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Financial Planning

Considering an Employee Stock Ownership Plan (ESOP) as a Form of Succession? Beware of Potential IRS Scrutiny

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By Chris J. Roe, CPA, PFS

Employee Stock Ownership Plans (ESOPs) offer an excellent succession strategy for businesses. These plans not only enable employees to share in the company’s growth and financial rewards, but they also furnish immediate tax advantages for the departing owner and continued tax benefits for the business itself.

What is an Employee Stock Ownership Plan (ESOP)? 

An ESOP operates as a qualified retirement plan, subject to Employee Retirement Income Security Act (ERISA) regulations. It functions similarly to a 401(k) plan and eventually becomes the company’s owner following a sale.

The transaction’s structure is straightforward: the current owner sells their shares to the ESOP in exchange for cash and a promissory note that is paid over time. To finance the initial cash payment, both the company and the ESOP secure loans from a bank. Over time, as the business generates profit, these are used to repay the original shareholders and the bank.

Common Misconceptions about ESOPs

Despite its seeming simplicity, several misconceptions about ESOPs persist. Here are a few of them: 

You will receive a lower sale price compared to selling to a third-party buyer. While this may be the case when dealing with strategic buyers or private equity firms, those with businesses difficult to sell may find ESOPs a more favorable option. Additionally, given the tax benefits of ESOPs, your after-tax proceeds may be significantly more.

You’ll lose control of the business, which will be managed by many shareholders having a say in operations. In reality, your employees, who are indirect owners via the ESOP, do not have voting rights concerning the business’s day-to-day activities. Governance falls to the ESOP Trustee and the appointed board of directors, a board the outgoing owner can lead if they wish. This arrangement ensures the former owner maintains control over operations until they decide it’s time to retire.

You’ll miss out on future growth of the business if you sell to an ESOP. While it’s true selling your stake means you won’t reap all the rewards of the business’s expansion, you can mitigate this by negotiating for warrants as part of your deal. These warrants can give you a stake in the business’s future growth, essentially providing a “second bite at the apple,” typically within a 7 to 10-year timeframe.

You won’t benefit from the tax deferral options you heard are available to C Corporation shareholders if you’re an S Corporation. In certain instances, if C corporation shareholders sell their stock to an ESOP and reinvest 100% of the sale price in qualified securities (basically US stocks and bonds), the capital gain realized will be deferred until a security bought with the proceeds is sold. This benefit does not currently exist when selling S corporation stock. Nonetheless, with adequate planning, you may convert from an S Corporation to a C Corporation before the sale to take advantage of tax deferrals. Additionally, there may be strategies that allow you to switch back to S corporation status, enabling you to defer taxes on income related to the ESOP shares until employees start receiving distributions. Be aware, the IRS has a keen eye for scrutinizing any transaction where corporate reorganizations are done solely for tax benefits. 

ESOP ownership and covering the debt to former owners and banks will hamper growth. Contrary to this belief, if the ESOP owns a substantial portion of the S Corporation, the company could experience roughly a 30% boost in annual after-tax cash flow, given that ESOPs are not tax-liable entities. While at first the ESOP needs to use its cash to pay down debt, after approximately five years, the ESOP can use the funds—otherwise owed to federal and state governments—to invest in its business operations or strategic acquisitions. In other words, it can grow even faster.

Four Benefits of ESOPs

So, why should a company consider adopting an ESOP? Here are four compelling reasons: 

  1. Tax-Advantaged Exit Strategy with Continued Control: The ESOP offers a unique way for current owners to sell their shares tax-efficiently while allowing them to remain in control of the business, should they desire to do so.
  2. Employee Participation in Economic Rewards: By enabling current and future employees to have an ownership stake in the company, the ESOP allows them to participate in the business’s financial success.
  3. Unparalleled Employee Incentive: The ESOP is one of the most effective ways to incentivize and reward employees. They create a sense of ownership and commitment, increasing productivity and job satisfaction.
  4. Investment Diversification: While the primary purpose of an ESOP is to invest in the company’s stock, it also offers the flexibility to diversify its investment portfolio over time, providing an added layer of financial security for the employees.

