Section 11 Asset Protecting Your Accounts Receivables Accounts Receivable Leveraging

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1 Section 11 Asset Protecting Your Accounts Receivables Accounts Receivable Leveraging Leverage Your Office s Accounts Receivables (A/R) for Asset Protection, Estate Planning, and Potentially to Create Retirement Savings Introduction The topic of protecting a medical practice s A/R is WHITE HOT right now in this era of litigation and abnormally high verdicts being handed down by out-of-control juries. There are various ways to protect a medical practice s A/R, and this section of the book will discuss in great detail the number one option (and what to avoid when being pitched the plan by advisors). It will try to convey to readers the real-world truth and the actual financial benefit of the A/R leveraging plan to a physician in retirement. The A/R leveraging plan is what I consider the second most abused sales tool in our industry today. I will explain this in detail in the upcoming pages. However, let me start by giving you a general overview of how the plan works. Overview of A/R Leveraging Plan The A/R Leveraging Plan involves using a medical office s A/R balance as the primary collateral for a bank loan. Depending on the lender used, the loan will be equal to the revolving A/R balance generally ranging anywhere from 30 to 120 days. (The A/R balance is the real value of the A/R not the inflated amount a medical practice has on the books for what is billed). Depending on the lender used, the loan may be equal to the entire A/R balance (that has not otherwise been borrowed against). Since the bank will have a primary lien against the receivables balance, this asset protects the balance from the claims of other creditors. Once the bank loan is made, the loan proceeds can be invested for the purpose of providing the physician with death benefit protection and, potentially, a source of supplemental retirement income. Cash value life insurance can be ideal for this purpose for a couple of reasons. First of all, since creditor protection may be a major concern, individually owned life insurance may be advantageous due to the fact that it may enjoy significant protection under state creditor protection statutes. Copyright 2010, The Wealth Preservation Guide 1

2 Secondly, an individually owned life insurance policy may provide the physician with income tax advantages. One advantage is that any growth of the policy cash value will be income tax deferred and, potentially, income tax free depending on how the client chooses to take money out of the life insurance policy in retirement. The bank making the loan will very likely require the life insurance policy be assigned as secondary collateral to the bank. Although, in most cases, the bank will look primarily to the accounts receivable balance in the event of default, the life insurance policy cash value provides a liquid source of collateral in the event the accounts receivable balance is insufficient to pay back the loan. The loan will typically be outstanding as long as the physician is still working (i.e., until retirement). However, the loan will need to be extended from time to time; and the bank will likely do so, assuming the physician continues to be a good credit risk. Once the physician retires, the loan agreement will generally provide that the loan must be repaid within a specified period of time. Oftentimes, the loan agreement may give up to 180 days in order to provide sufficient time for the outstanding accounts receivables to be collected. Keep in mind that the receivables, once collected, will be income taxable. Therefore, it may only be the net after-tax amount of the receivables that is available to repay the bank loan. This is part of the sales pitch that is omitted by most advisors pitching this plan. The A/R available at retirement will not be sufficient to pay back the loan; and, therefore, a physician will have to come out of pocket to pay it off or money from the life insurance policy will have to be used. Once the loan has been repaid, the bank s secondary collateral interest in the life insurance policy is released; and the physician now owns the policy unencumbered. At this point, the physician is free to begin taking potentially income tax free distributions from the policy s cash value for purposes of supplementing his or her retirement income. If the above summary is a little confusing, below you will be able to see a few simple flow charts and examples that will help you understand the A/R Leveraging Plan. Asset protection sales pitch It seems as though everyone is now an asset protection specialist. It does not seem to matter if you are an attorney, CPA, financial planner, insurance salesman, or a ditch digger. If you get in front of a physician client, you have been told to bring up the issue of asset protection. Why? Because there seems to be a national frenzy created by consultants that revolves around the premise that every physician is in danger of having their A/R seized by creditors in a lawsuit. Copyright 2010, The Wealth Preservation Guide 2

