Maybe you are already a practice owner. Or maybe you are thinking of owning your own practice. Maybe you are just curious what the 2-year penalty is all about. For those of you thinking of owning your own business, congratulations! It is absolutely worth it, if you like the business side of medicine. However, there is a huge downside beyond the work that it takes to run a business. Let us call this issue the 2 year penalty for a business owner. It might be closer to 2.5 years for most business owners.
What Is The 2 Year Penalty?
The 2-year penalty is a reference to banks looking at your past 2 years of tax returns to determine your current financial situation in order to approve any possible loans. This includes a mortgage for your primary residence.
As a medical practice owner, you often have the advantage of making more money than being an employed physician.
However, there is a huge downside financially. Banks scrutinize you like a hawk when applying for any loans. They will comb through everything as a business owner when trying to get a conventional loan.
In a practice like ours, we have grown more than 100% year over year for 3 years in a row. As you can imagine, our tax return from 2019 looks different from what is going on today.
Trying to get approved for a new home can be a nightmare for new practice owners and you will be judged on income that you made 2+ years ago.
Is It More Like 2.5 Year Practice Owner Penalty?
The deadline to file your business tax returns is March 15th if you are filing as an S corp. Most of the forms that we get from insurance companies come right at the deadline in or around January 31st.
Getting all my tax forms together, reconciling the finances, getting everything to my accountant for him to review and submit to the government is almost impossible to do in 6 weeks or less. So, we do like every business does. We file an extension on our taxes.
This means that my taxes for the previous year are often not filed until summertime. For example, I will still be relying on my 2019 and 2020 tax returns until mid or late 2022 when they finally get filed.
Good Luck With A Loan
Since I am trying to buy a house right now, banks are looking at my last 2 years of submitted tax returns. Looking at data from my 2019 and 2020 tax return is like looking at another company.
Our gross revenue from that year was about 30% what it was for 2021.
The two-year penalty really can hurt companies that are growing rapidly. Companies that are growing fast will not have strong numbers on tax returns 2 to 2.5 years ago.
Some banks are much easier to deal with than others. For example, Wells Fargo has been a nightmare to deal with due to how strict they are. They approved me for a loan that was 40% the loan of what 2 other banks who did more manual underwriting. Shout out to Truist and Regions for being extremely easy to deal with. The other banks did put effort into looking at my current profit and loss statements.
Profit And Loss Can Help
While trying to get a loan in the first half of the year, banks will know that your tax returns are going to be delayed. It is the norm. No one will be surprised.
To get an idea of where your business is currently at, they will ask for a current profit and loss statement.
While it is nice to see, larger national banks will often not put much stock in the profit and loss statement. These numbers do not need to be signed off by your accountant. They can be submitted by you.
WARNING — The Sell Out Surprise
The doctor who joined me 2 years ago is now buying into partnership and will be a practice owner.
Wow. This opened up a can of worms that I never saw coming.
TLDR: Do not sell out any portion of your business soon before obtaining a loan.
Like most business owners, I took a good chunk of my income in the form of distributions. This minimizes my tax burden. For those of you not familiar with distributions, I’ll have another post in the future about this. However, think of it like a stock distribution that you may own. You get a cash payment and then simply owe personal taxes on it. No FICA. This can really screw you if you are not careful.
Example Of How This Can Go Wrong
Let us say I am selling 50% of the business to her.
Let us also say that I made 350k in income the past two years. 150k in W-2 income, and 200k in distributions.
Banks will take the previous profit from the past two tax years and average them out monthly.
So, in my example above we get $12,500 a month in W-2 income and $16,666 in distribution income.
When I go to sell my 50% of my company, if I get a loan, the bank uses my CURRENT ownership stake to calculate income.
Now my w2 income is my income. That does not change.
BUT my distribution income of $16,666 changes to 50% for forward estimates based on current precent ownership. In the bank’s eyes, my income will change to $8,333 for distributions.
My bank thinks I will make my 150k in w2 income but now will only make $100k in distribution income to calculate what kind of loan I can get. They don’t realize that the physician buying in will change their pay structure to match mine and as such, distributions will drastically change for the future.
The 2 Year Penalty Keeps Going
You are always at the mercy of the previous 2 years when you own the business.
You are also at the mercy of what your current ownership percentage is.
Be careful when making any plans going forward. If you plan to buy a house around the time of selling a portion of your company, you just might find out that your bank really will have a hard time viewing your income the way they do.
As the saying goes, you are only as good as your last hit. With banks, you are only as good as your last fully submitted 2 years of tax returns and your CURRENT ownership at the time applying for the loan.