IRS Scrutiny of ESOP Tax Strategies

Given the substantial tax advantages of ESOPs, it’s not surprising that many advisors advocate for these benefits, sometimes pushing the boundaries of tax law. When tax strategies are marketed and ultimately abused, the IRS takes notice. 

In a pointed move, the IRS has zeroed in on ESOP transactions. In News Release IR 2023-144 released on August 8, 2023, the IRS begins by saying:

As part of an expanded focus on ensuring high-income taxpayers pay what they owe, the Internal Revenue Service today warned businesses and tax professionals to be alert to a range of compliance issues that can be associated with Employee Stock Ownership Plans (ESOPs).

“The IRS is focusing on this transaction as part of the effort to ensure our tax laws are applied fairly and high-income filers pay the taxes they owe,” IRS Commissioner Danny Werfel said. “This means spotting aggressive tax claims as they emerge and warning taxpayers. Businesses and individual taxpayers should seek advice from an independent and trusted tax professional instead of promoters focused on marketing questionable transactions that could lead to bigger trouble.”

Werfel noted the IRS is working to ensure high-income filers pay the taxes they owe. Prior to the Inflation Reduction Act, more than a decade of budget cuts prevented the IRS from keeping pace with the increasingly complicated set of tools that the wealthiest taxpayers may use to hide their income and evade paying their share.

“The IRS is now taking swift and aggressive action to close this gap,” Werfel said. “Part of that includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes involving complex or questionable transactions, including those involving ESOPs.” [ “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023]

The news release highlighted various concerns, such as valuation of the stock, allocation of shares to a disqualified person, and prohibited loans within the ESOP structure. 

In particular, the IRS drew attention to certain arrangements involving S Corporations that raised concerns. The agency viewed these strategies as potentially abusive, as they directed taxable business profits into the ESOP to avoid taxes while simultaneously lending those funds to shareholders tax-free to meet their cash flow needs. 

…[T]he IRS has seen promoted arrangements using ESOPs that are potentially abusive. For instance, the IRS has seen schemes where a business creates a “management” S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income. The IRS disagrees with how taxpayers interpret this transaction and emphasizes these purported loans should be taxable income to the business owners. These transactions also impact whether the ESOP satisfies several tax law requirements which could result in the management company losing its S corporation status. [ “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023]

As the News Release stated, the IRS is looking to educate taxpayers regarding the risks associated with ESOP strategies while also carrying out appropriate investigations. 

At Rx Wealth, we always caution clients about deals that sound too good to be true usually are. ESOPs, in our opinion, can offer significant advantages to business owners if implemented properly. Those considering an ESOP should seek qualified professionals for advice rather than strategy promoters.

If you’re exploring options for business succession and are interested in learning more about ESOPs, schedule your complimentary consultation here. We’ll give you the straight talk on ESOPS and explain how you can use them properly to benefit you, your family, and your employees.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

Preparing Your Business or Medical Practice for a Successful Sale

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By Chris J. Roe, CPA, PFS

Are you considering selling your business or medical practice? If so, you’ll need to take specific steps to prepare and maximize its value. Proper planning can make a huge difference in the selling process and help you keep more money in your pocket post-tax. 

