long-term, low-interest rate environment. Also, this arrangement may be combined with a related debt shield of the home (see asset protection Lesson #6), and an estate plan, to become a centerpiece of the Doctor’s asset protection plan.
7. Overall cost/benefit
The related lender AR financed structure, though a bit more complex at the outset, can be much more rewarding to the Doctor and his or her family. The main reason is that the interest payments are not “lost” to the bank. Rather, they are paid to a trust for the benefit of the family. In addition, this structure can also protect the Doctor’s home as well. For this reason, the authors often work with attorneys who have experience with this technique and introduce them to our clients when appropriate.
For most practices, the single largest asset is the outstanding Accounts Receivable. This generally represents between 16% to 25% of a practice’s annual revenue and 30% to 50% of a practice’s annual profit. One successful lawsuit against the practice resulting from the actions of any of the partners or employees could wipe out up to six months of income for ALL of the partners. This significant risk necessitates the protection of the Accounts Receivable.
In this chapter, you learned that related and unrelated lender AR financing strategies are viable for protecting this valuable practice asset. If you meet with your advisory team, they should be able to explain the differences between each plan and help you determine which plan is right for your situation.