[Editor's Note: This is a guest post from forum moderator and financial advisor Johanna Turner CPA, CFP, RLP. She is also an advertiser on the site. It deals with an important subject that many high income professionals will deal with at some point in their career.]
When I started out as a CPA 1980, all of our doctor clients were Personal Service Corporations (PSCs). Today, I would be hard-pressed to find a PSC used by a doctor or group that has been in business for less than 20 years. So why do some doctors hang onto them? Probably because that’s what their CPA is most comfortable with – which may not be in the client’s best interests. Look around: is your CPA or attorney set up as a PSC? I doubt it – they’re mostly PLLCs or S-corporations. So what do we know today that doctors don’t know?
Johanna Turner, CPA, CFP, RLP
Origin of PSCs
PSCs are a relic of the 1980s and before, when personal tax rates were higher than corporate tax rates. In order to prevent professionals from getting a tax break by incorporating, the IRS created a set of rules to define and tax PSCs. In general, your corporation is a PSC if it is owned and run by a professional(s) who must be licensed to practice that hasn’t filed an “S” election. In other words, it is a “C” corporation that pays a flat tax rate of 35% on all profits. [By the way, any corporation is, by default, a “C” corporation. It must file an election to be taxed as an “S” corporation. For the rest of this article, “corporation” will refer to a “C” corporation.]
There are a few benefits to operating as a PSC. You can choose the cash basis of accounting rather than accrual. You can deduct some benefits, such as life insurance , but amounts above $50,000 are taxable to you as an employee. You can also provide disability and dependent care fringe benefits to employees, including owners. (Note that tax-deductible disability premiums render any benefits collected as taxable.)
What are the problems of operating as a PSC? Mainly that 35% tax rate. PSC owners avoid the 35% rate by paying bonuses to shareholders at the end of each year. That’s right – all PSC owners go through the same annual ritual: prepare a draft of the tax return and then write bonus checks to lower the taxable income to as near zero as possible. Any losses must be used to offset profits of the two previous years or netted against future profits for 20 years. If you close the business or elect “S” status, however, unused losses evaporate.
What if your marginal tax rate is 39.6%? Wouldn’t it make sense to pay some tax at 35% through the corporation? Not exactly. The only way to get the remaining profit out of the PSC is to pay dividends. That means the corporation will pay 35% and the recipient will pay another 15% or 20% on the already-taxed profits, depending upon his/her tax bracket. That’s the “double taxation” problem with corporations. Since the goal is to bonus out any profits, PSCs rarely pay dividends.
Another disadvantage of corporations is that long-term capital gains do not benefit from the preferential capital gains tax rate that individuals enjoy. Any sales within a corporation that would normally generate a long-term capital gain will be taxed at 35%. In other words, you never want to use a corporation to hold appreciating property such as real estate or stocks.
If not a PSC, then what? You can choose to be self-employed or to incorporate and elect “S” status.
Self-employed
Your options are either sole proprietorship, a limited liability company (“LLC”) or another partnership structure (see below). If you choose to be an LLC, you will be a SMPLLC (Single Member Professional Limited Liability Co.) if solo or a PLLC if in a partnership.
I usually recommend self-employed for solo owners who have no employees, particularly if this is a second job. Any risk of lawsuit should already be covered by your umbrella, liability, and property and casualty insurance policies. You will not have to file a separate “business” tax return, at least for federal purposes, and you will report your profit or loss on a schedule C included with your form 1040. You can (and should) have a home office, if applicable to your needs, to deduct additional expenses. Be sure to check local zoning regulations and obtain any appropriate business licenses.
If you’re still concerned about liability, file online with your Secretary of State to become a SMPLLC. Rules and costs vary by state. The disadvantage is that you’ll likely have to file a separate state tax return and pay an annual fee, ranging from under $50 to $800 per year. The advantage, of course, is that you’ll have another layer of legal protection. If that helps you sleep better at night, it’s probably worth the cost and time. Your business will still file a schedule C attached to your 1040. (Note that PLLCs are not allowed in one state, California.)