  • Consider your exit strategy: Plan in advance what you want when you exit your business. Are you open to retaining an ownership stake or staying on as management? Think about how your ongoing compensation will be structured. 
  • Set realistic expectations: Many business owners just make up a value they want for their business. While this value does not just appear from thin air, it is usually the amount needed to retire and maintain their same lifestyle. This number is rarely accurate. Get a third-party opinion on your business’s worth. This information will help you decide if selling now is the right move.
  • Increase trailing 12-month earnings: Buyers often focus on this metric and will also look to your last three years to evaluate the consistency of earnings. Evaluate your operating income and expenses, and find ways to boost revenue while cutting unnecessary costs. 
  • Get your financials reviewed: Most buyers will request at least two, if not three, years of reviewed financials. This takes time and money, so plan ahead. The buyer will also usually do their own quality of earnings report, so you should consider obtaining one as well to prevent any unwelcome surprises. 
  • Address potential pitfalls: Proactively identify any issues in your business and either find a solution or be prepared to explain why they’re inherent to your operations. This foresight will help you during negotiations with potential buyers. If you hide issues from the buyer, they will discover them sooner or later, which may bring about lawsuits down the road.
  • Organize a due diligence data room: Collect and store your business data as if you were the buyer. This exercise provides insights into your business and demonstrates professionalism and organization, instilling confidence in potential buyers. You may also learn a few things about your business that you did not know. 
  • Assemble an advisory team: Don’t try to negotiate the business sale alone. Build a team of experts, including an investment banker, attorney, CPA, and financial advisor, to help you navigate the complex selling process. Rx Wealth works with business owners to help them build a competent team to manage their specific situation.  
  • Stay focused on daily tasks: Sellers commonly get wrapped up emotionally in the sales process. Instead, keep your attention on running your business. Delegate negotiation responsibilities to your team while you ensure that your earnings and financial projections remain on track.  
  • Maintain perspective and stay grounded: The selling process can be an emotional rollercoaster with highs and lows. Trust your team to help you through it, and avoid getting greedy or making excessive demands, as this can drive buyers away. Sellers have been known to continually request additional perks as part of the deal, such as ongoing health insurance coverage, payment of their cell phone and automobile expenses, and other similar benefits. Keep your eye on the prize, and don’t sweat the small stuff. 
  • Be aware of required third-party approvals: Familiarize yourself with any necessary approvals from vendors, property owners, minority shareholders, or governmental entities, as these factors can potentially delay the deal. 
  • Implement strategic estate and income tax planning: Ideally, tax planning should begin two to three years before a deal. Work with your team, well in advance, to position your business for sale from a tax perspective and maximize your after-tax profits. 

Selling your business or medical practice is a significant milestone allowing you to realize the wealth you’ve built over time. By staying focused and relying on your team of advisors, you’ll be well-positioned for a successful sale.

If you’re unsure how to build a team of advisors, maintain your lifestyle post-sale, or navigate the many decisions involved in selling your business, we’re here to help. With our extensive experience, we can support you by leading your team and guiding you through the process. Don’t hesitate to reach out and schedule a free initial consultation if you’re interested.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

11 Recommendations to Position Your Business or Practice for a Successful Sale

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By Chris J. Roe, CPA, PFS

Many private businesses and physician-owned practices face challenges when the owner decides it is time to make a transition. Whether an external sale or an internal succession, the process can be difficult and time-consuming. Many businesses fail to have a succession plan in place, whether it’s because they weren’t sure how to start creating one or just didn’t have a defined internal successor. This leads the business owner to seek an external sale. 

As a third-party sale is sought, the business owner, more often than not, realizes his mental business value is far different than the actual value third-party buyers are willing to pay. Given the goal is to maximize the value received, how do owners best position their business for sale? Here are several recommendations to consider:

Get Your Accounting Records in Order

Make sure your bookkeeping and financial statements are up-to-date and professional. If you are planning to head to market with the business, you will want to get at least the last two year’s financial statements reviewed by an external CPA Firm. This will give some assurance to the buyer that your books are in order.

Have Your Business or Practice Appraised

Hire a third-party appraiser to perform an outside business valuation. This will give you a good benchmark of what a third-party buyer may offer you.

Increase Your EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

Many buyers will value your business based on a trailing 12 months of earnings. You want your profit margins to be at or slightly above the industry average, so as you move forward, it is appropriate to review your earnings, profit margins, and expenses to ensure you are pricing your product or services appropriately, given the market, and have eliminated any unnecessary expenses. 

Ensure Consist Earnings and Cash Flow 

Buyers like to see strong cash flow and consistency of earnings. Wide fluctuations in cash flow and earnings tend to scare buyers and lower business values. 

