Self-financing may be your best option

Asurprising number of principals in veterinary practices depend on themselves for their financing needs. With conventional financing increasingly more difficult to obtain, it's now the No. 1 form of financing used by small business owners. It's quick, doesn't require a lot of paper work and often is less expensive than conventional financing.

The cost that comes into play is the "lost opportunity" cost — the amount that could have, or might have, been earned had those funds remained in savings or invested elsewhere. However, in the current economic climate, keeping financing within the family frequently produces the fastest and best results.

If you want to finance something yourself, know that the tax laws create a number of obstacles that must be overcome to avoid penalties and higher tax bills.

Reversing the bottomless pit

Although many veterinarians look first to cash savings as a financing source, often there are other assets that can be used, despite certain risks and drawbacks. Consider this example:

When John Jones' practice was turned down by several conventional lenders, even non-conventional funding sources seemed to dry up. His answer was to personally guarantee a $100,000 loan, run up expenses on his personal credit card and defer his salary. In short, Jones put himself in a position where he had a lot to lose — and the only way out was to succeed and profit.

Putting oneself at risk can attract lenders or investors to provide funds a business needs. Here are some strategies that can put the owner at risk, provide the needed funding — or both:

• Liquidate savings. If you have it, consider giving it up.

• Take out a home-equity loan. Remember, however, there is a limit to the amount of qualified residence interest that is tax-deductible. The aggregate amount of acquisition indebtedness may not exceed $1 million and the aggregate amount of home-equity indebtedness may not exceed $100,000. Interest attributable to debt that is over these limits is nondeductible personal interest.

• Get a bank loan. Usually any bank loan will require a personal guarantee, or the guarantee of friends or family members.

• Sell a vacation home.

• Take out a margin loan against your stock holdings.

• Never use personal credit card for business purposes. It is far too costly.

Imputed interest

When either lending to or borrowing from the veterinary practice, remember that, to count, it must be a legitimate, interest-bearing loan. A practitioner borrowing from his or her practice can face a hefty tax bill should the IRS view the transaction as a dividend payout rather than a loan.

Often, it is below-market interest rates or the lack of evidence of an arm's-length transaction that draw the attention of the IRS. The government is particularly interested in (1) gift loans, (2) corporation-shareholder loans, (3) compensation loans between employer and employee or between independent contractor and client and (4) any below-market interest loan in which the interest arrangement has a significant effect on either the lender's or borrower's tax liability.

If the IRS re-characterizes or re-labels a transaction, the result is an interest expense deduction when none was previously claimed and unexpected, taxable interest income on the lender's tax bill. The higher tax bills, often dating back several years, usually are accompanied by penalties and interest on the underpaid amounts.

Always a borrower be

For many veterinary practices, borrowing means a loan from the principal, owner or shareholder. In some cases, the principal borrows from the practice.

Loans and advances between so-called "related parties" are quite common in closely held practices. Corporate loans to shareholders probably are the most common ones seen by IRS auditors, with advances from shareholders to the incorporated veterinary practice running a close second, particularly in the early years of closely held but thinly capitalized corporations.

The IRS's interest in these transactions stems from the tremendous potential for tax avoidance — inadvertent or intentional. When an incorporated practice makes an interest-free (or low-interest) loan to its shareholder, in the eyes of the IRS the shareholder is deemed to have received a nondeductible dividend equal to the amount of the foregone interest and the corporation receives a like amount of interest income.

Fortunately, there is a $10,000 de minimis exception for compensation-related and corporate/shareholder loans that do not have tax avoidance as one of the principal purposes.

Although this transfer of taxable income between entities may appear to be offsetting, there can be a significant tax impact on the reallocation, depending on the relative tax benefits of the borrower and the lender and the deductibility of the expense deemed paid.

Downside: stock or loan

When IRS examiners review loans from shareholders and the common stock accounts of many practices, they frequently encounter "thin capitalization." That occurs when there is little or no common stock and there is a large loan from the shareholder. Section 385 of the tax code specifically considers whether an ownership interest in a corporation is stock or indebtedness.

The IRS' objective is to convert a portion, if not all, of the loans from the shareholders into capital stock. Naturally, this conversion requires an adjustment to the interest expense account because, at this point, the loans are considered nonexistent. The interest paid by the incorporated practice on these disallowed loans becomes a dividend at the shareholder level, equal to the operation's earnings and profits.

Loans gone bad

A business bad-debt deduction is not available to shareholders who have advanced money to a corporation and those advances were labeled as contributions to capital. A principal, business owner or shareholder who incurs a loss arising from his guaranty of a loan is, however, entitled to deduct that loss, but only if the guaranty arose out of his trade or business — or in a transaction entered into for profit. If the guaranty relates to a trade or business, the resulting loss is an ordinary loss for a business bad debt.

Sale-leasebacks

If your veterinary practice needs an infusion of cash but you are reluctant to invest additional money, an answer may lie with the tax benefits. Are those being wasted because of low or nonexistent profits? As a result, does the practice find itself in a low tax bracket?

An all-purpose solution might be the sale-leaseback of business assets. The practice might sell its building, various operating equipment, etc., to obtain working capital. The buyer, usually using borrowed funds, often is the veterinarian and principal shareholder. The practice then pays the buyer fully tax-deductible lease payments for the right to use the assets in its operation.

The new owner of the building and equipment, whether it's the principal, chief shareholder or possibly a trust established for the benefit of the principal's children, will receive periodic lease payments.

Thus, with one transaction, the owner has found a way to get money from the practice without the double tax bite imposed on dividends.

Another advantage of self-financing is that business control is not given to shareholders, nor will there be oversight by bankers or other lenders.

A disadvantage might be that sufficient capital may not be available.

Self-financing simply is an option — often the only one — for many in today's tough economy. Drawing on savings accounts, equity in real estate, retirement accounts, vehicles, recreational equipment, collectibles and other assets, more veterinarians than ever are finding the funds needed to keep their practices afloat.

Battersby is a financial consultant in Ardmore, Pa.