With multiple owners, called “members”, your LLC will be required to file a partnership income tax return, Form 1065. This is required even if your spouse is your partner. Your business results will be reported on a K1 that will “flow through” to your form 1040. A partnership enjoys two special benefits that aren’t available to an S-corporation:
- The partnership agreement governs the operations of the business, and
- Partners are allowed to make special elections not afforded to S-corporations, in particular, the 754 election.
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The flexibility afforded by the partnership agreement allows for a partnership to allocate profit and loss disproportionately rather than under the “one class of stock” rule for S-corporations, which we’ll learn about next. The 754 election is complicated and beyond the scope of this article.
There are two more kinds of partnerships, but they are rarely used, as follows:
- General Partnership (“GP”): each partner is fully responsible for the debts and obligations of all other partners. A GP is never used for professional practices.
- Limited Liability Partnership (“LLP”): Occasionally used in large multi-member practices. An LLP must have one managing partner, who typically has a significant ownership stake in the practice and assumes full responsibility for the actions of all partners. The limited partners can have no say in the management of the business but have no liability exposure, either. Management activities carried on by the limited partners could cause the protective liability veil to be pierced.
The downside to being self-employed for most doctors is the Medicare tax of 2.9% you’ll owe on taxable income.
S Corporation
To be taxed as an S-corporation, a corporation files IRS Form 2553 by the 15th day of the 3rd month of the year in which you want to be taxed as an S-corporation. The IRS is extremely forgiving if you forget to file on time. We’ve successfully gone back as far as three years to elect S status, but it’s not something I would routinely recommend.
The biggest benefit of being an S-corporation is that you will not have to pay Medicare taxes on distributions (the S-corporation’s term for “dividends”). I believe this benefit is hyper-inflated for professional practices, particularly for doctors. It is important to understand that distributions are paid from retained earnings and profits that remain in the business after paying market wages to the owners.
The general “red flag” rule of thumb for S-corporation owners is to pay distributions of no more than the salary of the owner(s), or a 50:50 split. With a medical practice, however, it can be difficult to justify excess profits generated beyond the efforts of the owner(s). Non-owner employees who contribute to the profitability of the practice and produce profits beyond their compensation (i.e. – generate income when you are not working), makes excess profits possible. Otherwise, if it’s just you, the RN, and the office manager and you don’t sell anything but care, I don’t see a lot of margin for distributions.
The disadvantages to operating as an S-corporation are:
- You are required to file annual federal and possibly state and local corporate tax returns. You will definitely need to pay a professional to prepare these forms.
- You’ll pay unemployment and be subject to payroll compliance and reporting. Even if you’re the only employee of your moonlighting job, the business will cut paychecks to you and you must receive a W2 at the end of the year and file all necessary tax returns during the year.
- You will need to set up an “Accountable Plan” to reimburse yourself if you have a home office. Not a deal breaker, but can be a bit of a headache to manage.
- Because of the “one class of stock” rule, you must pay “proportionate” distributions to every owner. In other words, if you have four equal shareholders, you must distribute the same amount to each, no matter their seniority, value to the business, etc.
- You will have to pay tax on any appreciated property removed from the business, even though you haven’t sold it. (Note that if the business sells the property, the resulting gain or loss will retain its character as capital or ordinary when passed through to you via your K1.)
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A few final points:
- If you are a shareholder in a multi-owner S-corporation, you should be aware of an important election under IRS section 1377 for mid-year ownership changes. Shareholders have two choices for reporting the year’s results when an owner leaves or comes on board. The default is to allocate results for the whole year proportionately on each K1. Otherwise, they can choose to file under section 1377 electing to treat the year as two parts of a whole and file two part-year income tax returns. In a high-profit practice, this can be significant. Let’s say, for example, that you leave a practice mid-year and profits double after you leave the practice. You will be taxed on a proportionate amount of those profits unless all shareholders agree to file a 1377 election. In all fairness, you should pay taxes only on the profits generated while you were a shareholder. Consider including a section 1377 requirement in your shareholder agreement.
