Best Strategies for Protecting Your Practice and Your Assets

January 12, 2009
Special Feature

How many new lawsuits do you think are filed in the United States each year? 1,800? 18,000? 1.8 million? Would you be surprised to hear that all of these choices are wrong? Nearly 18 million new civil lawsuits will be filed this year in the state and federal court systems. That equates to about 1 every 15 seconds.

How many new lawsuits do you think are filed in the United States each year? 1,800? 18,000? 1.8 million? Would you be surprised to hear that all of these choices are wrong? Nearly 18 million new civil lawsuits will be filed this year in the state and federal court systems. That equates to about 1 every 15 seconds.

If you consider that physicians face much more litigation risk than the average American because of malpractice risk, you can see why litigation is such a serious threat to every doctor’s financial security. Statistics reveal that about 58% of U.S. physicians who have been sued at least once in their lifetime, and that nearly 87% of physicians are concerned about being involved in unjust lawsuits and/or divorce.

You work hard for the money, so it’s only logical that you should want to protect it. What follows is the first of a multi-part series that will provide you with some of the tools and techniques that can achieve your goals of protecting your assets from unfounded lawsuits.

Your practice’s accounts receivable

A medical practice’s accounts receivable (AR) is the physician’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 AR has already been earned by your practice. You are only awaiting payment. Most physician practices “turn over” their AR every 60 to 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 are owned by the lender until the debt is repaid. By implementing one of these two account 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 while protecting existing and future assets from claims.

Let’s examine the basics of accounts receivable financing and the two different types of strategies you can use.

Accounts Receivable Financing

AR Financing is an arrangement where a lender makes a loan (“financing”) 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 called AR financing 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 article. Beyond this basic similarity, there are substantial differences between the two strategies that significantly impact the physician’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. In some states (most notably Texas and Florida), these lenders’ programs have become fairly popular. 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 the legal agreements of certain arrangements and we disagree with the structure and the method of following the formalities.

2. Borrower

In most of these arrangements, the borrower is the medical practice. In some, the individual physicians are the borrowers.

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 physicians. 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 physician, even though the AR has not yet been received. How the funds get out of the practice, how they are taxed, and what the physician 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 plan. In almost all cases, the proceeds of the loan will eventually be invested in some type of insurance or annuity contract.

4. Tax issues

This is the one area where we used to see claims made by the arrangement promoters that were not well-founded. Some programs have made great strides to handling this matter more 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 the plan. It is imperative that physicians 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 state-exempt assets like cash value life insurance policies and annuities. In states where such assets are not given protection, the protection of the proceeds is more challenging and may typically involve 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.

6. Economics

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 clients look at the unrelated lender AR financing arrangement more specifically as a protection tool and less 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 physician’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 physicians 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. This also assumes that all of the formalities are followed 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, ant that the loan rate is at a market-comparable rate. Making sure your arrangement follows the necessary guidelines is the job of the attorney who structures the arrangement.

2. Borrower

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 life insurance or annuity contract in a domicile where these policies are given the highest exemption protections or into an LLC that may then invest into life insurance or some security.

4. Tax issues

If the physician 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 borrower, 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 state exempt assets like cash value life insurance policies and annuities. In states where such assets are not given protection, the protection of the proceeds is more challenging and may typically involve LLCs that offer a certain level of protection.

6. Economics

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 and an estate plan to become a centerpiece of the physician’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 physician 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 physician’s home as well. For this reason, we often work with attorneys who have lectured on this technique and introduce them to our clients when appropriate.

Diagnosis

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 6 months of income for all of the partners. This significant risk necessitates the protection of the Accounts Receivable. In this article, you learned that related and unrelated lender AR financing are viable strategies 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.

Part 2 of this series will focus on captive insurance companies.

Darrell Aviss is managing director of SwissGuard International, GmbH, an independent financial consulting firm based in Zurich, Switzerland. The firm offers Swiss annuities to American investors through Swiss insurance companies established to meet the private investment and financial protection needs of international clients. Mr. Aviss welcomes questions or comments at 800-796-7496 or visit www.swiss-annuity.com.