Business Entity Classification for Doctors
When consulting with clients who are purchasing a new business or setting up one from scratch, the decision has to be made regarding a choice of entity. Doctors have to be aware of the classification Personal Service Corporation (PSC) that follows the entity choice of a C Corporation. A PSC is a corporation that performs services in the fields of health, law, engineering, and accounting among other service types. PSC’s that meet the criteria of both the function and ownership test are subject to a flat 35 percent federal tax rate (the highest marginal corporate tax rate). In the past there were reasons for a business to establish this type of entity, primarily the deductibility of health insurance and other employee benefits. Tax rules have changed, and other entity options such as Sub-Chapter S Corporations and Professional Limited Liability Corporations (PLLC) are being used to offer doctors better tax strategy options with more flexibility.
When helping clients make a decision regarding the choice of entity, several questions should be considered. Is this a business start-up where revenue and profit are not significant in the first couple of years? Does the spouse or owner have W-2 income or 1099 income from another business? If one or both of these factors are present, there may be an opportunity to expedite the use of operating losses by establishing the new business as a PLLC. Profits or losses from this entity are passed through and taxed on the individual LLC member’s tax return and are subject to the individual income tax rates and self-employment tax. If the business has losses it may be able to offset other income from wage or 1099 income, thereby reducing federal and state income taxes. The potential reduction in taxes could be particularly helpful to aid cash flow to the practice and assist in the payment start-up expenses or loan repayments.
Sub-Chapter S Corporations are also a popular entity choice for profitable medical practices and allow for payroll compensation to the shareholder. S Corporations are also pass-through entities whereby the profit of the practice is taxed at the individual owners’ income tax rate. With proper tax planning, distributions of cash to the owner can be paid without additional payroll. This characterization of cash is different than dividends that are paid from a C Corporation. S Corporation distributions avoid the double taxation encountered in a traditional C Corporation.
Knowing the differences in entity type can establish a better understanding of how doctors get paid from their practices, and what the resulting tax burden might be. Many doctors are paid as independent contractors or employees prior to ownership, but that arrangement changes with ownership. A common mistake for LLC owners is to take compensation through payroll. Payroll is appropriate in S Corporation ownership, but not in LLC ownership. Instead LLC owners pay themselves from business profit and cash flow.
There is certainly no right or wrong determination about an entity choice, but proper consulting prior to starting a business, and during its life cycle can help doctors minimize their business and personal tax liabilities. I95