Sorting Out the Options Doctors Must Consider Several Legal Entity Choices

When starting up or reorganizing a medical or dental practice, doctors must decide what form of entity to practice under.

The choices usually include the following: sole proprietorship, general partnership, C-corporation, S-corporation, limited liability company (LLC), and limited liability partnership (LLP). A professional corporation (PC) may either be a C-corporation or an S-corporation.

In choosing an entity, there are four main issues to consider: personal liability protection, tax treatment, flexibility, and administration. We are going to touch on the significant aspects of each of these areas, although the subject matter is much more encompassing than this article.

Personal Liability

I preface this with advice to consult a business attorney on liability issues. None of these entities insulates you from liability resulting from your own negligence or actions that may harm another party. That is what malpractice and general liability insurance is for.

However, there is a difference in liability protection between general creditors and parties suing you for actions of your employees or co-owners. In the case of a sole proprietorship and general partnership, the individual owners are at risk, as are their personal assets for any such liabilities.

By incorporating as a C-corporation or S-corporation or registering as a limited liability company (LLC), practitioners can insulate themselves from personal liability for the debts or liabilities of the practice or for acts or omissions of other members, agents, or employees of the practice.

There are some gray areas with limited liability partnerships (LLP) which may depend on specific state statutes and for which you should consult an attorney. For individual liability protection purposes, there’s no good reason why practitioners who are operating as sole proprietorships or general partnerships shouldn’t at least register their entity as an LLC.

Tax Treatment

In discussing tax treatment, we will first group sole proprietorships, general partnerships, LLCs, and LLPs as “pass-through” entities. C-corporations and S-corporations will be identified separately, even though S-corporations have characteristics of both pass-through entities and C-corporations.

Pass-through entities aren’t taxed at the entity level, and the owners don’t get compensated through payroll like employees do. Owners simply take cash distributions during the year. All the net earnings, including any distributions to owners, are passed through and reported by each individual on his or her individual tax returns.

Sole proprietorships and single owner LLCs report all items of income and expense on Schedule C of their individual tax returns. Multiple owner LLCs, LLPs, and general partnerships must file partnership tax returns. Partners don’t receive a W-2 form, but rather a K-1 form with the applicable tax reporting information. Most of the tax benefits that were once enjoyed by practices operating as C-corporations are now available to owners of S-corporations and pass-through entities.

C-corporations, professional or otherwise, are treated as separate, distinct taxable entities. This means the incorporated medical or dental practice is required to file corporate income tax returns, pay federal and state income taxes on net income, and may be subject to other state franchise or excise taxes. Stockholders are also employees and are compensated through payroll with appropriate withholdings for payroll and income taxes. They receive a W-2 with annual earnings and withholdings for individual income tax reporting. Any undistributed profits that are retained for growth, working capital, or debt service will be taxed at the applicable federal and state corporate rates.

Only C-corporations can still deduct premiums paid for owner practitioner disability insurance and the first $50,000 of group term life insurance for owner practitioners. Professional C-corporations can also fully deduct long-term care insurance premiums for owner practitioners. Owners of pass-through entities and more than 2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} owner practitioners of S-corporations are only eligible for a more limited deduction which must be taken on their individual returns.

In addition, owner practitioners of professional C-corporations are eligible for the tax-free benefits of employee cafeteria plans, whereas more than 2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} owner practitioners of S-corporations and owner practitioners of pass-through entities are not.

The federal income tax rate on professional C-corporations is currently 35{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}, which, coincidentally, is also the maximum federal income tax rate for individuals. The problem with C-corporations, however, is that earnings can be taxed twice if practice assets are sold, or the corporation is dissolved. This is because gains on sales of assets and retained profits are first taxed at the corporate level and when cash or assets are distributed to owners, they may be taxed again as dividends or capital gains.

Although some of this can be mitigated by careful planning, it is problematic. Also, compensation and deductions at the corporate level that are deemed excessive or otherwise unallowable by the IRS can be recharacterized as dividends and taxed again at the individual level. C-corporations may also be subject to an unreasonable accumulated earnings tax of 15{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} but it is unlikely to see this in professional corporations.

S-corporations have attributes of both C-corporations and pass-through entities. Practitioner owners are also employees and are paid compensation through payroll, like a C-corporation. S-corporations must file corporate tax returns but do not pay any federal income tax at the corporate level. Some states, such as Massachusetts, assess an entity-level income tax if gross receipts are $6 million or more. Any net profit after owner compensation, whether retained in the practice or not, is passed through and reported by practice owners on their individual tax returns.

One distinct tax advantage of an S-corporation is that any allocations or distributions of profits to owner practitioners above and beyond their direct payroll compensation are not subject to self-employment or payroll taxes. This could mean a savings of anywhere from 2.5{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} to 15.3{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of such earnings. All distributions of C-corporation earnings aren’t subject to self-employment or payroll taxes either, but they would be taxed as dividends. The pass-through entity earnings are subject to self-employment tax, whether distributed or retained in the practice.

Flexibility

There are operational differences in the various entity types that may be more significant than tax differences. For example, medium to large group practices could be affected by the limit of only 100 stockholders in an S-corporation.

C-corporations and pass-through entities can be owned by another corporation or entity, but S-corporations can only be owned by U.S. individuals, by another S-corporation, by estates, or by certain qualified trusts. C-corporations and S-corporations are subject to state law limitations on non-practitioner ownership. Pass-through entities are more flexible.

C-corporations can have several classes of stock: for example, common and preferred. S-corporations can only differentiate between voting and non-voting stock. Pass-through entities can make special allocations of income and equity ownership among owners.

C-corporations and S-corporations have no restrictions on continuity of life. Pass-through entities, excluding sole proprietorships, are generally subject to partnership laws on term and termination may occur when there is a 50{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} or more change in ownership, except in states that allow single-owner LLCs.

Administration

Obviously, the simplest entity to administer is the sole proprietorship that needs only to have a federal identification number and to register its name locally.
C-corporations and S-corporations are subject to state corporate laws that are more encompassing and formal than for non-corporate, pass-through entities which are, in essence, governed by their own internal agreements, with minimum restrictions imposed by law.

The greater flexibility of general partnerships and multiple-owner LLCs and LLPs, however, can make administration very cumbersome. Trying to explain to health care practitioners the ins and outs of partner capital accounts, estimated tax payments, allocation and pass-through of income and deductions, tax basis issues, and transfer of ownership logistics can be a nightmare — and understandably so. Many lawyers and accountants don’t fully understand these. Individual tax planning and projections can be full of variables and uncertainties, and hence very difficult, especially in large practices with many owners.

Weighing the Choices

Deciding which entity to practice under involves weighing the various pros and cons of personal liability protection, tax treatment, flexibility, and administration. And remember that the entity of choice today may not be the same 10 years from now.

If your practice was organized in the ’70s or before, it was probably set up as an unincorporated entity such as a sole proprietorship or general partnership. If it was organized in the ’80s or even the ’90s, it may have been set up as a C-corporation because the concept of professional corporations was relatively new, and practitioners were seeking to protect themselves from the general debts and obligations of their practice as well as the acts and omissions of their colleagues.

Also, there were significant tax benefits to practitioner stockholders of professional corporations that weren’t available to sole proprietorships and general partnerships. S-corporations became popular in the early ’80s, and since then there have been so many tax and legal changes, other entity choices may now appear more attractive.

Unfortunately, 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. This is a subject to be covered in another article.

Although this author currently recommends S-corporations and LLCs more than the other entity choices, this was not always so. Be sure to consult with your accountant and attorney before making a choice.

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.