Develop Your Add-Backs List

As business owners, we tend to live our lives through our business. When you are negotiating a sale, there will be expenses you are incurring, such as company-provided automobile, discretionary travel, meals and entertainment, and professional fees, that will not be considered as part of the sale and will increase the sale price when added back. The new owners will not incur these expenses. You should evaluate your expenses and develop a list of these add-backs.

Be Prepared to Either Be a Minority Owner or Carry a Promissory Note

Depending on the buyer, you may be required to roll over some of your sale price into the equity of the new company. Also, depending on your business size and buyer, you may be required to carry a promissory note to help the buyer purchase your business. Either way, you need to understand you are no longer in control of the business you sell.

Helping with the Transition

Be prepared to continue to work in the business to help transition it or to help grow it. This will serve to ensure your carried ownership in the new business will be maximized upon a future transaction. Also, develop your ongoing salary expectations for your continued work in the business. Keep in mind that if your salary expectations are much greater than you are currently making, it will reduce the purchase price of your business. 

Evaluating Your Staff & Staffing 

Evaluate the strength of your staff and whether or not you are understaffed. Keep in mind that if a buyer has to add staff to operate the business, they will lower your purchase price. Make sure your staff is adequate to run the business in its current state.

Do Pre-Transaction Tax Planning 

The value of your business is not what you get for it but what you keep after taxes. Take the time to sit down with the proper professionals to do tax planning that will increase the amount you get to keep from the sale. Bear in mind these things take time, and the more in advance you decide you want to sell, the better the planning opportunities will be.

Assemble Your Team 

You will need a team of people to help you sell your business and to manage the family’s wealth post-sale. We normally serve as a team lead and help business owners assemble and coordinate amongst all team members. It will be difficult for you to be the coordinator, given the stress and emotions you will be going through when the sale process begins. You will need a team of attorneys, your CPA, an investment banker, and other professionals. 

Mental State 

Begin to prepare yourself mentally for the emotional roller coaster you will go through when selling your business. Additionally, prepare yourself for the post-closing regret that so many business owners experience.

While succession in a private business, family-owned enterprise, or physician-owned practice can be problematic and time-consuming, a sale can be a wonderful thing. If you take the time to prepare for the exit, your sale will turn out to be a wonderful event in your life.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

Growing Your Wealth: 11 Survival Tips for New Physicians

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By Chris J. Roe, CPA, PFS

Over the years, Rx Wealth has advised many professionals and business owners who have built a life of wealth, and a major contributor was their ability to earn and invest their money over a long time period. 

As a newly practicing physician, you will earn significant money affording you a comfortable lifestyle. But remember, you’re starting later in the game than other professions. Thus, it is imperative that you focus more intently on building wealth. Before you know it, you will be approaching retirement. 

Here are 11 recommendations to help you stay the course.

Tip #1: Take Care of Your Health

Your health is your key to a successful, rewarding career and life. Take care of yourself first.

Tip #2: Save Money for Retirement Stat

You will need to live below your income level, invest for the long term, and control underlying investment costs while setting realistic expectations and following through on execution. Retirement sneaks up on you quicker than you think.  In our experience, it is the follow-through on execution that busy professionals fail to do.

Tip #3: Access Coverage for Risks

This means having enough term life insurance to provide for your family in the event of your premature death. Also, ensure you have adequate amounts of disability, malpractice, and property and casualty insurance to protect you and your family from natural disasters, accidents, and litigation.

Tip #4: Protect Yourself From Creditors 

Own your assets in a way that will protect them from future creditors. Also, if you own your own practice, make sure you are protecting the assets of the practice, such as equipment and receivables, from potential creditors.

Tip #5: Update Your Estate Plan

Maintain up-to-date wills, powers of attorney, and other important estate documents so that your affairs are handled appropriately if you become incapacitated or pass away.

Tip #6: Factor in Future Inheritances

If you are expecting a future inheritance, you should be having conversations with your parents about the proper way for them to leave you an inheritance so that it is outside the reach of divorcing spouses or creditors.

