Avoiding Costly Tax Traps Changing the Legal Entity of Your Practice Is a Complex Matter

As I wrote last month, deciding which legal form of entity to practice under involves weighing the various pros and cons of personal liability protection, tax treatment, flexibility, and administration. Your choice of entity today may not be the same as it was 10 years ago and may not be the same 10 years in the future, because of changes in tax laws and regulations, laws affecting your practice, and changes in the nature of your practice.

Does this mean you are stuck with the choice you have made? Not necessarily, but changing entities can be very difficult and costly and should be done only after a very thorough professional analysis of the legal and tax implications.

Practices that operate as sole proprietorships or general partnerships can easily practice as either limited liability companies (LLCs) or limited liability partnerships (LLPs) by registering as such in your state of practice, subject to individual state laws. There is a fee to do so and usually ongoing annual reports to file, but this is well-worth the additional liability protection afforded to LLCs and LLPs. This does not cause any change in tax treatment and reporting.

The decision to incorporate sole proprietorships, general partnerships, LLCs, and LLPs is also fairly uncomplicated. However, the practice would then have to operate under the rules of state corporate laws and would have to file corporate income tax returns and be subject to corporation tax laws and regulations.

Options for Professional Corporations (PCs)

If a professional corporation (PC) decides to change its form of business to either an LLC or S corporation, the process can be complicated.

Reorganizing as an LLC requires a business reason other than tax avoidance. It also requires the corporation to first be dissolved and the net assets to be distributed to the shareholders. This can have costly tax implications because it will immediately trigger recognition of accounts receivable at the corporate level, which in turn may result in a corporate-level income tax to be paid.

Upon the distribution of net assets, shareholders may be subject to a second level of taxation. Making this choice will also require reregistering your practice with the IRS, your state, and third-party payers to obtain new tax ID and provider numbers, all of which could disrupt billing and cash flow.

Making an S corporation election is simple if you choose to do so as soon as you set up your PC by filing Form 2553 within 75 days of incorporating your practice. This requires the consent and signatures of all the shareholders. If, however, you choose to make an S corporation election after you have been practicing for a while as a PC, there are some pitfalls and tax traps you could fall into. First, you could be subject to a corporate-level tax (“built-in gains tax”) on assets not yet taxed — such as accounts receivable, appreciated assets such as real estate, and practice goodwill — if you sell the practice or any of these assets within 10 years of making the S corporation election.

Accounts receivable outstanding on the date of election is subject to the built-in gains tax when collected, to the extent of net income recognized in the first year or later, within the 10-year window. The net income is then taxed again as ordinary income at the shareholder level.

To avoid the built-in gains tax on accounts receivable, you have to show losses or no net income to the practice for 10 years. This requires careful tax planning before each year end. Unfortunately, this negates two of the advantages of making an S corporation election: being able to reinvest earnings without incurring a corporate-level tax, and being able to generate income for doctors that is not subject to payroll taxes. At the end of the 10-year period, the built-in gains issue goes away.

Other ways to mitigate the recognition of built-in gains include: obtaining a low appraisal of the practice at the time of the S election; reducing accounts receivable to the extent possible before making the election; declaring built-in losses at the time of the election, such as deferred compensation, accounts payable, and other accrued liabilities; generating net losses prior to the S corporation election that can then be carried forward to offset built-in gains recognized; and not selling the practice assets or dissolving the corporation for 10 years.

Conclusion

Changing your practice’s legal form of entity may be a strategically good idea, but it should not be done without first consulting with your accountant and attorney to be sure it is the right move for you and to plan properly to avoid costly traps down the road.

James B. Calnan, CPA is partner-in-charge of the Health Care Services Division of Meyers Brothers Kalicka, P.C. in Holyoke; (413) 536-8510.