- I have never been able to find reasonable justification for forming an LLC and then filing an S-election rather than just forming an S corporation to begin with. You will have no more liability protection and it’s just an extra step.
- File paperwork to incorporate or form an LLC before you start your business. Otherwise, you will not have liability protection for any transactions before your entity’s official start date and you will have to file a split-year tax return. It is always complicated when you file payroll tax returns with separate EINs (Employer Identification Numbers) for the same tax year.
Can you change from one entity to another? Absolutely. Review the steps with your CPA or financial planner in order to plan ahead for any tax or liability pitfalls.
I believe a PSC is rarely – if ever – appropriate for today’s professional practice. If you’re operating as a PSC “just because”, it might be time to get a second opinion on your options.
Regarding the limitations of the home office deductions for one that is taxed as an S-corporation, can you not use an Accountable Plan to reimburse the “employee” (yourself) for the costs associated with the home office use? I know you probably can’t depreciate that percentage of the house, but I was under the understanding that you could reimburse yourself the other expenses (utilities, prop taxes, insurance, etc).
Also, do you use a salary cutoff where being taxed as an S-corp tips the scale? For instance, at a salary of 250k, it doesn’t seem reasonable, but at a salary of 800k being able to take 400k of that as a distribution means saving about 15k at 3.8% (2.9 medicare + 0.9 medicare surtax). I feel the benefits of S-corp taxation are overstated as you allude to, but for certain high earners there are potential savings to be had.
I think, and we specialize in S corporations, that the math works better than you indicate here.
I’m pretty sure that WCI will think this is okay, but here’s a post to my current blog post about safe harbor S corporation salaries:
http://evergreensmallbusiness.com/safe-harbor-s-corporation-salaries/
I’m in trouble with some of my CPA friends for sharing these points, but as noted in the post you probably have more flexibility that you realize.
Three other quick, related points:
1. The last really relevant tax court case on this topic concerned a CPA name David Watson in a basically one employee S corporation. He tried to take $20K as salary and $220K as distribution. IRS said “no way.” But in end, court set the values as $90K salary and $140K. There’s more to this story than I can cover here. But those numbers should give some white coat professional who don’t believe an S corporation will work something to think about.
2. When you incorporate, some deductions like pensions and health insurance become deductions not just for income tax purposes but also for self-employment tax purposes. This can be a factor with high income shareholder-employees.
3. If you ever think you might have something you can sell (like a medical clinic or a dental practice), operating that business as an S corporation will let you avoid the 3.8% medicare tax on the sale. This can be a big number.
JM, Yes, you are correct about the accountable plan. It has been so long since I submitted this article that I had forgotten about including the accountable plan option. Thanks for catching that – I’ll update and submit change to Cindy.
We judge the merits of benefits of incorporating on a case-by-case basis. If you have an employee(s) and other revenue besides your main job (such as a web presence to promote something), you can easily make a case to pay a salary and distribute the rest. At $800k, yes, you could surely make a case for savings via distributions. For a doctor at $350k or under, I doubt the benefit would be there given the administrative costs. If you can justify at least $100k distributions in addition to paying yourself “market” salary for your specialty and area of the country, that’s a kind of rule of thumb. Note that CA charges a minimum $800 franchise fee annually (or 1.5% of profits) so you have to include that cost along with income and payroll tax prep fees. Other states vary, of course.
Great article.
One reason I find my clients avoid S-Corporations in favor of LLCs is to avoid corporate franchise taxes. This of course varies state to state, and profession to profession.
Regarding this comment, “I have never been able to find reasonable justification for forming an LLC and then filing an S-election rather than just forming an S corporation to begin with. You will have no more liability protection and it’s just an extra step.”…
Let me throw out a handful of features that sometimes people think do justify using an LLC as a platform…
1. In many western states, an LLC possibly does provide better legal protection to business owners than does a regular corporation. This is too big a topic for a blog comment, but someone interested in this feature can google on the phrase “charging orders.”
