The Shareholder Loan Trap: What Dentists Don’t Realize They Owe

Announcer:
Hello everyone. Welcome to the Millionaire Dentist Podcast, brought to you by four Quadrants Advisory. On this podcast, we break down the world of dentistry finances and business practices to help you become the millionaire dentist you deserve to be. Please be advised, we do speak with an honest tongue and may not be safe for work.

Jarrod Bridgeman:
Hello and welcome to The Millionaire Dentist. I am your host, Jarrod Bridgeman, and we've got a hot new episode for you. And in studio I have our CPA, Kevin Rhoton. Casey Hires is not in today. Kevin, I brought you in today to speak to not only myself, but to our audience as well about shareholder loans.

Kevin Rhoton:
Yes. How you doing? That's absolutely right.

Jarrod Bridgeman:
And that's the thing, you're like an expert on this, right?

Kevin Rhoton:
Actually, yeah. We see shareholder loans quite a bit in the consult process. A lot of prospects coming in, see that. And that can be definitely a red flag. And we have a lot that it's surprising how many practice owners are oblivious to actually even having them.

Jarrod Bridgeman:
So a lot of these people, if they don't know they have one, do they even know what it is?

Kevin Rhoton:
No.

Jarrod Bridgeman:
After you point it out, so can you walk me through what a shareholder loan is?

Kevin Rhoton:
Yeah, so for practice owners, you have the business, the practice itself, and then the owner, the individual. And it's a loan that's in between the practice and the owner. And according to the tax code, that needs to be treated like a third party, that arm's length transaction.

Jarrod Bridgeman:
So in terms of it having the word loan in the verbiage there, it would be an expected, it's paid back with interest.

Kevin Rhoton:
Yes. And so there's two ways. Obviously the practice can loan money to the shareholder or vice versa. The shareholder can loan money to the practice. Either way, again, it needs to be set up correctly with a promissory note, with interest, with payments, things like that. That's what the IRS says it has to be.

Jarrod Bridgeman:
Okay. So why would an owner not know they even have one? How does that even happen?

Kevin Rhoton:
Because a lot of times, transactions, whether it's distributions or money taken out or money put into, most of the time the red flag comes in with money that's taken out of the practice by the shareholder and by, we'll say numerous reasons, shoddy accounting, or it could just be that the practice owner does not have a CPA, someone like us that's working with them throughout the year. They just have their tax preparer and they give them all the information, all the money that they pulled from the practice throughout the year, "Here, fix my tax returns." And then they'll be like, "Okay, you did this wrong but we can hide it here."

Jarrod Bridgeman:
What is the perceived benefit that people think they're going to get out of putting any distributions into a shareholder loan? Why do they think that's the better option?

Kevin Rhoton:
To bypass capital gains tax on excess distributions. So another key phrase here is tax basis. Shareholders have tax basis that has to be tracked in their ownership of the practice. And if they pull money out, if they take distributions in excess of tax basis, that creates a taxable transaction, taxable event. To bypass that, they'll say, oh, it's not a distribution, it's just a shareholder loan that all "payback" or we'll pay back at a later time and then it will just sit on the balance sheet to bypass.

Jarrod Bridgeman:
Is there a time when, let's say we're looking at an owner in their 60s or 70s and they're ready to retire and close down their practice and they're not declined the bars. But they have a large shareholder loan, haven't really paid attention to it. What happens if they close down their practice with install all that money?

Kevin Rhoton:
So yeah, that's actually a really good question and a good point because if that's sitting on the balance sheet when it's time to sell the business, that net against the value of the practice will lower how much money you get from selling their-

Jarrod Bridgeman:
So it's one of those things where if you're taking a shareholder loan or your accountant put it under there, you're saying, this is future Kevin's problem. It's not my problem now it's the future problem. But then you're also throwing up red flags potentially for the IRS.

Kevin Rhoton:
That's right. For there is a line on the tax return that for an 1120S, if you're an S corp, that on the Schedule L line seven that the IRS requires you to-

Jarrod Bridgeman:
Okay, so this is talking about, okay. So if you don't have have one or not, a shareholder loan, that is, this would be one of the places you could find this?

Kevin Rhoton:
Yeah.

Jarrod Bridgeman:
If you're in S corp and you're looking at section seven of your tax, your tax return?

Kevin Rhoton:
It's on the Schedule L, it's on fourth page of the tax return. I'm getting probably too deep into the, but it's reported, the IRS wants you to report loans to shareholders because they want to see that. And a lot of times, so you can look there also on the balance sheet, if your balance sheet should show in the assets section loan to shareholder, we've actually also seen where accountants will actually hide a shareholder loan on a different line, other current asset so to speak, and just a loan receivable.

Jarrod Bridgeman:
So that's even more negative at that point. That's even worse of a thing to do, to try and hide the shareholder loan?

Kevin Rhoton:
Yeah, I feel like that's hiding the shareholder loan because the IRS, if they see a shareholder loan, like I said, they want to see that that's being paid off and they want to make sure that it's set up like a loan, that it's just not an amount being, again, hidden on the tax return. And if it's just sitting somewhere else, that can definitely be a big red flag. IRS can come in and deem those not a shareholder loan, deem it a distribution. And if it's a significant amount, you could pay 10%, 20% of that amount in taxes plus penalties and interest going back to whenever that originated.

