I plan on acquiring a practice and creating an S corporation. What are the best ways to structure the practice loan?
Edward C. Challberg, MBA, MST, CPA
Acquiring a practice entails acquiring the assets of that practice. The purchaser can depreciate and/or expense most, if not all, of the cost of the tangible assets in the first year, thereby creating a significant deduction. The depreciation deduction, when added to normal operating expenses, can result in a significant loss. Can the loss be deducted? That depends.
There are three tax limitations when practicing within an S corporation: (1) stock and debt basis, (2) at risk, and (3) passive activity losses. The most relevant for most dentists is the stock and debt basis limitation. The limitation is the initial value of the stock (usually $1,000) plus amounts loaned to the corporation by the dentist shareholder. Therefore, if you have $75,000, $150,000, or $200,000 in losses and no loans to the corporation, the most you can deduct is $1,000, the cost basis of the stock. The remainder is suspended and carried over to succeeding years to be offset against future income.
A lender will normally arrange the loan between the lending institution and your S corporation since your dental practice will be in the S corporation. Ask the lender to arrange the loan between the lending institution and you as an individual. You will then turn around and loan the money to the corporation. The corporation will repay the loan to you, and you will repay the loan to the lending institution. If the loan is $500,000, you then have $500,000 + $1,000 (stock) = $501,000 in basis against which losses can be allowed.
Some lending institutions will allow such an arrangement. Some do not, so find out up front. Alternatively, you might arrange that half the loan or some other portion be treated in this manner.
Some lenders will say, “We’ll just have you guarantee the loan.” That sounds like the same thing, but the tax law will not allow it. The loan agreement must state that the loan, or a portion of it, is between the lending institution and you as an individual or it won’t work.
Although there are a number of considerations in negotiating a loan for your practice acquisition—such as term, interest rate, and payment—this one feature will do the most to maximize your tax advantages.
Andrew Hinrichs, CPA
As you buy your dental practice, you must make several decisions about the best way to structure your practice loan. The financial health of the dental practice you are about to purchase will drive many of these decisions. Your personal financial goals and the facts and circumstances relating to those goals will also impact your choices.
For instance, you must decide the best term length to pay back your loan. When looking at future projections of the practice cash flow, is 10 years best for the flexibility in cash flow of practice? If you were to pay the loan off in seven years, it would minimize your total interest paid, but is that going to be best for your personal debt reduction goals?
When you analyze the profitability of the practice you’d like to purchase, the term length will significantly impact the cash flow available for you to invest in new technology and market or update your practice. It will also affect the amount of cash available to you to put to work personally, whether that is to invest in your retirement, reduce your student loan, or buy a house.
There is also a reason to consider who the borrower should be. This means, should the S corporation take the loan, or should you personally take out the loan to then turn around and personally loan the money to your S corporation? If you are looking to buy a good practice with healthy cash flow, either scenario will not likely have a significant impact for you.
However, perhaps you are looking to buy a struggling practice at a reasonable price because you believe you can turn it around. In this case, you will want to be mindful of the borrower to avoid unfavorable tax consequences. If an S corporation is operating at a loss, the tax law will limit the amount of loss that can reduce other income on your personal tax return unless you, as the shareholder, have basis in your investment, the S corporation. Past earnings will create basis, or if appropriately structured, debt can create basis, allowing the loss from your S corporation to reduce other income on your personal tax return. As this will be a new business, you will not have past earnings and must create basis through debt.
EDWARD C. CHALLBERG, MBA, MST, CPA, has been working primarily with dentists for 32 years, helping them acquire and build their practices, manage their taxes, and plan for financial independence. He is a long-time member of the American Institute of CPAs, California Society of CPAs, and Academy of Dental CPAs. Contact him at (415) 491-1322 or firstname.lastname@example.org.
ANDREW HINRICHS, CPA,
is CEO of Hinrichs+Pesavento (H+P), an exclusively dental CPA and advisory firm. H+P helps dentists around the country to pay less in taxes, keep more profit, and achieve a work-optional life. He enjoys guiding dentists on their Journey to ownership as they work toward buying a dental practice. He’s a member of the Academy of Dental CPAs. Contact him at email@example.com or visit buyyourdentalpractice.com.