‘S’ or ‘C’ corporation: Maximize tax treatment of your practice
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When choosing a structure for a practice, you are making two choices: what legal structure to choose and which tax treatment to select.
In this article, we will focus on tax treatment selection. While we will leave the discussion of the legal structure of a medical practice to another article, we must at least acknowledge it here because if the practice is structured as a limited liability company, it opens up two tax treatments in addition to S corporation and C corporation. An LLC owned by one owner can be taxed as a “disregarded entity” and one owned by multiple owners can be taxed as a partnership.
Basics of tax treatment
All businesses, including medical practices, that incorporate are automatically C corporations absent an election to become an S corporation. Similarly, an LLC that chooses to be taxed as a corporation is a C corporation unless it elects to be taxed as an S corporation using Form 2553. Both S and C corporations have separate tax ID numbers and are required to file tax returns with the federal and appropriate state tax agencies. Both entities have shareholders and can be created in any state in the country.
When a C corporation earns profit (the difference between income and expenses), it must pay tax at the corporate level. Compensation paid to practice owners, as long as it is reasonable, is deductible by the corporation on its tax return (and is, therefore, not taxable to the corporation).
The salary received by the owner is taxable to the owner as wages. After the C corporation pays taxes, distributions of earnings already taxed at the corporate level can be paid to the owners in the form of dividends. These would generally be taxed to the owners as qualified dividends, thus leading to the “double taxation” of such earnings. As you will see below, this drawback is often overrated.
An S corporation is also a separate entity that must file its own tax return. However, the S corporation is often referred to as a “pass-through” entity. Rather than paying tax at the corporate level, all income and deductions pass through to the shareholders and the shareholders must pay tax on any S corporation income at their individual rates. Tax will be paid on the owner’s share of taxable income regardless of whether that income is distributed to the owner. Whether the income of an S corporation is paid to the practice owners as salary or as a distribution will not impact the ordinary federal or state income tax rates that will be applied to that income for the owner. There is never any tax to the corporation; therefore, there is no “double taxation” in an S corporation. How the income is paid to the owners will impact Federal Insurance Contributions Act and Medicare taxes. W-2 wages are subject to these taxes while the owner’s share of taxable profits is not generally subject to payroll taxes.
Double taxation
Mistakenly, most practice owners think of S and C corporations as having identical benefits. Many practice owners and their advisors elect to form an S corporation instead of a C corporation to avoid the C corporation’s potential double taxation. For this reason, the S corporation election is often made without two important considerations.
First, the double taxation problem can be easily avoided by reducing profits to zero, or close to zero, at the end of the year with reasonable compensation and bonuses to the owner(s). Second, some benefits are deductible by a C corporation but not by an S corporation. Determining which of these factors might be meaningful to you can help you determine which structure is right for your practice.
Additional deductible benefits
For some practices, C corporation can be the right choice because of the deductions it allows. The corporate deduction for fringe benefits paid to employees is generally limited for shareholders owning more than 2% of an S corporation. However, a C corporation enjoys a full deduction for the cost of employees’ (including owner employees) health insurance, group term life insurance of up to $50,000 per employee and even long-term care premiums without regard to age-based limitations. If one has a small corporation and a lot of medical expenses that are not covered by insurance, the corporation can establish a plan that results in all of those expenses being tax deductible. Fringe benefits, such as employer provided vehicles and public transportation passes, are also deductible.
In contrast, health insurance paid by an S corporation for a more than 2% shareholder is not deductible by the corporation. The shareholder must generally take a self-employed health insurance deduction on his personal return. Long-term care premiums paid through an S corporation are also not deductible with regard to these shareholders. The shareholders, in deducting them personally, are subject to the age-based limitations.
Lower tax rates
C corporations currently are subject to a flat 21% tax rate on taxable corporate income. For practices looking to maintain capital inside the practice rather than distributing it out, this lower tax rate could be beneficial. An S corporation owner in the highest tax bracket would have that taxable business income subject to a 37% tax rate. However, many small businesses, including medical practices, want to maximize distributions to the owners rather than maintaining capital inside the practice. In this case, an owner in the top tax bracket would be subject to the corporate tax rate of 21% plus a 20% tax on the ensuing dividend distribution and likely the 3.8% net investment income tax on the dividend as well. For an owner in this situation, an S corporation or a C corporation that can bonus out taxable income would be preferable.
C corporations can take advantage of the full Section 179 expense deduction in writing off furniture and equipment in the year of purchase since they are afforded their own Section 179 deduction limitation. Shareholders of an S corporation must accumulate the Section 179 deduction among each of their pass-through entities, thus they could be limited in a given year.
If the practice has rental activity, a C corporation has the advantage of using rental losses to offset operating income. Shareholders of an S corporation must treat rental losses as a passive activity subject to the passive loss and at-risk rules.
Recent budget proposals have included assessing the Net Investment Income (NII) tax on flow-through income of active owners of S corporations. This additional 3.8% tax would mean S corporation profits are taxed in the same manner as wages since the NII tax rate and the Medicare tax rate are the same.
Best of both worlds
Many practices can take advantage of the benefits provided by both C corporations and S corporations by setting up two distinct entities to operate different aspects of their practices. Perhaps the S corporation will be used for the operating side of the practice while the C corporation will be used for management functions (billing and administration) or for a retail function. In this way, the practice as a whole can take advantage of the tax deductions afforded a C corporation, along with the “flow through” advantages of an S corporation. Using an S corporation in tandem with a C corporation may also provide some additional asset protection. As long as all formalities of incorporation are followed, as well as compliance with rules for employee participation in all benefit plans, medical practices can often benefit from this “dual” corporate structure.
Understanding the differing tax aspects of S corporations and C corporations is an important first step in determining which structure will work best for your practice. Planning with your tax advisor should include discussions about fringe benefits, expected number of owners, compensation and distributions, as well as exit strategies. Once you have selected a structure (or structures) for your practice, your advisor can help you take advantage of all available benefits to maximize your potential tax savings.
For more information:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, IL. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Carole C. Foos, CPA, is a partner and tax consultant. They can be reached at 877-656-4362 or mandell@ojmgroup.com
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