By Dr. Daniel Smith, WCI Columnist
Founding father, Benjamin Franklin, once remarked after helping finalize the Constitution that, “Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes.” Taxes are the largest source of income for federal, state, and local governments, and the variations and nuances are numerous, to say the least. At the same time, the IRS posits in the Taxpayer Bill of Rights:
“Taxpayers have the right to pay only the amount of tax legally due, including interest and penalties, and to have the IRS apply all tax payments properly.”
Despite only being legally required to pay taxes that are owed and no more, the tax code is fraught with loopholes, double taxation, inequity, and inconsistency—which makes overpaying and underpaying very real possibilities. In theory, business taxes should be fairly straightforward: you pay taxes on profits either via the corporation or the shareholder. In a sense, that is the case, but as in all things government, the answer is never quite that straightforward. Even if Benjamin Franklin was completely correct.
Today, I’ll try to generalize how the IRS views various business structures and, thus, show how they are taxed. In the same vein, I hope to point out a few tax pitfalls into which the unwary might fall.
*Disclaimer: I am not a CPA or tax professional. Please consult your tax professional or the specific publication from IRS before acting on this information.
A sole proprietorship is really just you in business for yourself. Many businesses in the U.S. are just that, people performing services or selling goods on their own.
Because you are your business, the IRS treats the business income or loss as your personal income or loss and it flows through to your personal return via Schedule C. This flow of profits and losses through to your personal return means that the sole proprietorship is a “pass through” entity. The tax “deductions” of a sole proprietorship are just the costs of doing business. For a physician, this could be scrubs, a stethoscope, CME, and anything that you require to do your job.
Let’s have a different example, though. Say you have a truck that you utilize 50% of the time for true business purposes, like driving between two different hospitals you cover, and 50% of the time for personal use. The IRS lets you deduct that 50% business usage, because that’s basically a cost to the company: gas, useful life of the vehicle, and maintenance. Note that you can’t deduct driving to and from your primary place of business because this is considered commuting. The same concept applies to machinery, computers, tools, buildings (possibly even part of your house), supplies, etc. If it’s used for a business purpose, you may deduct the business portion of the item’s use as an expense on your taxes.
This leads me to the first tax mistake: deducting expenses of a personal nature on your taxes. Let’s use the truck example again and say that you drive your truck between hospitals about 10 miles per day. Let’s now say that, on your way between hospitals, you pick up groceries—which is two miles out of the way, totaling 12 miles for that day. The IRS deems that extra two miles of driving to have been personal use of the truck, the value of which may not be deducted on your taxes. Where do people get snared by this? When they buy a “business vehicle” for work purposes and then claim every single mile as an expense when it’s also the grocery-getter, the child-hauler, the Disney World-taker, etc.
Now, let’s take a different path and see where you could deduct expenses that mix both business travel and pleasure. Let’s say you’re a sole proprietor locums hospitalist and need CME to maintain your license and board certification, so you decide to go to WCICON 2023 and fly out to sunny Phoenix for some CME-approved wellness. Let’s also say that after the conference, you play some golf, go out to eat with your spouse at Ocean Prime, visit the Desert Botanical Garden or the Phoenix Zoo, etc. Your flight, hotel room (for the days of the conference), and even your meals during your time at the conference are fully deductible as they would be expected business expenses you’d have to pay regardless of your other frivolities. The after-conference activities would not be deductible. The IRS does scrutinize meals for extravagance, so carefully consider whether that kobe filet with shitake and marsala reduction is truly reasonable.
The second tax mistake is forgetting that you have to pay Social Security and Medicare taxes on your income. If you’re a W2 employee, your employer pays half of Medicare (1.45% for each half) and half of Social Security tax (6.2% for each half up to an income of $147,000) while you pay the other half of each. If you’re a sole proprietor, Uncle Sam doesn’t give you a pass on the half that your employer would have paid. Because you are your own employer, you pay both halves of Medicare and Social Security tax for a total of 15.3% (with the Social Security portion of 12.4% capped at $147,000 of income). If you enjoy the success of being a high earner, Uncle Sam rewards you with an additional 0.9% Medicare tax on income of more than $200,000 or $250,000 if you’re Married Filing Jointly.
