S Corporation, C Corporation, Or Both?
Choosing the form and structure of one’s medical practice is an important decision. Most advisors to medical practices believe that the avoidance of potential double taxation makes the S Corporation the logical choice. This “conventional wisdom” overlooks the potential benefits a C Corporation can offer. If you want to truly have your practice be an engine and explore ways to reduce unnecessary taxes and would like to see how you can do this without having to change any of your insurance provider or Medicare provider numbers, understanding this chapter is crucial.
The Tax Basics of Corporations
Per the last chapter, there is no reason to practice as a sole proprietorship or general partnership. This results in unnecessary lawsuit risk, in addition to the inability to take advantage of many valuable tax-deductible business expenses mentioned in this chapter.
In our analysis, we need to compare and contrast C Corporations and S Corporations (re¬member that PLLCs and PAs that are used in some states are also taxed as either an S or C corporation). All businesses that incorporate are automatically C Corporations, absent an election to become an S Corporation. Both S and C Corporations have separate tax ID numbers and are required to file tax returns with the federal and appropriate state tax agencies. Both entities have shareholders. Both entities can be created in any state in the country.
When a C Corporation earns profit, it must pay tax at the corporate level. Profit is the difference between income and expenses. Compensation paid to physicians, as long as it is reasonable, is deductible by the corporation on its tax return (and is therefore not taxable to the corporation). The salary received by the owner is taxable to the owner as wages. After the C Corporation pays taxes, distributions of earnings already taxed at the corporate level can be paid to the physician-owners in the form of dividends. These would generally be taxed to the physician-owners as qualified dividends, thus leading to the “double taxation” of such earnings. As you will see below, this drawback is often overrated.
An S Corporation is also a separate entity that must file its own tax return. However, the S Corporation is often referred to as a “pass through” entity. Rather than paying tax at the corporate level, all income and deductions pass through to the shareholders and the shareholders must pay tax on any S Corp income at their individual rates. Whether the income to an S Corp is paid to the physician-owners as salary or as a distribution will not impact the federal or state income tax rates that will be applied to that income for the physician. There is never any tax to the corporation, therefore there is no “double taxation” in an S Corporation.
Double Taxation—Much Ado About Nothing
Mistakenly, most physicians think of S and C Corporations as having exactly the same benefits. Since the C Corporation has a potential double taxation, most doctors and their advisors elect to form an S Corporation to avoid one more potential problem. First, the double taxation problem can be easily avoided by reducing practice profits to zero, or close to zero, at the end of the year. This is done by the thousands of medical practice C Corporations that exist today. Second, after you review the next sections you will see the increased benefits C Corporations offer medical practices, including the cost (in time, not money) of using and zeroing out a C Corporation far outweighing the benefits of an S Corporation.
Additional Deductible Benefits of a C Corporation
Contrary to much “conventional wisdom,” a C Corporation can be the right choice for many small entities because of the deductions it allows. The corporate deduction for fringe benefits paid to employees is generally limited for shareholders owning more than 2% of an S Corporation. However, a C Corporation enjoys a full deduction for the cost of employees’ (including owner employees) health insurance, group term life insurance of up to $50,000 per employee, and even long term care premiums without regard to age-based limitations. The C Corporation can also deduct the costs of a medical reimbursement plan. If one has a small corporation and a lot of medical expenses that aren’t covered by insurance, the corporation can establish a plan that results in all of those expenses being tax deductible. Fringe benefits such as employer provided vehicles and public transportation passes are also deductible.
In contrast, health insurance paid by an S Corporation for a more than 2% shareholder is not deductible by the corporation. The shareholder must generally take a self-employed health insurance deduction on his personal return. Long term care premiums paid through an S Corporation are also not deductible with regard to these shareholders. The shareholders, in deducting them personally, are subject to the age based limitations.
Digging Deeper on the Potential Benefits of a C Corporation (over an S)
Before some of the authors were educated on the potential benefits allowed for C corporations, we too often advised doctors to use S Corporations. However, when we realized that the potential tax benefits to many doctors can be hundreds of thousands of dollars over a career by using a C Corporation rather than an S, we changed our minds.
The two most financially significant benefits allowed for C corporations are the following:
1. Only C Corporations can offer Section 79 plans
As you will read in chapter 5-5, Group Term Life plans, also called “Section 79” plans for the tax code section that authorizes them, are only available to C Corporations. These plans can be utilized in addition to a qualified plan like pension, profit-sharing plan/401(k) or IRA. While the specifics of Section 79 plans are described more specifically in Chapter 5-5, it is important to note a few of the following important benefits:
· These plans can be utilized in addition to a qualified plan like a pension, profit-sharing plan/401(k) or IRA.
· The funds in these plans can grow in the top (+5) asset protection environment in most states and in a (+1) to (+3) environment in California.
· In a group practice, not every doctor need contribute the same amounts—this is extremely beneficial for group practices with doctors who want to “put away” differing amounts.
2. Only C Corporations Can Offer Doctors Full Deductibility for Long-Term Care Insurance
As you will see in chapter 7-4, long-term care insurance—a coverage vital to preventing your family’s forced “spend down” and loss of assets—can be deductible to a corporation. However, it is not deductible for an S corporation as to the 2%+ owners. This means that for 99% of medical practices, the insurance would not be deductible to the S corporation practice. Using the C corporation, however, such policies would be 100% deductible. As the total premiums on this type of insurance can be over $100,000 over ten years, the total tax saving could be $40,000 or more per doctor—typically, well worth the time of creating year-end bonuses.
Changing from an S to a C Corporation
If you are already operating as an S corporation and are interested in converting to a C, the good news is that it is extremely easy. A simple revocation of the S election can be made instantly for an S corporation. This can be done until March 15th for that calendar year and any time for the next calendar year.
Get the Best of Both Worlds—Why Not Use Both an S and a C?
If you are already using an S corporation and it is after March 15th and you do not want to wait until the following year for these benefits, you could consider what many practices have done—for this, and general asset protection reasons—that is, to create a 2nd entity as a non-medical management company.
In fact, many practices can take advantage of both the C Corporation and the S Corporation by setting up two distinct entities to operate different aspects of their practice. Perhaps the S Corporation will be used for the operating side of the practice (professional practice of medicine) while the C Corporation will be used for management functions (billing and administration). In this way, the practice as a whole can take advantage of both the tax deductions and benefits afforded a C Corporation and the “flow through” advantages of an S Corporation. See the diagram below. This may also provide some additional asset protection. As long as all formalities of incorporation are followed, as well as compliance with rules for employee participation in all benefit plans, medical practices can benefit from this “dual” corporate structure.
In this chapter, we pointed out that many Doctors may be using the wrong type of legal entity for their practice. If wealth creation and asset protection are priorities in the practice, a C corporation should be strongly considered—and the special benefits C corporations allow should be closely examined. For doctors using S corporations, it is easy to convert to a C Corporation, and to use a 2-entity structure as well. In the next chapter, we will explain other ways to use multiple entities for medical practice asset protection.
Continue to the Next Section