3 See if this sounds familiar: Dr. Smith is visited by his local life insurance agent (or financial planner) who wants to discuss the important topic of asset protection. Normally, Dr. Smith would not find time to meet with his insurance agent unless he had a real need; but since Dr. Smith is worried about losing his assets in a lawsuit, he finds time to meet with the insurance agent. The agent meets with Dr. Smith and tells Dr. Smith about the horror stories of physicians from all over the country and how they have been losing their A/R in medical malpractice lawsuits. When Dr. Smith has that worried look in his eyes, the insurance agent asks the magic question.. Do you have your A/R protected from lawsuits, Dr. Smith? The insurance agent knows the answer is no; and when Dr. Smith says no, the agent strikes by whipping out on the table a PowerPoint presentation on A/R Leveraging. The insurance agent goes through the sales pitch, which is loaded with fear tactics; and at the end of the presentation the agent shows Dr. Smith how he can not only asset protect his A/R but also create a tax favorable supplemental retirement benefit. One other main part of the sales pitch is to tell a physician the largest asset their medical practice owns (the A/R) is considered a dead or dormant asset because the A/R just sits there on the books without creating any gains for the physician owner(s). As I point out below, in the real world, the A/R Leveraging Plan can work in the following three ways when considering the Plan from a financial point of view: 1) 44%+ better than post-tax investing. 2) Expense neutral where the client did not gain or lose money by implementing the plan. 3) -25% or worse than post-tax investing. When I say post-tax investing, I am talking about how the client would do if he/she did not implement the A/R Leveraging Plan and instead took the money home he/she would have paid for interest on the loan involved in the Plan and invested in the stock market on a post-tax basis. A/R Leveraging Asset Protection Nirvana? Is the A/R Leveraging Plan an Asset Protection Nirvana? The honest answer is no with a caveat. The caveat being that the A/R Leveraging Plan can work great or it can work poorly depending on the following factors: Copyright 2010, The Wealth Preservation Guide 3

4 1) Interest Rates The A/R Leveraging Plan is one that requires a loan for upwards of 20 years. The lower the interest rates and the longer loan rate is fixed, the better the plan will work. This is a significant flaw with this program and an item overlooked and abused by those selling it. Most loan structures are fixed for less than five years. Some are fixed only for twelve months, and some float the interest rate monthly. However, the illustrations given out to make the sale typically will illustrate the loan interest rate as a level rate going out years. This is totally unrealistic given our current low interest rate environment. If you ll recall, commercial lending rates in the 1980 s were in excess of 18%. 2) Investment Returns If the investment where the borrowed money is placed does not perform well (7% or better), the likelihood of the A/R Leveraging Plan working better than post- tax investing is reduced (unless interest rates on the loan stay abnormally low). However, when salespeople pitch this plan, most use rates of return that are in excess of 8%. If you are pitched this plan, ask the salesperson to re-run the numbers using a 6% rate of return in the life insurance policy and see how they turn out. They will look terrible (I know because I ve run them). If interest rates are moderate throughout the life of the Plan and if the return in the investment is similar to what the S&P 500 has done over the last 30 years, then the A/R Leveraging Plan, when done right, may be a nice and economically effective way to asset protect a medical office s A/R (as long as a physician understands the risks associated with the plan). The problem in the past and still in the marketplace with the A/R Leveraging Plan is that it is not done right a majority of the time and is not sold with full disclosure. A/R Leveraging done wrong Before talking about the ways to implement a properly setup A/R Leveraging Plan, I think it is important to understand what is currently being pitched in the marketplace and what, in my opinion, is the wrong way to implement an A/R Leveraging Plan. Copyright 2010, The Wealth Preservation Guide 4

5 General Business Loan Lender A/R as Collateral Equity of Life and/or Annuity As Collateral Medical Practice, P.C. Deferred Comp. Agreements Physicians Loan/ Investment Life Insurance and/or Annuities How does the above plan work? This method involves 1) making a bank loan to the business which 2) then distributes the loan proceeds to the participating physician(s) pursuant to the terms of a deferred compensation agreement. The distribution is treated as a property transfer under I.R.C. Section 83. 3) The physician then funds a life insurance policy with the distributed money and 4) the life insurance policy is collaterally assigned to the bank as secondary collateral for the bank loan. It is contended that the assignment of the life insurance policy constitutes a substantial risk of forfeiture by the physician pursuant to Section 83; and, therefore, transfer of money to the physician is not taxable until some later time. The client is told the following when being sold the Section 83 Plan: 1) The medical practice can write off the interest on the loan. This is a much debated point, but the vast majority of the time, the interest will NOT be deductible. This is the most abused part of the A/R leveraging sales pitch. The salespeople tell you they don t give tax advice, and then they give out illustrations assuming the interest is deductible. If you have this plan reviewed by your CPA, the chances are great that he/she will not know why the interest is not deductible. Have him/her look up Title 26, Section 264(a)2 and 3 of the tax code which will explain why the interest for most plans will NOT be deductible. Copyright 2010, The Wealth Preservation Guide 5

