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A brief overview of options to choose from.
Last March around “Match Day,” I was chatting with an excited young physician who had completed his residency and had an opportunity to join an established physician as an independent contractor. We spoke about the Match Day relief he and fellow future physicians experienced as they learned where they had landed to spend the next three years or more in their specialty of choice. All the hard work through medical school and a grueling residency had paid off, and the enthusiastic young man was about to start his career as a physician. During the conversation, one big question came up. He was working as an independent contractor, so how best could he position himself? Should he establish his own LLC or remain in Schedule C? It was very confusing to him when he tried to research the various options, particularly as his friends were giving him their own ideas, some of which weren’t even applicable to his situation.
This wasn’t a unique quandary for him to find himself in; it’s not uncommon for physicians who are setting up their own practices to be confused by the decisions and processes involved. There are several types of corporations that might be best suited to a practice, and it’s best to understand what each would mean to a particular business model, including what needs to be taken into consideration when making the choice to establish one over another.
Operating as a sole proprietorship exposes the owner to a great deal of liability, as the owner takes on the business liabilities at a personal level, putting personal finances at risk. Establishing a corporation protects the owner from the personal liability, but what makes each corporation structure unique?
First, let’s talk about LLCs.
An LLC, or Limited Liability Corporation, is a simpler type of corporation that provides several benefits to its members, which could be one owner, several partners, or a group of businesses. The fees to start up an LLC are relatively low, and the required paperwork is not overwhelming. This corporation offers the main benefit of protecting the members’ personal assets against business liabilities. There is also a pass-through of profits, meaning the government doesn’t tax at the corporate level, but the profits are taxed as members’ income. While this may not seem important, it’s considerably easier to file on personal returns than the great amount of paperwork needed for company filings, and should the business take a loss, it can be claimed on member tax returns to lower the tax burden. On the downside, because the profits are passed through to members, members are also responsible for paying self-employment taxes, which are Medicare and Social Security taxes, personally based on the business’ total net earnings, which often yields a very high rate. Also, members cannot be considered employees, and should a member leave, the LLC is immediately dissolved.
As LLCs are governed by states, there are some states that do not allow the formation of an LLC for certain licensed professionals. In those states, professionals must open a PLLC, or Professional Limited Liability Corporations. The PLLC is very similar to the LLC in terms of risk protection and taxation; however, there are rules regarding who can be an owner of the business. State regulations differ between whether all owners must be licensed professionals, or if a certain number must be licensed. Malpractice suits can still be brought against members of the PLLC, but this organizational set up does limit liability to other members from malpractice suits brought against one member.
To avoid the taxation issues inherent in the LLC model, an S Corporation may be a better solution. For small businesses with fewer than 100 employees, the S Corporation is a tax status that sets up the business to no longer count as self-employment, meaning that profit is taxed at the business level rather than the personal. When incorporated as an S-Corp, a business must pay employees a reasonable salary, but any leftover profits are not subject to self-employment taxes as they are in an LLC which can mean a huge tax savings. This also could allow for a portion of profits to be taken as W-2 income, and then some taken as a distribution; there would be no Medicare tax on the amount taken as a distribution. There are also tax savings involved in having the business pay for health insurance coverage, as well as retirement planning options. In addition to the personal asset protection of incorporating, establishing an S-Corp also allows for more flexibility in the continuance of the business. An S-Corp can exist after the death of the owner, and it’s easier to transfer ownership of the S-Corp than with some other types of business models.
Rather than a tax status, a C Corporation is an actual legal entity created to create limited liability for a business and keep profits within a business. However, there are two levels of income taxation, on both the corporate and personal level, and it has a more complex set up and maintenance, with a required annual board meeting and complicated establishment fees. This organization truly only makes sense for a large corporation with many shareholders because of the double taxation and the complexity of the administration, which often requires the ongoing assistance of a professional.
Unfortunately, there’s no single answer to this question. As an example, consider a young physician about to make $800,000 on his 1099. If he had an LLC, he would have paid about 3.5% in Medicare taxes on the full $800,000. However, if he established his business as an S-Corp, he could have taken a salary of $250,000 (which is the prevailing wage for his line of work) and then the rest as a K1 distribution. By taking this distribution, he would have saved about $19,250 in Medicare taxes (3.5% of $550,000), a substantial sum.
However, if the physician’s income was only $100,000, either an LLC or sole proprietorship might have been better options. He would have saved on the higher set up cost and annual tax filing costs associated with corporations.
It can also be important to pay attention to state PTE (Pass Through Entity) tax law. For example, New Jersey recently adopted the NJ Bait Tax Law, which enables an individual to pay their state income tax from the corporation and take the deduction. While S-Corps will benefit from this legal change, single member LLCs may not qualify under this law.
With so many variables, it’s best for physicians with plans to incorporate to speak with an experienced financial advisor who will take into account the various aspects of their growing business, from the company structure to the income amount to the potential tax savings available. Through a careful analysis of costs and benefits of each structure, a financial advisor can guide a business owner to make an informed decision on the way to incorporate that will best serve the success of their business.