“Now, wait a minute,” you might say. “Why am I taxed on what amounts to the employer’s part of my Medicare and Social Security taxes?” Well, you actually aren’t! You’re allowed to deduct half of your Medicare and Social Security taxes as a business expense attributed to you as the “employer” of yourself. Clear as mud? Basically, a business gets to deduct Social Security and Medicare taxes that it pays for its employees because taxes are a business expense, just like property taxes. Since you are both employer and employee, you have to pay both halves of each tax but get to deduct the “employer” half of your taxes as a business expense.
More information here:
Partnerships are legal structures in which the partners contribute capital, property, or some technical skill to perform the functions of a business. Most commonly, partnerships in medicine are physician practice partnerships. Partnerships can also consist of general and limited partners, much like you’d find in a real estate syndication where the general partner (GP) does the administrative and logistical work of the syndication or business and the limited partners (LPs) typically contribute capital. Generally, a partnership is another example of a “pass through” entity and, thus, does not pay taxes. The partnership profits and losses are allocated according to the operating agreement—commonly in proportion to ownership but which can be different, especially in the case of GP/LP agreements—and sent to the partner via a K-1. The K-1 is basically a partnership’s declaration of how much value (or loss) you as the partner received from the partnership.
Tax pitfalls in a partnership usually arise when the profit or loss is allocated differently than one assumes. Let’s say that you are a limited partner in a real estate syndication. The syndication invests in multifamily real estate on the equity side. The total returns are listed as ~ 8%-9% per year. You send your money and patiently await your K-1 the next spring. In the interim, you start receiving checks and depositing them, never considering the taxes on these profits since you know that you can depreciate equity real estate and shelter most, if not all, of the income. The K-1 comes in, and you find that the syndicator has claimed most of the depreciation and sent you mostly taxable income. The third tax mistake was failing to scrutinize the operating agreement in that partnership. The operating agreement contains all the details regarding how the partnership is . . . well, operated: voting rights, selling ownership stakes, bringing in new partners, liabilities, splits of profits (and losses), annual meetings, etc.
More information here:
An S Corporation is a corporate entity that passes profits and losses down to its shareholders. Much like partnerships and sole proprietorships, S Corporations avoid being taxed at the business level, allowing income and expense to flow onto the shareholders’ federal tax returns. For physicians, the benefit to incorporating includes the pass through deduction as well as taking some profits as non-dividend distributions to shareholders (i.e. you) which aren’t taxed by Social Security and Medicare and which may qualify for the lower long-term capital gains rate.
The pass through deduction exempts 20% of qualified business income from federal taxation, and it also applies to all pass through entities like sole proprietorships and partnerships. Notably, distributions don’t have Medicare and Social Security taxes taken out because they aren’t wages—instead, they're profits from a business distributed to shareholders. Note that your wage as an employee of the S Corp will still be fully taxed as if you were the employee of any other practice. S Corps also declare shares of profits, losses, credits, etc via K-1s, like partnerships do.
One of the advantages of S Corps, as previously mentioned, is the avoidance of double taxation. However, S Corps have several restrictions, one of which is the loss of allocation control. Let’s say that you are a member of a four-member LLC being taxed as an S Corp. All of you take a salary in the form of $200,000 per year and a distribution of another $100,000 each for total compensation of about $300,000 per year per member. Let’s also say that in one particular year, one of the members was absent for about half the year due to health issues. The other three members see the sick member’s patients in clinic, and the business does the same in revenue as in years past. Salary notwithstanding, if the members took distributions in the usual fashion, all members would still receive $100,000 as a distribution even though one member was absent for half the year. In a partnership, the allocation of income and resources can be controlled in a more granular fashion. This brings up the fourth tax mistake—not realizing that S Corporations lose control of income allocation because non-salary distributions are indeed distributed according solely to ownership percentage.
Another advantage of S Corp distributions is the preferential tax treatment that they receive from the IRS. If distributions of profits from the company exceed your basis (what you’ve paid into the business to get it started and to keep it running), then your distributions are generally recognized as long-term capital gains and are subject typically to a lower marginal rate than earned income. The mistake in taking too much money in distributions as opposed to earned income is two-fold. The first is that the IRS may perceive your wages as unreasonably low and revoke your “S” election which pushes all your income into the wages bucket. The second error is our fifth tax mistake: wages but not distributions count toward your income in determining employer profit-sharing calculations.
