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April 20, 2022
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Private practice orthopedists often overlook a simple tax reduction tactic

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On one hand, the tax tactic described in this article applies only to a limited number of orthopedists: those who are in private practice and in practices that are taxed as S corporations.

Sanjeev Bhatia, MD
Sanjeev Bhatia
David B. Mandell, JD, MBA
David B. Mandell

On the other hand, as S corporations are the most popular form of medical practice in regard to taxation, the number of orthopedists who could benefit from understanding the tactic is large. For this reason, and the fact that recent federal income tax proposals have targeted this strategy, we thought this would be a valuable topic to cover in this column. The bottom line is the tactic can be helpful to many orthopedists for as long as it continues to exist.

S corporation tax basics

Orthopedists who work in an S corporation practice and are also owners can be paid both as an employee of the practice — receiving a W-2 statement — and as an owner of the practice through a K-1 distribution. One key difference between income earned as employee compensation (W-2) and income earned as a K-1 profit distribution is that you pay FICA (Medicare and social security) tax on the income earned as an employee, but do not necessarily pay it on K-1 profit distributions. Although the large social security portion of FICA phases out after income of $147,000 in 2022, the Medicare tax has no phase out. Also, the Medicare tax increased under the Affordable Care Act to 3.8% for higher income taxpayers.

Although this is a 3.8% tax, ignoring this tax opportunity may cost orthopedists $10,000 or more each year of their careers. During a career, this can amount to nearly half a million dollars of lost capital, for no good reason.

Another key difference is that W-2 wage income is not eligible for the more recent qualified business income (QBI) deduction, but profit distributions could be. Keep in mind that a medical practice is considered to be a specified service business and, thus, may not be eligible for the QBI deduction. However, for medical practice owners whose personal taxable income falls below certain thresholds, a QBI deduction may be available on medical practice profit distributions.

Case examples

Two case examples, based on common practice scenarios, help illustrate the planning opportunity.

Dr. Smith is part of a five-physician orthopedic practice. She earns about $400,000 annually as an orthopedist. She calls the four other physicians “partners,” but technically they are co-owners of the practice, which is an S corporation. Each month, Dr. Smith gets paid $20,000. Then, at the end of each 6-month period, she gets another $80,000 based on the practice’s performance. Her accountant deems both the monthly and semi-annual payments to be salary payments. Thus, she pays Medicare tax on all $400,000 for a tax of $12,950, which is at the 3.8% rate on wages exceeding $250,000 and at the 2.9% rate on the first $250,000 of wages. This, of course, is in addition to state and federal income taxes, property and other taxes. Assuming a 5% growth rate, if she works for 25 years earning the same income, she will have lost more than $615,000 in Medicare taxes.

In addition, if Dr. Smith’s deductions reduce her income such that her taxable income falls below $340,000, assuming she files a joint tax return, she is also missing out on a potential 20% QBI deduction.

Dr. Jones, also an orthopedist, is in the same economic situation. However, his certified public accountant (CPA) treats the monthly payments as W-2 wages and the semi-annual payments as K-1 distributions of the profit earned by the practice. Thus, he pays Medicare tax on $240,000 for a tax of $6,960. If Dr. Jones works for 25 years earning the same income, he will have lost about $330,000 in FICA taxes, assuming a 5% growth rate, which is an improvement of $285,000 compared with Dr. Smith.

In addition, if Dr. Jones is married and files a joint tax return, and his mortgage interest, taxes and charitable contributions cause his taxable income to be less than $340,000, he may also be able to take a QBI deduction of up to $32,000 per year.

The previous cases are hypothetical and any change or deviation from the circumstances discussed above could affect the outcome. However, many would prefer Dr. Jones’ tax situation vs. Dr. Smith’s.

It is a lost planning opportunity when many physicians have all or most of their income treated as W-2 compensation when, in fact, much of it is earned from the profitability of the practice rather than from the doctor’s personal services. Wouldn’t most orthopedists prefer to be in Dr. Jones’ position? The question really comes down to what the tax rules are that govern this situation.

Reasonable compensation

The rules dictate that the orthopedists in the previous case examples be paid “reasonable compensation.” As one would expect, what constitutes “reasonable” is based on the facts and circumstances of each situation, rather than a bright-line dollar amount.

In discussions with several CPAs with decades of experience, the consensus is that one should follow a simple rule. Basically, one can reasonably be paid as a W-2 salary what one would need to pay an outside orthopedist with the same training to join your practice. The rest of your compensation can be characterized as distributions. One CPA, practicing for more than 20 years, commented, “This is what I do for my clients, and when the issue has been discussed in audits over the years, the IRS finds it difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job.”

Looking again at the earlier examples, let’s assume Dr. Smith could attract another orthopedist to her practice paying a $250,000 salary. This would allow her to avoid Medicare tax on $150,000, saving more than $5,500 annually. Not coincidentally, Dr. Jones is in the right situation.

By applying this simple analysis to one’s present compensation formula, one can get a quick idea of whether one could benefit from taking more compensation as S corporation distributions, thereby saving Medicare taxes. In some cases, orthopedists may even find that they have been too aggressive and need to pay themselves more W-2 wages to avoid a problem upon audit.

Current proposal threatens tactic

As we noted in the second paragraph of this article, the House-passed version of the Build Back Better Act would subject distributions from S corporation practices to the 3.8% net investment income tax, thereby eliminating this technique. This rule may only apply to certain levels of income and to taxpayers whose overall income meets certain thresholds. Also, this is only a proposal. It may change significantly before becoming a law if this act is passed.

As hard as orthopedists work, being tax efficient in the way they characterize compensation is crucial. Many physicians practicing in S corporations have not been efficient in the way this article demonstrates.