Entity matters

MGMA Connexion, Sep 2004 by Webster, Lee Ann H, Webster, Bruce C

Financial consequences of entity selection for the physician-owned practice

reader take-away

* Learn the various legal forms a medical practice can take

* Learn the tax implications for each legal entity

* Learn how basis issues can affect taxation of medical groups

* Compare the financial/tax aspects of various entities

C corporation? S corporation? Partnership? Sole proprietorship? Limited liability company? When a physician-owned medical practice selects a legal structure, it also opts for a set of tax attributes that can have a significant impact on operations and financial decision-making. Whether forming a new practice, contemplating a merger or simply dealing with the tax and operational issues of their current situation, practice executives and physician owners need to understand the tax and financial implications of the different entities.

Entity types

C corporation - Many businesses - including medical practices - incorporate because doing so protects the owners from personal liability for corporate obligations (excluding malpractice claims). C corporations pay tax on their net income at the corporate level. Most physician-owned practices are considered qualified personal service corporations, which pay a flat 35 percent income tax rate.

A qualified personal service corporation is any corporation in which substantially all of the activities involve performance of services in certain fields, including health, and substantially all of the stock is owned by current or retired employees, or the beneficiaries or estates of such employees. C corporation practices that are not qualified personal service corporations pay corporate income taxes according to a graduated rate, beginning at 15 percent on the first $50,000 of taxable income.

S corporation - An S corporation is the corporate version of a "pass-through" entity, which does not generally pay income taxes. Instead, the owners include their share of the entity's taxable income on their personal tax returns and pay the related taxes. An S corporation may have no more than 75 shareholders who can only be individuals, estates, qualifying trusts or certain other qualifying shareholders.

Sole proprietor - A physician practicing alone who chooses not to incorporate would generally be a sole proprietor. (Some states do allow single-member limited liability companies.) A sole proprietor reports practice income and expenses on his/her individual tax return and pays the related taxes - including Social Security and Medicare - at applicable individual rates.

Partnership - Multiple physicians practicing together who do not incorporate or form a limited liability entity operate a partnership. It is advisable to have a written partnership agreement that defines how income, gains, losses, deductions and credits are allocated among the physician-owners who report these amounts on their individual income tax returns and pay the related taxes, including Social Security and Medicare, at their applicable individual rates. State laws generally hold the partners jointly liable for partnership obligations.

Limited liability entities - Limited liability companies (LLCs) and limited liability partnerships (LLPs) are business entities that offer liability protection to their owners similar to that of corporations, but LLCs and LLPs are treated as partnerships for tax purposes. Governance for these entities varies according to the state laws under which they are created.

The issues

Double taxation - A C corporation pays tax on its net income after all deductions, including physician salaries. When a C corporation has accumulated previously taxed net income ("earnings and profits") and pays a dividend, that dividend is also taxable to the shareholder - resulting in double taxation. For most physician-owned medical practices, this is not an issue, because they usually pay out all or most of their profits in the form of physician compensation. Double taxation could arise if the corporation has nonemployee shareholders who desire a cash payment as a return on their investment or in practices with potential unreasonable compensation issues, as discussed below.

Double taxation can also occur when a C corporation liquidates. Both the corporation and the shareholders pay income tax on the gain from the sale or distribution of corporate assets. Many physicians put real estate, such as the clinic building and related land, in another entity, such as a partnership, to avoid this problem. Owners contemplating the liquidation of a C corporation need to evaluate the treatment of accounts receivable (A/R) and possibly pay their subsequent collection as compensation to avoid double taxation.

The pass-through entities (S corporations, partnerships, sole proprietorships and limited liability entities) are generally not subject to double taxation. An exception exists for S corporations with "built-in gains" or excessive passive income. Built-in gains are the unrealized gains on assets that a C corporation has at the time it elects S corporation status. The S corporation pays a corporate-level tax when and if these gains are realized during the 10-year period following the conversion.