Related-party financing and advances to and from affiliates are commonplace in the health care industry, especially within the skilled nursing industry as well as other for-profit, fee-for-service healthcare providers. These advances allow operators to manage cash flow and liquidity between facilities with less reliance upon third-party financing such as lines of credit or term debt.

Particularly in an environment with increasing interest rates, these advances enable operators to save on interest expense and improve net income. However, it is critical to structure your related-party activity in such a way that you maximize the benefits of these transactions and minimize the potential risks to your operations. Note that the scope of this article does not consider the tax implications or regulations around related-party activity which can also be significant.

There are three main considerations to keep in mind when making related-party loans and advances.

CONSIDERATION #1 - IMPUTED INTEREST

Imputed interest is interest accrued on a liability that does not bear interest or does not have a reasonable rate of interest, typically based upon market rates for similar borrowings as of the date of the initial borrowing. The authoritative GAAP around imputed interest is included in Accounting Standards Codification Topic 835, Interest, Subtopic 30.

Particularly in an environment with increasing interest rates, imputed interest could have a material impact on your profitability if the related-party advances meet the requirement to impute interest under this Subtopic. To avoid this, all of your related-party advances should be structured in such a way that excludes them from this guidance. The Subtopic provides eight different examples of circumstances in which imputing interest under ASC 835-30 does not apply.

The exclusions specifically relevant to the health care industry are listed in summary form as follows:

• a. Trade payables from transactions with suppliers in the normal course of business that are due within one year. This is most commonly seen with management fees payable in the skilled nursing industry.
• b. Security deposits, which are sometimes paid as part of a related-party lease agreement
• c. Transactions between parent and subsidiary entities or between subsidiary entities affiliated through common ownership. These are most commonly seen as intercompany advances, affiliate advances and amounts due to or from a holding company.
• d. Loans payable on demand with no stated maturity date.

Structuring related-party advances between parent/subsidiary or affiliated entities is the most effective way to shield these liabilities from imputing interest under GAAP. For member loans and other transactions with related parties not under common ownership, either selecting an appropriate market rate of interest or structuring the advance as a loan payable on demand will shield these transactions.

CONSIDERATION #2 - COLLECTABILITY AND CREDIT LOSSES

ASU 2016-13 Financial Instruments - Credit Losses (Topic 326) is a new accounting standard effective in 2023. It modifies certain aspects of accounting and disclosure requirements for loans and receivables and may result in significant adjustments for expected credit losses if there are large amounts of uncollectible related party advances.

ASC 326-20 provides certain scope exceptions for this standard that are helpful to keep in mind when setting up related-party loans and advances.

Loans and receivables between entities under common control are exempt from the guidance in this Subtopic as are receivables from operating leases accounted for under ASC 842. In most cases these operating lease receivables are also between entities under common control.

Note: Loans and advances between officers and members without a controlling interest in the entity are subject to the provisions of this Subtopic. Member loans and loans from other affiliates not under common control are also subject to this Subtopic's guidance.

The most effective way to address risks around this standard are to ensure collectability of related-party loans and advances and closely monitor entity performance to ensure they can generate enough free cash flow to repay these balances. Loans from members or management should be limited to individuals who meet the common control provisions as described in this standard.

CONSIDERATION #3 - COVENANT COMPLIANCE

Related-party advances may be limited or forbidden by financial covenants on third-party debt. It is important to carefully review the language and limitations around these advances to ensure there are no unexpected covenant violations stemming from improper affiliate advances.

In addition, related-party advances may harm the Company's liquidity ratios if these advances are considered short-term and presented as current liabilities. Structuring advances to be repayable on demand without a fixed repayment term will enable you to structure them as long-term liabilities which will likely have a favorable impact on your financial ratios.

Generally, interest is treated as an add-back for purposes of covenant compliance to arrive at EBITDA or EBITDARM and so the impact of imputed interest will be negligible for these reporting covenants. However, a significant interest accrual could result in violations of the liquidity ratios previously noted or a violation of a no-net-loss provision.

As a result, it is important to make sure all of your related-party advances are structured to either avoid imputation of interest altogether based on the scope exceptions previously noted, or classified as loans with a reasonable rate of interest.

MANAGING RELATED-PARTY ADVANCES AND LOANS

Related-party advances are a powerful tool to manage your operations' cash flows but require close attention to avoid the risks noted in the considerations above. These advances should be reconciled between payable and receivable on a regular basis and the total amount of such advances tracked on an entity-wide basis.

Advances should be repaid when possible based upon the recipient's free cash flow to reduce the amount of outstanding liabilities and avoid subsidizing unprofitable or failing entities. These advances and loans are usually uncollateralized and at the bottom of the list when it comes to repayment as a result of bankruptcy or liquidation. This could produce serious effects on individual entities' net income if these amounts are written off, and if an advance falls within the scope of ASC 326 as described above could result in significant writeoffs for GAAP purposes if found to be uncollectible.

These advances should always be viewed as additional borrowings/debt just like a line of credit or term note as there is cash flow being used for these advances and a related opportunity cost.