2. An LLC is probably easier to not screw up because the governance is easier… E.g., we sell DIY kits at my blog for both corps and LLCs and LLCs are considerably easier to govern in many states… Something that shows up when we compare the corporate bylaws document we provide with the regular corporation kits to the operating agreement we provide with the LLC kits.
3. An LLC is often easier to handle during its pre-S-corp phase. E.g., a single member LLC that hasn’t made an S election is treated as a disregarded entity which probably means a sole proprietorship. That’s often a reasonable and super-easy way to handle a sideline business if you’ve got a regular full-time gig. But if, later on, the LLC’s activities ramp up, the member can elect S status and have an S corporation.
4. An LLC can make an election at the end of its life to not be treated as S corporation or as a corporation and instead be treated as a disregarded entity. This provides for a simple, low-cost “wind-down” phase.
BTW, I don’t understand your comment that forming an “S Corp” LLC requires an extra step. It doesn’t really, does it?
With a corp, you file the articles of incorporation and then the 2553 form.
With an LLC, you file the articles of formation or organization and then the 2553 form.
These look to me like the same amount of work.
what is the difference between S and C corporation?
All corporations start out as “C” corporations. An S corporation is a C corporation that has filed an election on Form 8832 to be taxed as an S-corporation. C-corps pay taxes on the net profits of the corp. The only way for the shareholders to get $$ out is to pay salaries or dividends. All publicly-traded corps are “C” corps because S corps have limits in place to prevent unknown shareholders from owning stock (can have no more than 100 shareholder, shares can’t be owned by partnerships and some other entities, cannot have 2 classes of stock, and so forth).
Net profits of an S-corporation “flow through” (figuratively) to be taxed to the shareholders’ personal tax returns (form 1040) and are reported to the shareholders on forms K1. In most cases, shareholders are paid salaries and excess earnings are paid out as “distributions”, kind of like dividends. Net profits of an S-corporation are not taxed for Medicare, so a high earner can save taxes on the amount that the corporation earns in excess of the “fair” salaries paid to the owners.
Dividends paid by C corporations have already been taxed and are also taxable to the recipient, hence the term “double taxation”. Distributions paid by S-corporations have already been taxed and are, thus, not taxed again.
Thanks for the write up. However, I have a one member S-corp and you do not “definitely need to pay a professional to prepare these forms.” No state version of the 1120s is needed here. Turbotax business does just fine. I enjoy doing my own taxes like Dr. Dahle. I enjoy understanding every deduction and where every dollar goes. I pay myself a reasonable salary and then take distributions. I take appropriate business and max individual 401k deductions.
I do constant employed position with benefits vs s-corp analysis and contractor always wins out.
I don’t think an 1120S is a DIY project. For what that’s worth… And I see dozens of these DIY returns every year.
BTW, I also wouldn’t (personally) ever have an 1120S prepared by a tax practitioner who wasn’t doing a lot of these returns every year.
I don’t want to be snarky–the last time I did that here WCI assigned me a couple of blog posts as penance–but what medical or dental procedures would you as a patient ever comfortably task to someone who does the thing once or twice a year? Or even a dozen times a year?
Final comment: All that said, if the tax liability is low, I’d say DIY away… no reason to spend a dollar to get back a nickel.
I had a CPA look it over and found some minor errors and helped me complete the balance sheet portion. How much does your firm charge to review taxes already completed for any missed deductions or errors?
Also, have an unrelated question, not sure if you can answer it here relating to nexus and state income tax and telemedicine. I just started working out of state this year. I am solely doing telemedicine part of which is in a state that has income tax (mine does not). I do this from home. The clinic pays a third party, the locums company based in another state, which then pays my s-corp registered in my home state only. I am wondering if I can avoid paying the state income tax for that state and the repercussions of not doing so and waiting for nexus determination if it is an issue. This could be a questions for a tax attorney however.