6 2) The borrowed money that is poured into the life policy will grow with no tax consequences and can be borrowed from the life policy income tax free in retirement. What the promoters of the plan do not tell the client is when the cash in the life policy gets above the amount of premium poured into the policy, they will have to recapture as income each year the investment gains in the life policy. I call this phantom income because the client ends up paying tax on money not in their hands. For example: If a medical office borrowed $200,000 from a lender to encumber/asset protect the office s A/R and if that $200,000 was invested into a life insurance policy owned by Dr. Smith, the first three to five years there would be less than $200,000 in cash surrender value in the life policy. For the first three to five years, Dr. Smith has no tax consequences. If in year five the cash surrender value in the policy grows from $200,000 to $220,000, I would tell Dr. Smith he now has $20,000 in phantom income that he must report on his tax return. This is a subject that promoters of the Section 83 A/R Leveraging Plan do not discuss and instead let a client s local CPA try to figure out prior to the sale going through. When you run the numbers of the A/R Leveraging Plan where the client has to recapture as income the growth in the policy above its basis (what was originally paid in premium), the plan is an absolute 100% guaranteed loser from an economic standpoint. If clients actually understood this, they would never use a Section 83 A/R Leveraging Plan. 3) There is no immediate income recognition of the borrowed money. If you don t think it sounds strange the medical practice can borrow $200,000 in my example above, give that money to Dr. Smith and not have him recognize income on that money, you should. The promoters of the plan say because there is a risk of forfeiture of the life insurance policy back to the bank (because of the collateral assignment), the physician does not have to recognize income on the borrowed money. Without getting too technical with the reasons for why I do not believe that is true, I ll simply state that it is my position that Dr. Smith in the above example should recognize as income in the first year of the plan the $200,000 that was borrowed and poured into the life insurance policy. When you run the financial numbers for the A/R Leveraging plan with a client who has to recapture the borrowed money as income in the first year, the plan CANNOT work in a positive financial manner for the client. 4) There will be enough A/R left in the medical practice to pay back the loan used to protect the A/R. This part of the sales pitch is very deceptive. If a medical practice had $200,000 of A/R on the books and therefore took out a $200,000 loan on the A/R to asset protect it, eventually the $200,000 has to be paid back. Loans for the Plan are interest only loans to be paid back in full when the plan is terminated. Copyright 2010, The Wealth Preservation Guide 6

7 So what s the problem, and why won t the $200,000 of A/R on the books at termination pay back the $200,000 loan? Because the client will have to pay income tax on the A/R prior to paying off the loan. Therefore, if the client was in the 40% tax bracket, he/she would only have $120,000 left after tax on that $200,000 and then would have to find an additional $80,000 in post-tax money to pay back the loan at termination of the A/R Leveraging Plan. Section 83 A/R Leveraging Summary I would not recommend that anyone use a Section 83 plan because I: 1) do not believe the interest is deductible; 2) believe the client should recapture as income all the money borrowed in year one; and 3) believe the client would have to recapture as phantom income all the growth in the life policy above its basis each year. A/R Leveraging Done Right A/R Leveraging can be done correctly so as to asset protect a medical office s A/R. While reading over the following pages, keep in the back of your mind the most important question, i.e., while the A/R Leveraging Plan can be done correctly, is it a plan worth implementing given your particular circumstances and fears about the loss of your A/R in a lawsuit (for most the answer will be NO). See the following schematic. Lender A/R Pledged to Guarantee the loan Medical Office SPIA is also collateral Bank loans money Physician (personally) Life policy is also used for collateral Physician uses borrowed money to fund SPIA SPIA (immediate Annuity) Premium Paid Over 3-5 year period Life Policy Copyright 2010, The Wealth Preservation Guide 7