Jarrod Bridgeman:
So let's say someone's out there listening right now, they're taking a look at their return right now and saying, "Oh shoot, I do have one." They may not have looked at it because they pay their standard CPA. If it's on there, what do we suggest should happen with that? What are there steps that they may not know to do to pay it back or?

Kevin Rhoton:
So what we do when new clients come in, sign up, we start working with them, there's multiple ways that we can look at tackling that and fixing that. One way, if it is a true shareholder loan that we want to set up, then yeah, we need to set up a promissory note. We need to make sure it looks like a note you'd get from a bank or from someone else.

Jarrod Bridgeman:
Promissory note, is that similar to the promise rings that the Jonas brothers used to wear, anything like that?

Kevin Rhoton:
No, not at all. It is more business term like you would get from a bank or lending-

Jarrod Bridgeman:
I've seen those, yes.

Kevin Rhoton:
... institutions. But yeah, in monthly payments, start paying that back. Now if it's something where, okay, in the past you did move distributions, show it as a shareholder loan, we'll start knocking that down as we help with increasing that basis.

Jarrod Bridgeman:
Does it need to be retroactively, have an interest added to it? Let's say it should have had a X percentage amount.

Kevin Rhoton:
We don't necessarily go that far. Yeah, we deal with it going forward. It's too much of a red flag to go back, but we'll definitely start knocking it out going forward. And when the IRS sees that, okay, they're chipping away at this issue or they're working on it, then that's definitely a plus.

Jarrod Bridgeman:
Okay. I'm on my tax return. Holy shit, there's a shareholder loan. I had no idea about this. How do I confront my accountant?

Kevin Rhoton:
First I'd say, what is this? If you have no idea, what is this? What we do is, okay, I want to see multiple years tax returns, multiple years financials, even get into the GL, the actual transactions. What transactions make this up and really want to dig into what that was. Sometimes we've seen where practice owners will take a pretty big lump sum out to purchase a building. Maybe they now bought the practice and then a few years later they're purchasing the building itself. Then they'll take a pretty big distribution, pretty big amount from the practice checking and set it up as an intercompany. That's sort of can be, is a little bit different, but can be the same as a shareholder loan. If you're taking money out personally to put a down payment on a building, that can be treated the same way.

Jarrod Bridgeman:
So this would be one of the times you would say it seems worthy to do a shareholder loan?

Kevin Rhoton:
We actually usually say no, we want to get away from shareholder loans. It's just with the tax advantages to an S corp, that is actually something that can put in jeopardy your S corp status if that's not handled perfectly. And especially-

Jarrod Bridgeman:
That's a whole nother trip to work with.

Kevin Rhoton:
S Corps are known for being a pass through entity, so there's no double taxation. If you put that into jeopardy, that can be huge tax consequences.

Jarrod Bridgeman:
Huge consequences from that one.

Kevin Rhoton:
And then if you have multiple doctors that own multiple shareholder loans, that can get into unequalness distributions, things like this.

Jarrod Bridgeman:
Let me ask you this. I just read recently that the author of Rich Dad, Poor Dad is $1.2 billion in debt right now. How do I do that? That sounds like just a bunch of free money. How do I get away with that?

Kevin Rhoton:
Maybe you can just file for bankruptcy or something and go hide somewhere.

Jarrod Bridgeman:
Kevin, I wanted to thank you so much for being on here. Is there any other last notes that you have for our listeners out there when it comes to with the shareholder loans?

Kevin Rhoton:
Just the usual, go look at your tax returns. Go look at your financial statements that hopefully you're getting from your accountant, tax preparer and look for those, circle those. If you don't know that you have them and you see them, ask them about it. Better yet, come and ask us about them.

Jarrod Bridgeman:
That's right. You can give us a call. You can go on our website and fill out a form, we'll reach out to you. So fourquadrantsadvisory.com is a good place to go. We're going to be in a few areas coming up pretty soon. We're going to be in San Antonio, that's in Texas, Kevin.

Kevin Rhoton:
I like Texas.

Jarrod Bridgeman:
We're going to be doing some events there as well as leading up to Tampa and then Nashville. If you'd like to come and see us in person and maybe hear more about ways we help with our accounting, with our investing with our financial team, go to fourquadrantsadvisory.com/events and register. You don't know what you're missing out on. Food, bourbon, golf, all kinds of stuff. It's pretty sweet.

Kevin Rhoton:
Brisket down in Texas.

Jarrod Bridgeman:
Brisket down in Texas. Thanks, Kevin.

Kevin Rhoton:
Thank you.

Announcer:
That's all the time we have today. Thank you to our guests for their insight and for sharing some really great information. And thank you to you, the listener for tuning in. The Millionaire Dentist Podcast is brought to you by four Quadrants Advisory. To see if they might be a good fit for you and your practice, go on over to fourquadrantsadvisory.com and see why year after year they retain over 95% of their clients. Thank you again for joining us and we'll see you next time.