We don’t review self-prepared returns as a service… so I can’t give you a price. Sorry if I implied that. (The returns I see are from people who’ve decided to stop the DIY approach.)
Regarding nexus, as a general rule, if you don’t enter another state, don’t have property there, and don’t employ people there, you don’t have nexus and so don’t need to worry.
Caution: The least little bit of property or work in a state probably does trigger nexus.
Any idea if telemedicine through a third party and then to my s-corporation consider work for nexus purposes? Any tax law attorneys you know I could consult with?
You working in, say, AZ for a hospital in CA over a broadband internet connection doesn’t create nexus.
But if you visit CA to “sell” the work or participate in some committee, that probably does.
BTW, a client of mine who works in WA but has a second home in CA had CA assert nexus because he mentioned he brought his company laptop to CA and paid 3 bills. That’s a harsh outcome. But totally in keeping with the law.
FYI I don’t think determining nexus and then (separate issue) doing the apportionment is a tax attorney thing. It’s what your CPA does when he or she does your return. Or what you need to do as the preparer if you’re taking a DIY approach.
Thanks for the answer. You must be psychic because the clinic is in Arizona! I’m here in Florida. I have never stepped foot in Arizona. Anyway, I assume if I don’t pay their tax based on my interpretation of nexus and they later determine I had nexus for some reasons the worst thing that can happen is a tax assessment with a penalty?
Alex, I respectfully disagree with you, but odds are that you will never have problems or be the subject of an audit, anyway. Basis calculations alone make preparing an S-corp return tricky. I’ve never received a self-prepared s-corp return that had these calculations done correctly. otoh, I’ll admit you may be the exception to the rule. It sounds to me as if you have a good grasp of the basics.
We review returns at no charge for prospective clients and at an hourly rate ($250/hr, minimum 1 hr) otherwise.
Nexus laws vary by state. You should research the specific laws in the state where you are doing telemedicine. In some states, NO physical presence is required for nexus. See http://bit.ly/1Y6cLaO. NY is particularly onerous. A CPA with experience in multi-state taxation would probably be more helpful than a tax attorney for state issues as a tax attorney typically works within the legal system of the state(s) where (s)he is licensed.
I agree with JFOX… but I guess I would. 🙂
There are some errors (unintentional I’m sure) in the comment from JFOX.
An S corp is really an entity that’s made an election to be treated using the rules of Subchapter S. Historically, only corporations made the Subchapter S or Sub S or S election. But other eligible entities can make the election. E.g., LLCs are eligible entities and can make the election. The entity makes the election using a 2553 form.
BTW as I hinted at above, I think that these days pretty much all S corps should be LLCs or similar entities
FWIW, and as JFOX describes, the practical advantage of the S election is that it causes your business income to get split into wages (which are subject to payroll taxes) and a distributive share (which is not subject to payroll taxes.)
The classic well-known S corp example was John Edwards the former US Senator and Presidential and VP candidate. His law firm earned him one year something like $26M but he split that into $250K of wages and basically $25M-ish of distributive share… thereby avoiding payroll taxes on roughly $25M of income.
Very nice article. Where does a professional association/corporation (PA) for into all of this? Any benefits over the others? I’m pretty naive on all of this just now coming out into practice.
In general, a professional (someone licensed by the state) can’t use a “regular” corporation or “regular” LLC for their business….
Instead, they need to use a professional corporation or a professional LLC. The professional thing is really a legal deal though and not a tax deal. I.e., a professional corporation and a professional LLC can be S corporations.
A professional association is not a legal entity except at the state level in a few states (TX, for example). In general, it is more often a nonprofit formed for a group of professionals for a specific purpose (furthering a worthy cause, for example). So, to answer your question, it really doesn’t figure in the decision of what entity to choose. As for benefits, they are covered in the article.