When it comes to managing debt, creativity is often required.
For example, the interest paid on borrowed funds is deductible by a borrowing chiropractic practice. However, funds directed to equity investment are not. According to a report issued by the Joint Committee on Taxation (JCT), “the after-tax effect of debt financing is more favorable than equity financing because of the deductibility of interest.”
To expand, grow, or even exist, it is often necessary for a practice to use a variety of financial resources, initially broken into two categories: debt and equity. Debt involves borrowing money that must be repaid, plus interest, while equity involves raising money by selling an interest in the practice or business.
Debt, equity, and taxes
Combining interest deductions with depreciation deductions, credits, preferential rates, or the tax exemption for earnings financed with debt all too often leads to a negative tax rate, according to the JCT, which also states: “A taxpayer may have anmincentive to incur debt so that deductible interest expense, in combination with other deductions such as depreciation or amortization, may shelter or offset the taxpayer’s income.”
The report noted that substituting debt for equity in corporate transactions may increase earnings per share. By using debt rather than equity, an incorporated practice or business can increase its after-tax earnings per share by substituting debt for equity capitalization. Unfortunately, because of the new Section 385 debt-equity regulations, there is a potential fly in the ointment that, over vocal bipartisan Congressional protests and adverse testimony of many business groups, became a reality in October 2016.
Comparing debt to equity financing
Many chiropractic practices operating as regular corporations are already seeing many otherwise routine, ordinary business and financial transactions, such as shareholder loans or securitization, reclassified as equity. Consider the pros and cons when managing debt and equity:
- Because the lender does not have a claim to equity in the chiropractic practice, debt does not dilute the principal’s ownership interest in the practice. There are no investors or partners as such. The chiropractor makes all the decisions and owns all profits.
- If financing using debt, the interest paid on the loan is tax-deductible. This means that it shields part of the practice’s income from taxes and lowers its tax liability.
- A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest and has no direct claim on future profits. If the chiropractic practice is successful, the principals reap a larger portion of the rewards than if they had sold stock in the practice.
- Except in the case of variable rate loans, principal and interest obligations are known amounts that you can forecast and plan.
- Interest on debt can be deducted on the practice’s tax returns, lowering the practice’s actual loan costs.
- Raising debt capital—or borrowing—is less complicated because the practice is not required to comply with securities laws and regulations. Even better, the practice is not required to send periodic reports to investors, hold share- holder meetings, or seek shareholder approval before taking certain actions.
The downside of debt financing
- Unlike equity, debt must be repaid at some point.
- Large loan payments may be due at the same time that funds are needed for other purposes. A failure to make loan payments on time can ruin a chiropractic practice’s credit rating, making future borrowing difficult and more expensive.
- Interest is a fixed cost that raises the practice’s break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Practices that are highly leveraged (that have large amounts of debt as compared to equity) can find it difficult to grow because of the high cost of servicing the debt.
- Cash flow is required for both principal and interest payments, and it must be budgeted. Few loans are repayable in varying amounts over time or based on the business cycles of the practice.
- Debt instruments often contain restrictions on the practice’s activities, preventing it from pursuing alternative financing options and non-core practice opportunities.
- The larger a practice’s debt- equity ratio, the riskier lenders and investors will consider it to be. Accordingly, many practices are limited in the amount of debt they can carry.
- A practice is usually required to pledge its assets to the lender as collateral.
- And, in many cases, principals and shareholders are required to person- ally guarantee repayment of the loan, often pledging their personal assets. If the practice goes under, the principal or shareholder may lose his or her personal assets as well.
Although incorporating is a well- known strategy for limiting liability, it doesn’t always protect the personal assets of the principals or share- holders. In addition to any personal assets pledged to secure financing, courts are increasingly looking behind the corporate shield.
Although the new rules apply only to financial instruments in the form of debt, they largely target corporate groups, which consist of U.S. and non-U.S. corporations, REITs, and regulated investment companies.
The newly issued debt–equity rules have significant implications for the more than 4.5 million businesses and professional practices in the U.S. that operate as S corporations.
Where permitted by licensing regulations or law, an incorporated chiropractic practice operating as an S corporation does not pay corporate income taxes; instead, the share- holders are taxed on the income they receive from owning stock in the S corporation. This benefit comes with a caveat because the number of share- holders of an S corporation is limited to 100. Under the new debt-equity rules, S corporations could effectively become regular corporations and face a new set of taxes and regulations.
According to the S Corporation Association, “Re-characterization of related-party indebtedness as stock may result in the loss of S corporation status in nearly all circumstances.” A shareholder may own equity in an S corporation that is broken down into related affiliates, perhaps the practice, a clinic, or other activity. Even though ownership is the same for these affiliates, they are separate—but related—entities. What’s more, these entities often make extensive use of related-party debt for cash management and to increase the liquidity of assets.
However, should any of this debt be transformed into equity, these related entities would effectively be paying each other dividends that would, consequently, qualify them as owners of each other. That violates the shareholder requirement that an S corporation has, forcing it to lose its status.
More truth or consequences
Because of the final Section 385 debt-equity regulations, many practices operating as regular corporations will see otherwise ordinary business and financial transactions reclassified as equity investments. After all, many practices routinely use debt transactions among subsidiaries, affiliates, and related businesses as a means of cash management or changing internal capital structure for more liquidity, not corporate tax avoidance. These transactions may soon have to be taxed under the new rule.
But, that’s not all. Unfortunately, the new rule was retroactive to April 4, 2016. The U.S. Chamber of Commerce continues to maintain that companies need time not only to understand the impact of the rules but also to implement systems to comply with them. A practice or business would potentially need to change the way it does business in this regime.
The new rules also effectively impose additional costs, as well as put some practices in a position where they are unable to comply.
Many (if not most) chiropractic practices do not have systems in place to track the information needed to comply. In fact, the documentation required to determine whether a transaction is debt or equity is rarely tracked. As a result, more time may be needed to begin tracking trans- actions properly. Additionally, some past transactions may, in retrospect, be impossible to document properly.
The fly in the ointment
Which is best, debt or equity financing? The decision between equity and debt financing ultimately comes down to the kind of chiropractic practice operated. But in general, the mix of debt and equity financing used will determine a prac- tice’s cost of capital.
According to many experts, quite a few traditional small practices opt for debt financing to start or build their operations. Equity financing is usually more suited for businesses and professionals in the technology or innovation sectors, which tend to be higher-risk ventures offering investors a bigger return.
Deciding whether to finance a chiropractic practice through loans or by giving shareholders a stake in the operation is a serious matter and all options should be explored, including the tax implications, and the potential cloud created by the IRS’s newly issued debt-equity regulations.
Obviously, professional advice is recommended.
Mark E. Battersby is a tax and financial adviser, freelance writer, lecturer, and author located in Philadelphia. He can be reached at 610-789-2480
Disclaimer: The author is not engaged in rendering tax, legal, or accounting advice. Consult your professional adviser about issues related to your practice.