Tax Basics: Loan to Shareholder

In this module, we're going to talk about what's called a loan to shareholder balance. A lot of dentists don't know what a loan to shareholder is, but it's extremely common, particularly with early stage new owner dentists. And it's. I want you to, I want you to understand what this is because in some ways it can be a measure of how financially disciplined you have been with your finances. It's also a number that is reported to the IRS and definitely could raise red flags for you. So let's understand what it is. To understand what it is, we need to understand that there's a difference between your actual cash flow, which is your actual money in and your money out, and your profit and your taxable money in money out and your profit. Most of it's the same, 80% of it's the same. But there's a couple things that are different and this discrepancy between the two can create a context for a loaned shareholder to arise. Let's run through an actual cash flow example. This is easy to understand because it's dollar in, dollar out. The math adds up perfectly. Let's look at collections. If you have a million dollars in collections in a given year and then your overhead is $600,000 and then you pay debt of $50,000, you are left with $350,000, a million less. $650,000 is $350,000. So at the end of the year, let's assume that that money is six sitting in your bank. And then on December 31, you take out $350,000. You're thinking, awesome, I got 350,000 bucks in my corporate checking account. I'm going to go buy a new house, I'm going to go buy new cars, I'm going to go do this travel here, etc. You pull out $350,000. Sometimes when you just buy a practice that is a complete over exaggeration, you might just have some money that's left over in your account from the working capital loan that you got from the bank. And yet you're trying to keep money in, but you also got to pay for all your personal needs. You have a house and you got a car and you got, you know, you got all this stuff you got to pay for. And if you don't have money over there, then you may need to go and dip into the practice and pull out money that really wasn't earned money. It was left over from the loan from the bank when they deposited a cash balance in your practice to help you get through the first year of transition, which is very, very common that banks do to help the doctors get through that early period. Now let's go look at the taxable profit. What. How is the IRS looking at your profits? Well, same thing. You got a million dollars of collections, so that's your revenue. And then you have your overhead, labor, lab supplies, facility marketing, and admin. That's all 100% deductible, no change. Now we get to the point of debt. And when I say debt, I mean just the principal portion on your debt. As I mentioned over and over in prior modules, that is not tax deductible. So you don't get a tax deduction for that. However, you do get depreciation, which if you haven't watched our module on depreciation. So stop, go back, watch that, and then come back here. Because depreciation is what the IRS allows you to deduct when you buy equipment. Now, when you buy your practice, that's called an asset purchase. You're not buying the stock of the seller. In the vast majority of cases, you're not, you're buying the equipment. They did a garage sale. They rolled up their garage door to their practice, and you went in and said, I'm going to buy all these dental chairs. I'm going to buy the, going to buy the CT or I'm going to buy the pano or whatever that is. I'm going to buy all the dental chairs and everything. And then you move those assets into your own corporation that you formed and own. That's called an asset purchase. And then whatever the price difference is between that and the value of everything you bought, that's tangible, it's called goodwill. So you move all these assets into your own corporation. Great. Well, you're going to get a tax deduction for the purchase of those through what's called depreciation. So watch that module. Now, in this case, early on, let's say that Your depreciation was $100,000 when you first buy a practice because so much of what's in your corporation was just bought as equipment and even goodwill, which is deductible, also, it ends up pushing your taxable income lower. Because look what happens here. If Your depreciation is $100,000, even though you only had to pay $50,000 in debt, those two things are related. Not exactly, but they are related because they both relate to equipment. You took on debt to buy your equipment to buy your practice. Depreciation is what the IRS allows You to deduct in the early years, because of the nature of the depreciation schedule, you get a lot more deduction. So in this case, you have $100,000. So what's your taxable profit? It's a million. Less 600,000, less 100,000. So your taxable profit is 300,000. Even though what was your net cash profit? 350,000. So you've got an extra $50,000. Now, if you went and you took that full $350,000 out of your checking account like we discussed, then what happens? You took out of your practice more money than you had in taxable profits to the tune of $50,000. Guess what? The IRS doesn't like that. The IRS says, hey, Doc, you know what your taxable profits were? 300,000. That's the most that we want to see you take out of your corporation and place into your personal account. Because that's your. That's your profit as we define it. But you're thinking, yeah, but my cash profit was 350,000. So I had an extra. I had extra money here to the tune of 50,000. The IRS says, I don't care. The way we Define profit is 300,000. You took out 350. So you have this thing called an excess distribution of $50,000. And the IRS is going to tax you on that. It's sort of a penalty tax for distributing more cash out of your practice than you had in profits. Now, why is this so common to doctors in the year or two after they buy a practice? It's because usually there's sort of a lull, a little bit of a lull there for six to 12 months. New Dr. Is figuring it out. You get all this depreciation from all the equipment you bought in the purchase of the practice. And so your taxable income is low. And that bank plopped an extra 50 to $100,000 sitting in your checking account as working capital to get you through that period. You need money personally, so you're sort of pulling that money over, and the amount you pull over ends up being more than your profits in your corporation. And we've seen this get into hundreds of thousands of dollars, and we have to report that to the irs. So what happens is we play a little trick, and it's not a trick that we want to push the envelope on because it can become tax evasion. But if you set it up properly, you can say, that extra $50,000. Look on the screen. That extra $50,000 that you took out of Your corporation in cash that exceeded the taxable profits is actually a loan to you. It's not a distribution to you as the owner, it is a loan to you as a shareholder as the owner of your corporation. And so we call it a loan to shareholder. And that prevents you from having to pay that penalty tax on your excess distributions. Now, if you want to make this legitimate, which you should, then there should be an interest that is attached to it. And typically I don't find doctors actually making payments on that, but at least they're recognizing interest income to the individual on their personal tax return. You pay a little bit of taxes on that, but it's a lot less than what you pay if you included the $50,000 in your taxable income for the year. Now, eventually what happens with your depreciation? Remember in the early years it's high and then it runs out, but your Debt is a 10 year debt, typically when you're buying a dental practice. So you're still paying debt and most of that debt is not tax deductible. So over time, your taxable income starts to go up because you run out of depreciation. And your cash flow income starts to sort of stays the same as you're paying the same debt every month, I mean every year. But your taxable income starts to go up and eventually have more taxable income than you do in distributions. And now you can reverse that loan to shareholder, or you can borrow personally, put money back in the corporation and pay off that loan as well on your corporate tax return. 11:20, it will say what your loan to shareholder is. You want to know what that is? Talk to your cpa. What's my loan to shareholder? How can I get out of this loan to shareholder? How can I prevent it from accumulating? Well, a lot of the reason, a lot of the ways you, you can do this, or I'll say one of the most important ways you can do this is to live on a budget personally. Because if you live on a budget personally and don't overspend on cars, don't overspend on houses, don't overspend on eating out, don't overspend on travel, you live within your means, then you don't have to pull out as much from the practice to take care of you, and therefore you avoid that excess distribution. The other option is you make sure that everything you pay yourself from corporation to personal is through payroll as a W2. And you don't take any draws or any distributions outside of payroll. So everything you take home shows up on your W2 at the end of the year. The disadvantage of that is you're going to end up paying more in taxes. You're going to pay more in FICA taxes as well. And it's probably going to create a loss. It could create a loss on your K1, because now your W2 is higher as an expense, and so your profits are lower, even a loss, and you can't use that loss in many cases to offset that W2. So you may end up paying higher in taxes. It's the appropriate or right way to do it, technically. So this is an area where you just got to be smart. You got to understand it, and you got a tax plan. You got to live within your means and handle this thing called a loan to shareholder carefully.