Tip #7: Consider a Pre-nuptial Agreement

One of the most traumatic and wealth-destroying events in a physician’s life is divorce. Over the years, I have seen many aging physicians continue to work solely to try and recover from a devastating divorce. To avoid the pain, simply get a pre-nuptial agreement before getting married.

Tip #8: Establish a Professional Team

You do not know everything; thus, you should hire a good financial advisor who works and coordinates your financial needs with a qualified CPA, lawyer, and property and casualty insurance broker. Remember, not all professionals act in your best interests, so be careful and diligent with your selection.

Tip #9: Take Colleague Advice With a Grain of Salt

Colleagues are a good source of guidance but beware not to follow the advice of your colleagues blindly. Use them as a source of information, but do your own investigation as your situation is unlike any other.

Tip #10: Monitor Your Finances

While undoubtedly you will be very busy with your career and life’s other demands, you need to take some time to meet regularly with your professional team and focus on your family’s finances.

Tip #11: Build a Support System

Achieving success and happiness is very dependent on the support system you build around you. Make sure you get along with your spouse, children, friends, and work colleagues. These people are the most important in your life and provide you with the needed structure and support to achieve success. 

These recommendations will be a solid basis to allow you to enjoy your life and career while you build wealth. Whether you are beginning your journey as a physician or are already on it, Rx Wealth is here to help you reach your destination.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pockets, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The situations or opinions mentioned in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing.

9 Myths Doctors Buy Into When Becoming Independent Contract Physicians

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By Chris J. Roe, CPA, PFS

We’ve had numerous inquiries from physicians about their desire not to be employed but to contract as independent physicians.

Forty to fifty years ago, physicians ran their own practices, doing the hiring, billing, and marketing all themselves. As time moved on and dramatic changes occurred in the healthcare industry, an increased number of physicians became employees instead of independent business owners. Health care systems, insurance companies, and the like either bought up practices or forced physicians to join them out of fear these systems would adversely affect their livelihoods. But now, the landscape is changing again. 

The wave of the future may be what we’ve dubbed the “hybrid physician model.” The hybrid physician model allows doctors to move from being employees to owning their own practice again. They won’t have to experience the hassles of hiring people, billing for services, marketing, and other administrative duties that come along with owning a business—all while earning a much higher annual income and receiving the enhanced income tax benefits of being a business owner.

In exploring the hybrid model, we’ve listed nine common myths physicians have and addressed each of them below.

Myth #1: Medical Malpractice Is Expensive

Physicians believe obtaining medical malpractice on their own will be cost-prohibitive, but this is not the case. Recently, we collaborated with a physician contracting directly with a medical facility. She realized she will receive an additional $80,000 per year in compensation, but was going to turn down the ability to go independent. Her initial mindset was medical malpractice insurance will be unreasonably priced and the cost will either exceed additional compensation or make the little benefit not worth the effort. However, after our conversation, she realized she can obtain medical malpractice insurance for $11,000 per year and we can assist in getting all other benefits in place. Our conversation changed her mindset regarding independence. We’ve built-in resources and relationships to help physicians nationally obtain medical malpractice for themselves or their group.

Myth #2: Health Insurance Is Hard to Obtain

While we find independent physicians struggling through the maze of health insurance, we recently uncovered a national resource that can place independent health insurance for physicians quickly. The cost ranges from $1,000 to $2,000 plus per month, and the premiums are tax-deductible if you’re self-employed. So, while the cost is high, your additional compensation and other benefits as an independent physician should far outweigh this cost.

Myth #3: Forming an LLC or Corporation Will Protect My Assets

While you may get limited asset protection by operating in a business entity, you’re on the hook if it’s you providing the medical services. However, if you employ other physicians or healthcare professionals to provide services, then you have a layer of protection from their malpractice. However, you must follow the business formalities each year, such as updating corporate records, holding meetings, and documenting business decisions.