8 The Steps for A/R Leveraging Done Right: 1) Bank loans money directly to the physician. The loaned money is equal to the amount of current real A/R on the books of the medical practice. 2) Physician purchases a single premium immediate annuity (SPIA) with the borrowed money. 3) The SPIA pays income for 3-5 years, and that money is used to fund a life insurance policy that is supposed to act as a long-term investment for the physician. loan. 4) The SIPA and life insurance policy are pledged as secondary collateral on the 5) The medical practice s A/R is pledged as the primary collateral for the loan. That is as complicated as it gets when doing A/R leveraging the correct way. Because the A/R is pledged as the primary collateral for the loan, it is asset protected as long as the loan stays in place. The Finances of the A/R Leveraging Plan If you ve taken anything from the previous information on the A/R Leveraging Plan, you probably know a medical practice borrows money to asset protect the A/R and the borrowed money is invested in a life policy. The A/R is protected, but how does that help or hurt you where it counts the most, i.e., your pocket book. The A/R Leveraging Plan in the past was sold more as a supplemental retirement plan than an asset protection plan. This was in the old days when advisors really did not understand all the negative tax ramifications of the Section 83 version of the Plan. Now that some sanity has set in with how to properly account for the A/R Leveraging Plan, clients should be told the Plan can work great or poorly depending on how the life insurance policy works as an investment and how low interest rates stay during the life of the Plan. Instead of trying to explain in paragraph form how well or poorly the A/R Leveraging Plan works from a financial standpoint, I instead will use three illustrations outlined below. The following are the important variables that remain constant with all three examples. 1) The client is a 45 year old male in good health (Dr. Smith). 2) The client is looking to asset protect $200,000 of A/R and, therefore, the loan taken out in the example is that same $200,000. Copyright 2010, The Wealth Preservation Guide 8

9 3) The lending interest rate stays the same in the examples (you ll notice I use as a base interest rate 6% and then I bump up the interest every five years. Interest rates at the time of the publishing of this book are at record lows, and I wanted to use more real world interest rates in my example). The following are the important variables that change in the three examples. 1) The age when the client borrows money out of the life policy that was funded with the borrowed money to create supplemental retirement income. In the first example, I use ages 71-85; in the second and third examples, I use ages The longer you wait to borrow money income tax free from a life policy the better the illustration will work. 2) The investment rate of return in the life policy. I assumed 7.9% annual return in the life policy in the first two examples and a 6% rate of return in the third example. 3) The investment rate of return on the money Dr. Smith could have invested in the stock market if he did not implement the A/R Leveraging Plan. In other words, if Dr. Smith did not implement the A/R Leveraging Plan, he would have extra income to invest because he is not paying non-deductible interest payments on the $200,000 loan. I assumed the same investment rates of return with the post-tax brokerage account as I used in the life insurance policy (which is 7.9% in the first two examples and 6% in the third example). Is A/R Leveraging a Good Deal Financially? Assumptions/Constants in the below examples -Medical Practice has $200,000 of real A/R on the books; -$200,000 of Loan Proceeds (used to encumber and asset protect the A/R) Loan Interest: 6% yrs 1-5; 7% yrs 6-10; 8% yrs 11-15; 9% yrs yr old Male Physician Non-Tobacco Preferred (Dr. Smith) -Pre- AND Post-Retirement Tax Bracket 40% Example 1 Assuming a 7.9% rate of return in the life policy and in the brokerage account. Borrowing from the life policy from ages Option One (invest interest payment) -Loan interest 8% netting a 5.3% ROR would grow to $668,504 in 25 years -If Dr. Smith drew down the brokerage account he could take out $62,410 after tax a year from ages (which should be in an FLP for asset protection) -A/R taxable when Dr. Smith retires -A/R vulnerable Option Two (implement A/R Leveraging Plan) -25 th Year Life Insurance Cash Value - $950,000 -Initial Death Benefit - $758, year Income Tax-Free Cash Flow ages $90,000. -Pledge of A/R to bank will take priority over other creditors and lawsuits to the extent of the loan balance and PA/PC guaranty -A/R taxable when physician retires Copyright 2010, The Wealth Preservation Guide 9

10 Financial Outcome Dr. Smith would have an extra $27,590 a year in post-tax retirement benefits from ages This is 44% better than taking the interest payment home and investing it post tax in the stock market. Example 2 Assuming a 7.9% rate of return in the life policy and in the brokerage account. Borrowing from the life policy from ages Option One (invest interest payment) -Loan interest 5.3% Net ROR would grow to $516,317 in 20 years -If Dr. Smith drew down the brokerage account, he could take out $48,200 after tax a year from ages (which should be in an FLP for asset protection) -A/R taxable when Dr. Smith retires -A/R vulnerable Option Two (implement A/R Leveraging Plan) -20 th Year Life Insurance Cash Value - $637,000 -Initial Death Benefit - $758, year Income Tax-Free Cash Flow ages $50,000. -Pledge of A/R to bank will take priority over other creditors and lawsuits to the extent of the loan balance and PA/PC guaranty -A/R taxable when Dr. Smith retires Financial Outcome Dr. Smith would have an extra $1,800 a year in post-tax retirement benefits from ages This is ONLY 3.7% better than post-tax investing. Example 3 Assuming a 6% rate of return in the life policy and in the brokerage account. Borrowing from the life policy from ages Option One (invest interest payment) -Loan interest 4.2% Net ROR would grow to $459,109 in 20 years -If Dr. Smith drew down the brokerage account, he could take out $40,185 after tax a year from ages (which should be in an FLP for asset protection) -A/R taxable when Dr. Smith retires -A/R vulnerable Option Two (implement A/R Leveraging Plan) -20 th Year Life Insurance Cash Value - $442,000 -Initial Death Benefit - $758, year Income Tax-Free Cash Flow ages $30,000. -Pledge of A/R to bank will take priority over other creditors and lawsuits to the extent of the loan balance and PA/PC guaranty -A/R taxable when Dr. Smith retires Copyright 2010, The Wealth Preservation Guide 10

