Should you incorporate your medical or dental practice for income tax purposes?

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Like any other business, medical and dental practices face ongoing challenges when it comes to properly structuring their practices for tax optimization. Complicating matters is the fact that each medical practice is unique. Some doctors and dentists choose to go into business alone, hiring administrative and nursing staff to support daily operations. Many others opt for a partnership, choosing to relieve some of the pressure by sharing facilities and employees.

Unfortunately, these differences can create headaches at tax time. Most practice managers realize early on that there are multiple ways to structure their medical or dental practices, both for liability and tax purposes. Here are four options for structuring your medical or dental practice, with the pros and cons of each. Remember, the same principle applies to all types of healthcare practices including psychotherapy, chiropractic, and optometry.

Sole Proprietor

Sole proprietorship are popular with medical professionals, who find that they require the least amount of paperwork on the front end. In fact, 95 percent of all U.S. businesses are individual owners of those businesses. One of the most popular ways to start  a medical practice is to set yourself up as a sole proprietor, which will require you to include a Schedule C in your individual income tax return and pay self-employment taxes on the income you earned.

Example: Dr. Smith is a plastic surgeon in Los Angeles who earn $400,000 per year. He has structured his practice as a sole proprietorship. He will pay taxes on his $400,000 per year at the individual tax rates plus self-employment tax.

It’s important to note a downside to filing as a sole proprietor. From a tax perspective, statistics show that there is a higher risk of an IRS audit if you file as a sole proprietor as opposed to a single shareholder corporation.  Also, if someone falls on your property or one of your employees behaves unprofessionally, you could be personally liable for any legal action that results. Personal assets could be seized, as well as your business’s assets. For high-income specialists like dermatologists, this could especially be an issue. Specialties that are prone to lawsuits, such as obstetrics and gynecology, should remember that it’s always important to protect assets.

LLC

A practice can also be structured as  a Limited Liability Company (LLC), which can reduce the personal liability if someone falls on your property or an unprofessional employee.

However, if there is only one owner, it is treated, by default, as a sole proprietor for tax purposes.  You can make an election to be treated as a corporation.

If there are two owners, by default, it is treated as a partnership for tax purposes.

LLC / Partnership

If you are a two owner LLC, it is treated as a partnership, unless an election is made to treat as an S corporation or C Corporation.

A partnership is a preferred structure if you need flexibility in sharing profits or adding owners.  The main advantage of a partnership is that you can allocate profits each year based upon criteria that is not connected to the actual ownership percentage.

Example: Dr. Molar and Dr. Wisdom,  oral surgeons in Michigan, have a net profit for the year of $500,000.  They both contributed $125,000 to start the practice as an LLC and own it 50/50.  However, during the year Dr. Molar was unable to work for a portion of the year; Dr. Wisdom accounted for 60% of the production.  Even though the partnership is owned 50/50, the partners can decide to allocate the $500,000 of net profit where Dr. Wisdom gets 60% or $300,000 and Dr. Molar receives $200,000.

A partnership is a “flow thorugh” entity because each member’s share of income “flows to” their Form 1040 and they pay tax on the income on their 1040.  The partnership (Form 1065) does not pay any federal income tax.

A disadvantage of the partnership structure is that a separate tax return will need to be prepared which means separate accounting and bank accounts for the entity need to be established.  Also, similar to a sole proprietorship, the individual members will also have to pay self employment tax on their Forms 1040.  Also, owners(members/partners) CANNOT be paid as an employee and receive a Form W-2.

In many states, tax time involves merely logging your earnings on your personal tax form. However, it’s important to note the laws specific to your state. If your business has more than one owner, your LLC will need to file a separate tax return for your business. Some states charge an LLC tax, while others charge an annual LLC fee, which can also be called a franchise tax, registration fee, or renewal fee. Check your state laws to make sure you know all the fees before you choose this route.

S Corp

An S Corporation is is legally a corporation that has “elected” to be treated as a S Corporation, which is another form of “flow through” entity.  Also, a business structured as an LLC can “elect” to be treated as a S Corporation instead of a sole proprietorship or partnership.  As with the partnership, the individual shareholders report their share of the S corporation income on their individual tax return and taxes are paid at the individual rates.

Similar to a partnership, a separate return is required to be filed (Form 1120S).  Due to this paperwork and accounting advice often required, an S Corp can be more expensive to set up, but the tax savings can be worth it. There are limits to an S Corp.  Generally an S corporation can only be owned by individuals and the number of owners is limited to  100 shareholders or less.  Profits and losses must be distributed to shareholders in accordance with their ownership percentage.  Thus the advantage of the partnership as to ease of adding owners and flexibility in splitting profits is a DISADVANTAGE to an S corporation.

Another disadvantage is also one of the most important things to note and that is with an S Corp, all owners and employees will need to be paid a “reasonable salary” to differentiate it as a business entity.

Example: Dr. Lollipop in Kentucky runs a thriving family practice. He looks at the year’s earnings and realizes he’s made $500,000 in net profits. He reviews salary averages for family practice physicians and finds an average of $185,161 for his area. He takes a $150,000 salary, which results in the company’s net profit to be reduced to $350,000.  This $350,000 “flows through” and is reported on his Form 1040.  Both the wages and the share of profit are subject to his individual rates. Unlike the partnership or sole proprietorship, the $350,000 share of company profit is NOT subject to self-employment tax.

Thus, another advantage of an S corporation is the ability to reduce self-employment tax.

C Corp

A C Corp differs from all others in that it is not a pass-through business. In other words, a C corporation files it own tax return and pays federal income tax based upon the profit of the company.  Owners will generally be paid as employees and report on their returns the wages paid to them and reported on their Form W-2.  Also, if the company pays a dividend, the owners will have a dividend to report on their personal return which is taxed at a reduced rate.  However, one negative about C Corps is  double taxation. Any profits are taxed on the business, then taxed again when shareholders are given their dividends from those profits. This double taxation can lead to complaints, but it’s important to note that due to the lower tax brackets, in some instances your dental or medical practice may owe less than it would have if owners had filed individually.

Example: Dr. Spine is a chiropractor in Idaho who runs a successful practice, structured as a C corp. His practice earns over $750,000 profit per year.  He is the sole equity owner of the practice. He does not take a salary from his C corp (a little unrealistic, but its just an example!). He would first have to pay a corporate tax on the $750,000. After he pays the corporate tax, any remaining profits would be subject to another individual tax.  Under the laws in effect in 2017, the corporation would pay tax at a rate of 34% and then if the net, after this tax is paid, is paid as a dividend to Dr. Spine, Dr. Spine pays another 15 or 20%.

As noted, it is unrealistic for an owner that works for the company to have no wages.  Specifically there are tax laws that do not allow this.

Here’s some take away points:

  • In general, the net profits of a Sole proprietorships, LLCs and S corps are paid on the tax return of the ownersand therefore taxed once at the individual tax rate.
  • C corps are subject to double taxation. Profits will be taxed at the corporate tax rate. Any remaining income will be again taxed at the individual rate.
  • Each entity has its own set of legal and tax benefits and set-up costs.
  • The taxation of each entity can differ from state to state.

Choosing the appropriate tax structure for your medical or dental practice can be a big decision, especially when tax rules change yearly. (NOTE: due to the income limitation on health services the affect of the new Qualified Business Income Deduction effective in 2017 is unpredictable in evaluating your tax structure.  Each business needs to be separately analyzed.)

When in doubt, consult a tax preparer.

Are you looking for additional help with setting up the tax structure of your medical or dental practice?

Click here to connect with one of Clineeds esteemed accounting partner!  Click to continue.

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