When you need one
- Funding a new PC’s expenses before its first payer payments, since dental credentialing and enrollment commonly leave a new PC without network revenue for months
- Covering a management fee shortfall during a ramp
- Funding a specific capital need in the PC
- Bridging a temporary cash gap from a large recoupment, a Medicaid dental benefit administrator’s payment delay, or an acquisition transition
Required elements
A note that will hold up as debt has all of these. Missing any of them invites recharacterization.The interest rate floor
Charge no less than the IRS Applicable Federal Rate (AFR) for the note’s term class:
The IRS publishes AFRs monthly.1
Below-AFR related-party loans trigger imputed interest under IRC § 7872, meaning the parties are treated as though market-rate interest were paid regardless of what actually happened, with the associated income and deduction consequences. They also invite arm’s-length recharacterization under IRC § 482, which authorizes the IRS to reallocate income among commonly controlled entities.2
Confirm the applicable rate and treatment with a CPA. Rates change monthly, and which AFR applies depends on the note’s terms and compounding.
Annotated example interest clause
Illustrative language, with annotations explaining each choice:Interest. The outstanding principal balance shall bear interest at a rate per annum equal to the greater of (a) [X]% and (b) the mid-term Applicable Federal Rate published by the Internal Revenue Service for the month in which this Note is executed, compounded annually. Interest shall accrue from the date of each advance and be payable [quarterly / at maturity].
Why each element
“the greater of (a) [X]% and (b) the … Applicable Federal Rate” The AFR floor. A fixed rate can fall below the AFR if rates rise between drafting and execution. The “greater of” construction prevents that result and permits a commercially reasonable rate above the floor. A real lender would usually charge an unrated borrower with no revenue more than the AFR. “mid-term” Must match the note’s actual term class. A three-year note uses short-term; a five-year note uses mid-term. Using the wrong class is a drafting error that undermines the whole clause. “for the month in which this Note is executed” Fixes the reference month. Without it, the rate is ambiguous. For a revolving facility, this construction is not sufficient. If the note permits multiple advances over time, either set the rate per advance by reference to the AFR for that advance’s month, or specify a single rate determined at execution that applies to all advances. Say which; ambiguity here is a real problem when the loan is examined. “compounded annually” The compounding basis affects which AFR applies. The IRS publishes annual, semiannual, quarterly, and monthly compounding rates. Match the note’s stated compounding to the published rate you use. “Interest shall accrue from the date of each advance” Interest runs from when money actually moves, not from execution. Important for a revolving facility. “payable [quarterly / at maturity]” Quarterly payments create a visible repayment history. Payment at maturity is simpler, but it may leave years with no payment activity and less contemporaneous evidence that the parties treated the advance as debt. Choose a schedule the PC can follow and document the reason for it.Two further drafting decisions
Subordination. Is the loan subordinated to the management fee, or pari passu? If the PC has limited cash, which gets paid first?- Subordinating the loan to the fee means the DSO gets its fee before it gets loan repayment, commercially odd from a lender’s view, but it keeps the fee flowing, which matters for the fee’s characterization as a real, cash-paid price.
- Pari passu is more conventional but can starve the fee.
Repayment hygiene
1
Make the payments
Actual transfers, matching the schedule. A note whose schedule is never followed is evidence the loan was never a loan.
2
Book both sides
Loan payable on the PC’s books, loan receivable on the DSO’s. Interest expense and interest income recognized as it accrues.
3
Reconcile monthly
The two balances must be equal and opposite. Divergence compounds.
4
Report interest
Interest income is income to the DSO. Confirm information-reporting obligations with your CPA.
5
Document any modification
Use a written amendment and the required board consents. If the payment schedule changes, document the new terms instead of allowing an unexplained course of nonpayment.
Danger patterns
Undocumented intercompany loans can delay diligence or affect price. A buyer’s quality-of-earnings review will usually reconcile each intercompany balance. Negative PC equity supported by unexplained transfers may indicate that the practice cannot fund its obligations under the documented arrangement and that the accounting does not match the actual cash movements. See How investors read DSO financials.
Verify
- Written note executed before the money moved
- Principal, maturity, and repayment schedule stated
- Rate at or above the correct-term AFR, with the compounding basis matching the published rate
- Revolving-advance mechanics specified if applicable
- Subordination relative to the management fee stated
- Board and manager consents on both sides
- Booked on both sides with interest recognized
- Payments actually made per schedule
- Balances reconciled monthly, equal and opposite
- Any modification documented by amendment
Sources
- IRS, Applicable Federal Rates, published monthly.
- IRC § 7872 (below-market loans and imputed interest); IRC § 482 (allocation of income among related taxpayers). 26 U.S.C. § 7872 · 26 U.S.C. § 482. Confirm current application with a CPA.