Your Money: Are You Over-Taxed?

April 1, 2006

Are you paying a tax you don't have to? Better find out - it might be costing you thousands each year.


Are you the owner of a medical practice taxed as a "flow-through entity," such as an S-corporation?

Most physicians we speak to who are partners in their practices are in this situation. As such, they are paid both as an employee of the practice - as one who would fill out a standard W-2 - and as an owner of the practice - as an S-corporation owner through a K-1 distribution. The key difference is that you pay Medicare and Social Security tax on W-2 income, but not on K-1 distributions.

While the large Social Security portion of FICA phases out after you reach an income of $90,000, the 2.9 percent Medicare tax has no phase-out.With a high enough income, 2.9 percent can add up to a great deal of money. We have seen physicians lose $10,000 or more each year because of this. For no good reason!

ARE YOU IN THIS BOAT?

Let's look at two examples:

  • Dr. Smith is part of a three-physician cardiology practice. He earns about $400,000 annually. He calls the two other doctors his "partners," but technically they are co-owners of the practice, which is an S-corporation. Each month, Dr. Smith receives $20,000 in income. Then at the end of each six-month period, he gets another $80,000 or so based on his practice's performance. His accountant deems both the monthly and semiannual payments as salary payments. Thus, Dr. Smith pays Medicare tax on all $400,000 of his income, totaling $11,600 in taxes. If he works for 25 years earning the same amount, Dr. Smith will have paid more than $550,000 in Medicare taxes, assuming a 5 percent growth rate.

  • At the practice down the street, Dr. Jones is in the exact same economic situation. However, her accountant treats her monthly payments as W-2 wages and her semiannual payments as K-1 distributions. Thus, Dr. Jones pays Medicare taxes based on $240,000 in income, totaling $6,960 in taxes. Her 25-year savings compared with Dr. Smith, assuming the same 5 percent growth rate, is $220,000.

Wouldn't you prefer to be in Dr. Jones' situation? Of course you would, provided her accountant's actions are legal. Which tax rules govern this specific situation?

The consensus among the experienced accountants with whom I spoke is that one should follow a simple rule of thumb. Basically, you should characterize as W-2 income the portion of your total compensation that is roughly equal to what you would pay an incoming young associate physician with your same training. The rest can be accounted as K-1 distributions.

One accountant who has been practicing for more than 20 years explains, "When the issue has been discussed in audits over the years, the IRS finds it very difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job."

Looking again at the examples above, Dr. Smith could easily attract a young cardiologist to his practice with a salary of $250,000. This would allow him to avoid the FICA tax on $150,000 of his income - saving him more than $4,000 annually. Dr. Jones is already in the right situation.

As hard as you work, throwing away hundreds of thousands of dollars over the course of your career - for no good reason - is a shame. Yet it happens every day.

David B. Mandell, JD, MBA is an attorney, lecturer, and author of the book, Wealth Protection: Build and Preserve Your Financial Fortress. He is also a cofounder of The Wealth Protection Alliance, a network of financial advisory firms whose goal is to help clients build and preserve their wealth. Sandy Stokes, III, CPA, MBA, has been serving the financial needs of physicians for more than 20 years, and he is a charter member of the Wealth Protection Alliance. Both David and Sandy can be reached at 800 554 7233, or via editor@phyisicianspractice.com.

This article originally appeared in the April 2006 issue of Physicians Practice.