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C corp, S corp, PLLC … SOS!

How you structure your practice on the front end has a far-reaching impact on revenue streams and tax liability for years to come. For this reason, it's vital that physicians carefully consider the various options and resulting implications before hanging out a shingle.

Lucy R. Carter and Sara S. Lankford, principals in Carter Lankford, CPAs, PC, place a heavy emphasis on healthcare accounting in their Nashville-based firm. The two CPAs said the issue of practice structure is one that continues to confuse and confound clients as they wade through the pros and cons of each organizational option.

"It used to be that if a physician wanted liability protection, their only practical option was a professional corporation … a C corp," explained Carter. However, she continued, changes in legislation have enhanced and afforded other options, including forming S corporations, limited liability companies (LLCs) and professional limited liability companies (PLLCs).

While there are certainly similarities between all the options, each also has its own distinct list of advantages and disadvantages.

"An S corp really operates just like a C corp with one major exception," Carter noted. "Whatever income or loss there is at the end of the year (after expenses and physician compensation) generally flows through to the individual physician-owners."

This may translate into a federal tax benefit. If set up as a C corp, the company would have paid a flat rate of 35 percent on any profit left in the corporation at the end of the year; and if the previously taxed profit was disbursed among physician-owners in subsequent years, each would have paid individual income tax, too. With the S corp, any profit (after expenses and physician compensation) passes through to the individual partners who are still required to pay personal taxes, but the federal corporate tax is eliminated.
"The big advantage is you don't have double taxation," Carter said.

However, she continued, keeping profits in an S corporation may not be the best alternative depending on state tax laws. For this reason, Carter and Lankford stressed that it is important to consult a tax expert in your area before making a final decision on structuring a practice.

It is also important to note that tax benefits that exist when a company sets up as an S corporation are not necessarily there when converting from a C corp to an S corp.

"People think, 'I'm doing a great thing by moving to an S corp because I don't have to worry about leaving profit in at the end of the year,'" Carter said. However, she continued, companies that convert may be liable for a built in gains tax (corporate level tax) for 10 years after the switch is made.

"Starting out as an S corp is great. Starting out as a C corp and moving to an S corp can be difficult," she said.

Other popular options that limit personal liability are LLCs and PLLCs. Each of these forms of business is a bit of a hybrid between partnerships and corporations (taxed as a partnership for federal income tax purposes while providing limited liability similar to a corporation). Lankford said the selling point to these forms of partnerships is that they afford the liability protection and are supposed to be much easier to administer.

"In fact, that's not necessarily true," she cautioned. "Partnership taxation is probably more difficult than corporate taxation. You really have to have strong accounting in place when you have a professional limited liability company."
"If," Lankford continued, "you are a single member, it's probably the best thing to do. One of the attractive things about a single member LLC is that they don't have to file a separate federal (partnership) return. They just file the information on their personal 1040."

Every state in the nation has now adopted an LLC law, and each state imposes differing taxes and fees. It is important to determine the applicable state tax cost when evaluating and adopting the LLC structure.

One benefit of the LLC is that expenses and income can be allocated any way the company wants, as opposed to an S corp where corporate net income must be allocated based on ownership percentages.

The downside to that, Lankford noted, is that one physician's expenses may cause him or her to wind up with a negative in their capital account … a hard concept to explain. Conversely, if all expenses are shared equally, other doctors may feel they have been slighted.

"The other downside to an LLC is the members are not employees so they don't get a paycheck. Instead, they get draws and have to make estimated tax payments," Lankford explained, adding that each partner always has to pay the full share of employment taxes (Social Security) because they are not an "employee" of the corporation.

"The problem is the first estimated payment is due on April 15," Carter said of the unfortunate timing. "If they get behind, they never seem to catch up." When that happens, the LLC partner is forced to pay a larger sum come federal tax deadline time … also April 15 … and the whole cycle begins again. Additionally, Carter pointed out, if physicians don't make their estimated tax payments throughout the year, they are in danger of being charged with penalties on top of the outstanding balance.

Far and away, the two most popular structuring options today are to form an S corp or LLC. For many, a 2001 United States Tax Court ruling against Pediatric Surgical Associates in Fort Worth, Texas was the death knell for the C corp. In that case, physician-owners were taking profits generated by employee physicians. The court ruled that the portion of their income from this source was unreasonable and was reclassified as a dividend, which made it nondeductible at the corporate level. Lankford said the end result was that the physicians involved wound up having to pay the 35 percent corporate tax rate in addition to personal taxes on the dividend amount.

"That opened up a Pandora's box about what doctors could and could not do as far as assigning income based on anything other than revenue generated from their personal service," she explained. "That opened the door to LLCs and S corps since they are a pass-through entity so you don't have the dividend issue."
When asked which business format they preferred, both Carter and Lankford said they lean toward the S corp. However, Lankford paused before answering.

"The reason I hesitated is the IRS has not been actively auditing for the last five or six years," she said. However, she added, they have recently hired many new auditors and will begin activities again this summer … S corporations are at the top of their list for audits.

One reason S corps are being targeted is because of the potential for abuse when it comes to passing out distributions from the corporation, explained Carter. Income passed out of an S corp is not subject to self-employment taxes so in some cases physicians were claiming profits as "dividends" rather than "compensation" to avoid those taxes. However, the dividend distributions are still subject to federal tax … so in many states, such as Tennessee, where the dividend distributions do not reduce the excise tax burden, Carter said it would be "tax stupid" to abuse the system.

Both CPAs stressed that before deciding which business form a practice should take, it's essential that physician partners engage in a little due diligence. Lankford said clarifying how the group wants to assign expenses, allocate compensation, add additional physicians and buy out partners on the front end would help avoid complications down the line.



April 2007

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