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Choose your entity: corporations vs. partnerships
 Mark E. Battersby |
When deciding on an entity by which to operate your practice for tax purposes, optometrists can choose from the regular, so-called “C” corporation, its pass-through small business cousin, an “S” corporation, a partnership, limited liability company (LLC) or a sole proprietorship.
To choose among those entities is to choose among significant differences in federal income tax treatment. Unfortunately, there is more to choosing the right structure for an optometry practice than taxes. Not only will the decision have an impact on how much is paid in taxes, it also will affect the amount of paperwork required for the practice, the personal liability faced by the principals and the practice’s ability to raise money. State and local licensing requirements must also be considered.
The toughest tax bite
Of all entities, the so-called C or regular corporation is subject to the toughest tax bite. The earnings of an incorporated optometry practice are taxed twice. First, a corporate income tax is imposed on the practice’s net earnings, then, after the earnings are distributed to shareholders as dividends, each shareholder must pay taxes separately on his or her share of the dividends.
Naturally, a corporation can reduce – or even eliminate – its federal income tax liability by distributing its income as salary to shareholder-employees who actually perform services for the corporation. Although this can reduce taxation at the corporate level, those who receive profits from a corporation in exchange for services must pay tax on the amount received, which is treated as salary. Fortunately, there is some relief available to individual shareholders who currently benefit from the new, lower tax rate on dividends.
This scheme of taxation differs radically from that applied to S corporations, partnerships, LLCs and sole proprietorships. These entities, often referred to as “pass-through” entities, do not pay an entity-level tax on their earnings. Only the principals in these practices are taxed on their share of the entity’s earnings.
Although the easiest structure is the sole practitioner involving just one individual, the liability issue frequently eliminates this entity from the starting gate. This is a shame, because the tax aspects of a sole practitioner are especially appealing. Income and expenses from the practice are included on the sole practitioner’s personal income tax return.
Two varieties of partnerships
If the optometry practice will be owned and operated by several professionals, partnerships might warrant a closer look. They come in two varieties: general and limited. In a general partnership, the partners manage the optometry practice and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership does not pay tax on its income but “passes through” all profits or losses to the individual partners. Each partner is required to report profits from the partnership on his or her individual tax return. Even though the partnership pays no income tax, it must complete and file a partnership informational return, Form 1065.
Personal liability is obviously a concern for optometrists, especially those using a general partnership. Similar to a sole practitioner, general partners are personally liable for the partnership’s obligations and debt. Partnerships are also more expensive to establish than sole proprietorships and often require more extensive – and expensive – legal and accounting services.
Corporate structure
Using the corporate structure for an optometry practice is more complex and expensive than for other types of business entities. The resulting corporation, however, is an independent legal entity, separate from its owners.
The biggest benefit for the principal in an incorporated practice is the liability protection. Although the courts are increasingly “reaching behind” the corporate structure, for the most part, a corporation’s debt is not considered its owners’ debt. Corporations also continue indefinitely, even if one of the shareholders dies, sells his or her shares or becomes disabled. On the downside is the double tax paid at both federal and state levels.
S corporations
An S corporation is merely an incorporated optometry practice that has chosen to be treated as a partnership for tax purposes. It offers some appealing tax benefits while providing the liability protection of a corporation.
With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there is just one level of federal tax to pay.
On the downside, S corporations are subject to many of the same requirements as corporations. This results in higher legal and accounting fees. They must also file articles of incorporation, hold directors and shareholder meetings, keep corporate minutes and allow shareholders to vote on major corporate decisions.
Personal service corporations
Professional athletes, entertainers as well as optometrists and other professionals have long benefited from the personal services corporation (PSC) entity. It is no secret that many optometrists incorporate their practices because of liability concerns. Because a large number of those incorporated entities involve the services of the practice’s principal or principals, they are frequently labeled as “personal service corporations” by the ever-vigilant Internal Revenue Service – a designation that a surprising number of optometrists have not found to be a deterrent.
Identifying certain PSCs as “qualified” and taxing them at a flat rate of 35% was our lawmaker’s way of reducing incentives for professionals to shelter part of their income in a corporate form with a lower marginal tax rate. However, PSCs remain popular because they afford optometrists protection against many forms of liability – and continue to provide the tax benefits of an incorporated practice.
LLC: A hybrid
While S corporations remain the most-used entity, the limited liability company or LLC introduced in 1997 is fast becoming the entity of choice. An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations.
LLCs were created to provide business owners with the liability protection that corporations enjoy without the double taxation. Earnings and losses of an LLC pass through to the owners and are included on their personal income tax returns.
Although it sounds similar to an S corporation, the LLC has no limit on the number of shareholders. In fact, any member or shareholder of the LLC is allowed a full participatory role in the optometry practice’s operation.
To set up an LLC, articles of organization must be filed with the secretary of state where the business will operate. Some states also require the filing of an operating agreement, which is similar to a partnership agreement.
Like partnerships, LLCs do not have perpetual life. Some states stipulate that the operation must dissolve after 30 or 40 years. Technically, a LLC dissolves when a member dies, quits or retires.
Despite its increasing popularity and many benefits, LLCs also have disadvantages, such as the inability to sell or transfer and a limited life. Remember that because an LLC is a relatively new entity, its tax treatment varies by state.
Group practices, PSCs
Professionals in group practices are often more concerned about liability exposure for the malpractice of their co-owners than themselves. Although a PSC, LLC or S corporation may shield an optometrist from claims against personal assets, the practice’s assets often remain at risk. For this and other reasons, professionals often form multiple PSCs when in group practice.
Generally, each professional forms a separate PSC in which the individual professional owns 100% of the stock.
A number of options available
The annual tax return provides options for many optometry practices. Entities with more than one member are permitted to elect corporate status on the annual tax returns. Thus, an entity that is a partnership under state laws may elect to be taxed as a regular C corporation or even as an S corporation for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under those so-called “check-the-box” regulations, entities formed as corporations may not elect to be treated as another kind of entity.
Circumstances and tax laws change; when they do, reassess your situation promptly.
For more information:
- Mark E. Battersby can be reached at PO Box 527, Ardmore, PA 19003-0527; (610) 789-2480; e-mail: MEBatt12@earthlink.net.