11 Financial Outcome Client would have $10,000 a year LESS in post-tax retirement benefits from ages This is 25% worse than post-tax investing. What seems interesting about the above three examples and what can we learn from them? What should quickly jump out at you is that, for the two illustrations which both worked better than post-tax investing, Dr. Smith had to wait at least until age 65 (and 71 worked much better) before accessing income tax free loans from his life policy. You can look at this fact two ways: first, it is great that a physician can asset protect his/her A/R and at some point down the road have the plan work as a nice supplemental retirement plan (or at least a break-even plan), or second, that you really don t want to get into a plan where you have to wait until age 65 to access money tax favorably from a life policy. What should also seem interesting is even if the Dr. Smith waited until age 65 in Example 3, he would have lost money with the plan. Because the internal rate of return of the policy was not high enough to counteract the rising interest payments, Dr. Smith would have been better off financially to invest the interest payments instead of implementing the A/R Leveraging Plan. Is your A/R really at risk to malpractice suits? This is one of the most deceptive features of the A/R leveraging sales pitch. Remember that I used to sue physicians for a living, I ran a medical practice for three years, and I m licensed to sell malpractice insurance to physicians. What I can tell you is that the A/R in a medical practice is more at risk to a sexual harassment lawsuit than it is a malpractice suit. Why? Because the medical practice does nothing wrong in most malpractice cases (aside from maybe a negligent hiring case) and because these suits are professional suits where individual physicians are sued. If you don t believe me, let me illustrate to you using a third-party example proving to you my statement is true. All physicians have or should have malpractice insurance. If they also have a medical practice, the medical practice has a SEPARATE policy with SEPARATE limits. A classic example is where a physician has 1 million/3 million dollar coverage and the medical practice has a separate 1 million/3 million dollar policy. Copyright 2010, The Wealth Preservation Guide 11

12 The question then is, what does the physician pay for his/her policy and what does the medical practice pay for its policy? If my example is an orthopedic surgeon in OH, he/she might pay $40,000 a year for the personal policy. What does the medical practice pay for its policy? Take a guess. The answer is about 10-15% of what the physician pays for his/her policy. Why is that? Because the insurance company wants to make money on the physician policy and lose money on the medical office policy? NO. It s because the medical practice the vast majority of the time has no liability. If that s the case, then why is the premium even that high for the medical office policy? Because the medical practice will still be sued and needs to be defended (so the premium is mainly used to pay for defense costs not because the medical office has any real liability). If, therefore, the medical practice has no real-world liability, then the A/R is not really at risk because the A/R is an asset of the practice not that of the physician. The above explanation is a long-winded way of saying that the A/R protection part of the sales pitch to A/R leveraging plans is bogus and is one reason why I say this concept is the second most deceptive sales pitch in the industry today. Is the A/R Leveraging Plan right for you? If you are looking at the A/R Leveraging Plan as a supplemental retirement plan, I d submit to you that you are looking at the wrong topic. You would be better off with the Equity Harvesting plan described on page 256 or by using a Defined Benefit plan or 412(e)3 plan (for the right client) or even a by using a CIC (which you can read about on page 217). If you are worried about losing your A/R in a lawsuit to creditors, now that you know the truth about this topic, you no longer should have this worry (and don t have to implement a plan to protect them). Bottom line Unless you are interested in rolling the dice with a large loan in hopes that the returns in your life insurance policy will sufficiently outperform the lending rates on a loan that can only be fixed for a short period of time, I recommend you look elsewhere for a way to grow your wealth. Copyright 2010, The Wealth Preservation Guide 12

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