A common recurring question I get from high-income practice owners and executives centers on the best techniques to protect a medical practice’s income after the individual physicians’ personal assets are well secured.The marketing for these strategies peaks around tax time and at year end when promoters are aware that doctors are especially sensitive to tax planning issues.
Income protection strategies, typically referred to as “accounts receivable financing” or in similar terms, do have a place and value for those that are financially qualified, but the strategy is not for everyone and must be a carefully determined fit for your income, expenses and long-term plans. Just because it’s theoretically a good idea does not mean it’s a good idea for you, no matter what the salesman says. This is not advice specific to you. Ever.
First, please understand that this is an insurance-based strategy, so if you are one of many doctors that automatically recoils at the mere mention of the “I” word, it may not be attractive to you. If that is the case, I’d suggest taking a deep breath and taking a look at the previous articles on life insurance I have shared in this forum, then revisiting this discussion.
Why is life insurance involved?
Because the economic efficiency is based in part upon the cash value, death benefit and tax-free growth the law provides to life insurance in certain forms. It just happens to be a good tool for the job.
I have examined and implemented variations of the strategy for a variety of physician and business owner clients in various specialties. Although the qualifications vary slightly between providers, here’s a basic outline of what I usually see:
How does it protect my income?
- Insurable physician in relatively good health
- Has a net worth of $2 million to $3 million plus, minimum
- Has a history of generating at least $1million in production annually for at least three years in a row
- Good credit
- Can contribute to and maintain a plan for at least 10 years
- Wants additional retirement income
- Wants additional death benefit for family and estate planning or at least has capacity for additional insurance
You take a large (typically million dollar plus) loan from one of several specialized commercial lenders familiar with complex financial strategies for high-income professionals. That loan is guaranteed by your practice, which makes a formal “collateral assignment” of your practice’s future income. This in essence “equity strips” the future income so that a recorded first position creditor, the lender, has first right to that income to pay back what you borrowed, much like the mortgage on your home being secured against the home itself.
What if I die during the plan?
The bank takes what you owe them and pays your family the rest from the insurance policy. For example, if you have a $4 million death benefit and die owing the bank $1 million, they pay off the loan and give your family the $3 million balance.
Where does the money I am borrowing go?
It goes into a (gasp!) life insurance policy in large, lump installments. Remember, the lender is making a speculative loan and taking the risk of you earning as much and working as hard as you did the previous years. They don’t just hand you the money and let you spend it as you please, lose it, or want it taken by another creditor. The insurance policy itself becomes additional collateral and the bank is collateralized by the cash value, receivables and the death benefit in most cases, making them “triple collateralized” against your death, insolvency or other creditors.
What are the loan costs?
It varies, and interest rate exposure is significant in making a decision on a strategy like this. Sometimes, the loan is a floating rate, typically LIBOR-based, and in others it is fixed at a higher, but more predictable interest rate. You are responsible for the monthly interest on the loan for 10 years to 20 years, or as long as you wish to have the protection of the lien over your receivables.
How is it paid off?
You pay it back by dying, or from the last period of receivables, and end up with a large, well-funded life insurance policy and in some cases, a significant source of retirement income in the form of payments from the cash value of your policy for many years, tax free.
Is it deductible?
Some promoters advise that the interest payments are deductible – my tax experts say it is not. Assume it isn’t and factor that into your costs carefully.
Plans ignoring the “Rule of Three.”
Many of the top tax advisors I work with around the country agree that the Rule of Three is a simple lay-person test and red flag for independent verification of the legality of any given tax plan. It’s amazingly simple: If you are promised that contributions are deductible, growth is tax free and distributions or withdrawals are tax free, tread very lightly. Many plans can offer two of the above three in some combination, but we rarely see all three together.