Myth #4: An S-Corp Will Save Me a Bunch of Taxes

Generally, being an S-Corp versus a sole proprietor may save social security tax depending on your salary and will save you Medicare tax. Any profit distribution taken over your wage is not subject to payroll taxes. However, the IRS is keenly aware of this, so you cannot set your salary too low. Additionally, setting your salary low will affect the amount your business can contribute to your retirement plan. Finally, depending on income level, your Section 199A business deduction may be greater as a sole proprietor versus an S Corporation. We recommend a detailed tax analysis before selecting which tax structure is best for you. 

Myth #5: S Corporations Are Simple to Run

When running an S-Corp, you’ll need to set up payroll to pay your wages. This requires an accountant or payroll service to process checks and applicable withholding along with filing the necessary payroll tax returns to the Federal and state governments. Additionally, you may be required to obtain workers’ compensation and unemployment insurance.

Myth #6: I Can Wait Till End of Year to Do My Accounting and Taxes

An S-Corp requires a separate Federal and state income tax return. These returns require more information about the business than a typical Schedule C (Form 1040) on your personal return. Since you’re self-employed, you’ll file quarterly income tax estimates for Federal and state income taxes. This needs to be calculated quarterly by an accountant. Having good electronic accounting records can make this less costly. We recommend you hire an accountant to do the monthly accounting so that quarterly and annual tax filings are seamless.

Myth #7: Using My Checking and Credit Cards for Business Makes Things Simple

While not having an additional checking account and credit card for the business seems like simplification, it makes the business accounting more complex and may cause legal issues with your business structure. Moreover, in our experience, it makes accounting and taxes very costly.

First, it takes your accounting professional more time to sort through the business transactions, but more importantly, we often see missed business deductions on the tax returns. Thus, you’re paying more taxes than required. We recommend you set up a bank account and credit card in the business’s name and use it exclusively for business income and expenses. As a result, your monthly accounting will be accurate, allowing you to pay the minimum amount of taxes you owe and to understand your business performance.

Myth #8: Forming an Entity and Doing the Taxes and Accounting Myself Will Save Me Money

If you’ve this thought, you’re not 100% wrong. We can all do things ourselves, but there’s always a cost or trade-off. So, while you may save money, is it worth your time and effort to do this yourself? What happens if you make a mistake? You normally find out at the wrong time, costing you thousands. As a professional, we recommend you stick to doing what you do best and leave the rest to experts.

While it may cost more money upfront, your peace of mind and time savings is worth it. One of our key tenants at Rx Wealth for managing a physician’s financial structure is to transfer all risk from the physicians to other parties when the cost of doing so is small. Your cost for having professionals set up the business, do accounting and tax work each year, and oversee the operations are small in comparison to the lifetime value of your earnings. Do not be penny-wise, pound foolish. 

Myth #9: I Can Negotiate My Own Reimbursement Contract

While you may be the best person to understand the economics of your contract, we recommend you hire an attorney who has done this before. There will be plenty of legal stuff, such as termination language, restrictive covenants, and patient ownership to cover, and who knows, the attorney may even negotiate a higher compensation rate than you. While it’ll cost some money upfront, it’s money well spent to make sure you are legally protected.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The situations or opinions mentioned in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing.

A Physician’s Dilemma: Do I Need a Prenuptial?

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By Chris J. Roe, CPA, PFS

Ah!! The dreaded prenuptial agreement. Nothing ruins the excitement of wedding planning faster than bringing up this topic. The word, when broached before marriage, reeks of distrust, betrayal, and lack of confidence the marriage will succeed. 

In helping doctors with prenuptials, I always advise that they not think of it as a belief the marriage will end, although statistics show marriages have a 50/50 shot these days. Instead, think of it as a document that spells out the personal financial choices you and your fiancée plan to make. Most marriages break down over lack of communication, often about finances. Well, a prenuptial starts the marriage off on the right foot with full disclosure and discussion around finances. 