A good example might be a family practice physician who earns $250,000 per year as a 0.8 FTE physician in a small practice. They are an independent contractor and elect for their LLC to be taxed as an S Corp, parsing out their earnings as $160,000 reasonable wages and $90,000 as a distribution. They also work as an occasional hospitalist as a W2 employee and earn $80,000 per year. They decide to contribute their elective deferral of $20,500 to their hospital’s 401(k). When it comes time to determine their profit sharing, they're surprised to find that their $160,000 in wages only allows them to contribute $40,000 into their S Corp solo 401k instead of the $61,000 total contribution limit for 401(k) plans [in 2023, it'll be a total contribution limit of $66,000].
Because they elected to take the other portion of their profits as a distribution, they couldn’t count it as a wage and, thus, their “profit sharing” was inadvertently capped. To be clear, corporate employers are capped at 25% of wages as the profit-sharing allocation to an employee’s 401k.
Limited Liability Companies (LLCs) are more of a legal structure than a tax structure. An LLC can be taxed as a sole proprietorship, partnership, or S Corporation (or even a C Corporation if you really want). I wrote this section really to bring attention to that fact. You can have all kinds of tax mishaps because you assumed you’d be taxed as one kind of entity and, in reality, should have operated as another. In theory, an LLC separates the assets of the members (owners) of an LLC from the liabilities of the company, i.e. limited liability. However, that limited liability has, well, limits. If you’re a one-member doc who formed an LLC under which you practice medicine, then any liability you professionally incur will also probably be inured to you personally.
Odds and Ends
There are a number of tax pitfalls that don’t fall conveniently into one particular business category. I’ll briefly touch on a few of these.
- Passive activity loss limitations: These are the losses that are limited in businesses where you don’t actively participate. The most common example here is rental real estate. Let’s say you’re a lawyer with a portfolio of four single-family homes, each generating depreciation losses of $40,000 per year. Unless you actively manage your own properties for rent, the IRS says you are a passive investor in those rentals and cannot claim those losses against wage or other income, except other passive income. For real estate, there’s the additional hurdle of working 750 hours per year in a real property business or trade as real estate being your primary profession (the profession in which the majority of your hours are spent). Here’s more info on this particular IRS designation, called Real Estate Professional Status. These passive losses are suspended until you have passive gains (usually the sale of a property) to count against the losses.
- Conservation easements: These are essentially lands that are placed into federal conservation programs for a big tax write-off. The way that they usually work is that a group of high-income individuals or entities need a way to defray a large tax bill. They purchase a piece of property, get it appraised (usually much higher than its purchase price), and then form a legal agreement with a land trust or federal entity to limit or suspend use of the land for a specified period of time. They’ve recently been the target of IRS audits, and physicians are prime targets for the sale of these easements as a guaranteed write-off. Interestingly, the IRS has been kind enough to provide the handbook for how it evaluates easements. Probably the individuals most likely to truly benefit from easements are farmers (because many easements allow you to continue to farm the land) or hunters who want to keep the land suitable for whatever game they hunt.
- Forgetting to document and keep good records: This is the pet whipping boy of all hospital compliance departments, but it’s also the biggest reason (outright fraud notwithstanding) that audits fail. The IRS generally goes back three years when it audits an individual for the first time. That means you’ve got to have your mileage logs, food receipts, travel expenses, payroll taxes, property taxes, continuing education expenses, etc. for three years. Personally, I keep as much documentation as possible in electronic format. With an additional $80 billion in additional funding flowing to the IRS over 10 years from the Inflation Reduction Act, be sure you’re not on the wrong end of any communication with the IRS.
More information here:
In summary, recall that “deductions” are really just business expenses. The most clever taxpayers find where personal and business expenses intersect. Remember also that your business structure defines to whom money is allocated, in what manner, and in what form. Last, to make such a dry subject more palatable, I leave you with three quotes on taxation.
“It is a good thing that we do not get as much government as we pay for.” — Will Rogers
“The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least amount of hissing.” — Jean-Baptiste Colbert, Controller-General of Finances for King Louis XVI
“The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin.” — Samuel Langhorne Clemens
If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.
Have you made other tax mistakes when dealing with your business? How much did those mistakes cost you? Would you set up your partnerships differently today? Comment below!