The arm’s-length principle
Apply the same discipline the entities would use with an unrelated counterparty. Ask whether an unrelated practice would pay the fee for these services, whether an unrelated lender would make the loan on these terms, and whether an unrelated party would accept the documentation. The principle applies in three legal frames:
Document each frame so a reviewer can reconstruct the transfer and its basis.
The three characterizations
Every dollar moving between your entities is one of these. If you cannot say which, that is the problem.1. Management fee, payment for services
The primary flow. PC → DSO, monthly, for services rendered under the management services agreement (MSA). Requirements:- Calculated per the MSA’s stated method
- An actual invoice from the DSO, numbered and dated, describing the period and the services
- Paid by the PC, from the PC’s account, on the PC’s authority
- Booked as expense by the PC and revenue by the DSO, at identical amounts
- Filed in both entities’ records
2. Loan, funding with an obligation to repay
Typically DSO → PC, funding the credentialing ramp before revenue arrives. Requirements:- A written promissory note, principal, maturity, repayment schedule, interest rate, events of default
- Board or manager consents on both sides
- An interest rate no lower than the applicable federal rate (AFR) for the note’s term class. Below-AFR related-party loans trigger imputed interest under IRC § 7872 and invite arm’s-length recharacterization under § 482.1
- Actual payments matching the schedule
- Booked as loan payable/receivable, with interest expense and income recognized
3. Distribution, return of capital to an owner
PC → its dentist shareholder, or DSO → its members. Not between the two entities, because neither owns the other. A “distribution” from the PC to the DSO is a category error with consequences. The DSO is not the PC’s shareholder. Whatever that transfer is, it is a fee or a loan repayment, and characterizing it as a distribution is evidence that the parties treat the PC as though the DSO owns it, which is the corporate-practice-of-dentistry (CPOD) allegation.Why a sweep is not a fee
The most common defect: an automated transfer moving PC cash to the DSO on a schedule, with no invoice and no service documentation. What is actually wrong with it:- No invoice means no evidence of price for services. The transfer looks like profit extraction, which is the fee-splitting fact pattern.
- Automation can create control. A DSO that can pull PC funds without action by the PC has withdrawal authority over the practice’s receipts. That was one of the facts in the OCA decisions. The Fifth Circuit voided OCA’s service agreements after considering, among other controls, that the company ran collections and barred dentists from withdrawing funds directly. Once the contracts were void, Packard held that OCA could not recover its money through restitution.2
- The amount usually isn’t the contractual fee. Sweeps take what’s there, not what the MSA specifies, which means the MSA doesn’t describe what actually happens.
- It’s unauditable. A reviewer sees cash leaving the PC with no supporting document.
In percentage-fee-ban states, the invoice basis is the defense
Dentistry adds formula-specific rules. Nevada, New Jersey, New York, and North Carolina expressly restrict specified revenue-dependent dental support compensation; Maryland’s permitted-support pathway uses a separate predetermined-fixed-compensation rule. The New York and California Aspen Dental settlements add party-specific enforcement facts. See Fee-splitting rules. A sweep that takes “whatever is there” can track collections even when the MSA states another formula. A reproducible invoice and lawful approval help show what was charged for which services, but paper alone does not make the amount, formula, control rights, or actual services compliant.The monthly sequence
Order matters. The PC covers its own obligations first. A fee paid ahead of clinical payroll, leaving the PC unable to pay its dentists and hygienists, is not a fee an arm’s-length practice would agree to.When the PC can’t pay in full
Common during the ramp. Two legitimate options and one wrong one. Defer part of the fee, documented in writing, with a stated expectation of when it will be paid. Lend the PC the money, on a proper note at no less than the AFR. Do not quietly skip the transfer or let the DSO pay PC expenses without an intercompany entry. Commingling often starts as an end-of-week convenience rather than deliberate misconduct. A perpetually accruing, never-paid management fee is itself a red flag. It suggests the fee was never a real price the PC could support, which is both an FMV problem and evidence that the PC’s economics don’t work. See Where the profit lives.What diligence reconstructs from your bank data
During a fundraise, a sale, or a lender’s review, someone will pull several years of bank statements from every entity and rebuild the money flow. What they are testing:
Clean intercompany hygiene raises valuation, and it does so through a specific mechanism: quality-of-earnings adjustments. A DSO whose fee income is fully documented, invoiced, and cash-collected has EBITDA a buyer can underwrite. A DSO whose fee income includes years of accrued-but-unpaid amounts has EBITDA a buyer will discount. See How investors read DSO financials.
Practices that hold up
- Invoice monthly, without exception, even when the amount is the same every month
- Pay from the correct account, by the correct entity
- Never pay one entity’s expense from the other’s account without an intercompany entry
- Reconcile intercompany balances every month so they remain equal and opposite
- Paper every loan before the money moves, not afterward
- Review the fee annually against FMV, and document the review
- Keep the invoices. They are the evidence a reviewer will ask for
Sources
- IRC § 7872 (below-market loans and imputed interest); IRC § 482 (allocation among related taxpayers). The IRS publishes applicable federal rates monthly: Applicable Federal Rates. Confirm current rates and treatment with a CPA.
- In re OCA, Inc., 552 F.3d 413 (5th Cir. 2008): opinion; Packard v. OCA, Inc., 624 F.3d 726 (5th Cir. 2010): opinion. See DSO case law.