If you cannot negotiate this while you are in love and on cloud nine about the pending marriage, what do you think a divorce settlement negotiation will be like? Think about it: when you are going through the emotional turmoil of a divorce, you are likely to feel betrayed, hurt, like a failure, or [insert unpleasant emotion here]. Fighting about how assets will be split or how much alimony you are on the hook for through a lengthy court battle with five to six-figure legal fees is not exactly an ideal way to settle things. Do you think going to court and you paying enormous legal fees will help your emotional toll? A prenuptial speeds up the divorce process, saving time, money, and emotional stress, not to mention your wealth.

While we strongly recommend getting a prenuptial agreement in most situations, before running and telling the fiancée you need a prenup, understand what it is and what it is not.

A prenuptial agreement is a legal agreement negotiated between the couple before marriage that determines a couple’s finances in the event of divorce or death. Generally, the agreement should address how the couple will split their money and other assets upon a divorce, what is considered separate property and not subject to marital distribution, how assets acquired during the marriage, including a home, should be split, and even debt. An important point to note is each person needs to be represented separately by an attorney to protect their best interest.

In understanding a prenuptial agreement, the following should be considered:

Marriage, like other agreements, is a contract entered into freely by two parties. The terms of the contract, while not formally written by the parties, are provided by the laws of the state in which a couple resides. Through a prenuptial agreement, couples have the opportunity to negotiate the marital contract versus relying on the one-size-fits-all laws of their state.

While you do not need to be wealthy to have a prenuptial, if you own assets, are going to inherit assets, or want to protect future assets (like your growing practice), you should consider a prenuptial.

When negotiating a prenuptial agreement, there is broad leeway for the couple. However, the agreement needs to be fair and equitable in the event of a divorce. It is still subject to a judge’s review and acceptance as part of a divorce proceeding. Moreover, a prenuptial requires transparency by both parties. Each will need to fully disclose all the assets, debts, and trusts for which they may be current or contingent beneficiaries and any potential inheritance.

As a highly compensated physician, you more than likely will be required to pay alimony to your ex-spouse. A prenuptial agreement can have your spouse waive alimony (in certain states) or set the amount and terms of any future alimony. For example, the alimony may be based on an amount to achieve a certain level of monthly income and no more, or a particular dollar amount each month adjusted over time for inflation. I have also seen a single payment based on a specific amount for each year of marriage.

Moreover, a prenuptial addresses premarital and marital debt. Should one spouse have significant debt, as most doctors do, the other spouse may not want to take it on in the event of divorce.

Furthermore, if you or your spouse have been previously married or have children, you want to make sure previous financial affairs and obligations are not mixed with your new marriage’s finances. Additionally, you can specifically address which of your assets goes to your children. However, a prenuptial agreement is not a replacement for a will.

Prenuptials do not and cannot address any future child support issues or custody. This will need to be worked out at the time of the divorce.

Finally, if you are a physician that will or does own your own practice, a prenuptial agreement may someday save you from having to give some value of your practice to an ex-spouse through a buyout.

Consider this: you are a mid-career specialty physician making, say, $650,000 per year. Early in your marriage and career, you and your spouse both worked, lived frugally, and saved diligently. You held off having children till your early 40s. The kids are now in high school and going to private school.

You and your spouse have amassed an eight-figure net worth. Your spouse currently does not work outside of the home and is taking care of the children. You decide to file for divorce.

After two years of legal battles and a lot of legal fees, you lose a large portion of your net worth to your spouse and are required to pay a substantial amount of your annual earnings in alimony to keep your spouse in the lifestyle accustomed. Additionally, you are going to pay for your children’s private school tuition.

While you still have a sizable net worth and are certainly not broke, you have just experienced a large and significant financial blow late in your medical career. More than likely, you will never recover from this sizable hit. 

As you consider a prenuptial, just know getting one is not very difficult nor is it terribly expensive, especially compared to the time and cost of a contentious divorce. It is recommended the agreement be negotiated and signed well in advance of the wedding date. Do not wait till the last minute to get this done.

Getting a prenuptial may seem unnecessary at the time of your marriage and a lot more effort than you want to put in at the time, so many people just forgo it and hope things work out. Well, as I always tell my physician clients, hope is not a strategy.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.