Finances

How the Corporate Entity You Choose for Your Practice Impacts What You Pay in Taxes

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Why your net profitability depends partly on your corporate entity.

By Adam Cmejla, CFP®

March 20, 2024

A key benefit of practice ownership is that it allows doctors to be authors, rather than storytellers, of their financials. That is to say that a practice owner is much more in control of how, when, and on which tax form, their income is reported.

Each tax form has its own purpose and contains its own formula: the sum, difference, product, or quotient, of that formula directly or indirectly influences the tax that you’ll pay on the income that you generate as a practice owner.

Keeping to the author versus storyteller theme, a practice owner must first decide: which piece of paper (tax form) do you want to use to start writing your practice’s financial story? The answer is predicated upon both the practice’s entity and tax election. These two questions—entity and tax election—are two mutually exclusive questions to answer when determining the corporate and tax structure of your practice, and thus beginning the quantitative narrative of your practice, and ultimately, how much you pay–or save–in taxes.

Understanding the Relationship Between Entity Type and Taxation Status

Before delving into a brief case study, let’s clarify the different types of corporate entities available along with benefits and drawbacks for each:

  1. Sole Proprietorship: The biggest advantage of a sole proprietorship is that it’s the simplest form of entity selection and tax filing. The practice is not a separate legal entity from the owner. While this offers ease of setup and operation, it also means personal liability for business debts and obligations. Another key disadvantage from a taxation point of view is the inability for the practice owner to control how their income is taxed. Because an OD who is self-employed through a sole proprietorship cannot pay themselves a wage/issue themselves a W-2, the remaining income of the practice owner after all expenses have been paid will be realized as self-employment income, subjected to self-employment taxes.

Reasons to establish as an SP

  • Ease of financial reporting.
  • No payroll requirements if you don’t have employees.
  • Lower initial costs: fewer legal fees, no need to file separate business tax return and typically less need for complex accounting services.
  • Ease of discontinuing the business: If a sole proprietor decides to cease operations, the process is much simpler than dissolving a partnership, corporation or LLC. There are fewer legal and financial requirements to meet, making it less cumbersome to close the business.
  • (Important Side Note): For some states, it’s actually more tax-advantageous to file as a sole proprietor rather than as an S-corp. New Hampshire is one of these states, as N.H. does not “recognize” subchapter-S corporations, therefore taxing them as a C-corp (more on the differences between those two below). This is one example of many of why it’s important to work with qualified, experienced professionals who can help discern these rules on your behalf.
  1. Partnership: In a partnership, two or more individuals share ownership. You cannot have a partnership with only one owner. Similar to sole proprietorships in terms of tax simplicity, they also involve shared liability. In a partnership, partners are also not able to pay themselves via W-2 wages, but rather, take “guaranteed payments” from the partnership and documented on Schedule K-1 (Form 1065) instead of on a W-2. These payments are taxed similarly to W-2 wages and self-employment income in a sole proprietorship in that they are also subjected to FICA taxes (Social Security and Medicare taxes). However, unlike a sole proprietorship, partners have more control over how that income is taxed based on which box of the K-1 the income is allocated.

Reasons to establish as a partnership

  • You have more than one owner.
  • State-level tax considerations: As mentioned above, some states do not recognize the pass-through nature of S-Corporations, or impose additional taxes or fees on them, which could influence the choice of entity.
  • Flexible profit-sharing arrangements: Partnerships allow for flexibility in how profits and losses are allocated among the partners, which can be tailored to suit the contributions and agreement of the partners. In an S-corporation (more on that below), profits and losses must be distributed according to the percentage of ownership or number of shares held.
  1. Corporation (C-corp): A corporation is a separate legal entity, offering liability protection, but with potentially higher tax rates and more complex regulations. The corporation itself also files its own tax returns and keeps its own set of financial records, which are critical for ensuring accurate reporting of revenues, costs and income of the corporation. Any profits from a corporation will be subjected to a corporate tax, which in 2024, is a flat 21 percent on all profits of the corporation. Should the practice owner want to take a distribution of profits, distributions from a C-corporation are classified as dividend income and will face another tax on the owner/shareholder’s personal return. This is how C-corps get affiliated with the dreaded-but-accurate “double tax” label.

Reasons to establish as a C-Corp

  • You plan to reinvest heavily in the business for acquisitions and scaling. While C-corporations are subject to double taxation (once at the corporate level and again on dividends to shareholders), they can benefit from retaining earnings within the company for reinvestment. The corporate tax rate may be lower than the individual tax rate for high-income earners, making it advantageous for companies that want to keep profits from the practice in the business to reinvest into future projects and never actually draw them out of the business.
  • You plan to raise capital and dilute ownership, but want to have different share classes. This ability to issue various classes of stock can attract investors, including venture capitalists and angel investors, who often prefer the C-corporation structure for its familiarity and investment potential. This is admittedly a rarity for optometry practices, but in some situations it could be attractive.
  • You want to have more than 100 possible shareholders. It is designed to support extensive growth, allowing for a potentially unlimited number of shareholders and making it easier to attract investment at various stages of business development. Again, not likely for optometric practice owners, but it could be viable for additional businesses that optometrists may be involved in as investors themselves.
  1. S Corporation (S-Corp): An S-corp combines some advantages of partnerships and corporations. It offers liability protection, and profits/losses are passed through to shareholders’ personal tax returns, avoiding double taxation. The practice entity itself can be set up as a subchapter S-corporation, and therefore, will also be taxed as an S-corp. In an S-corporation, the owner(s) MUST pay themselves a reasonable wage for the work that they do IN the practice, and the profits of the practice are passed through to the shareholder(s) as income and reported on Form K-1. Not paying yourself a reasonable wage is one of the surefire ways to fall under scrutiny of the IRS.

Reasons to establish as a S-Corp

  • You plan to harvest the profits of the practice out of the business on an annual basis and you want to avoid double taxation, thereby having the profits “flow through” to your personal tax return.
  • You’re not concerned with having different share classes of stock—all stock is treated the same for voting purposes.
  • You want more flexibility in controlling how much in W-2 wage income you pay yourself, thus controlling how much in FICA taxes you and your business will pay.
  1. Limited Liability Company (LLC): One of the most common misconceptions around establishing your practice as an LLC is that your entity selection determines your tax status. When we’ll ask practice owners how their practice income is taxed, they’ll say “As an LLC.” This response would be the correct answer if I asked them, “What entity selection did you make when you established ownership of your practice?” But, unfortunately, it doesn’t answer the question about how the practice is taxed.

Reasons to establish as an LLC

An LLC offers liability protection and tax flexibility, as it can be taxed as a sole proprietorship, partnership or corporation, depending on elections made (with the included benefits I listed above). This flexibility makes it an attractive setup for practice owners. In addition to having the flexibility to elect your taxation status at the genesis of your business, you can also change the tax election of your LLC by filing Form 2553 (if electing S-corp tax status) or Form 8832 (if electing C-corp status) by March 15 of the year in which you want to make the election change.

A Practice Owner Case Study

Let’s take the example of a practice owner who has unknowingly and successfully operated their practice as a single-member LLC, but has elected to be taxed as a sole proprietor for years. Let’s also assume that the total amount of income they take home from the practice is $350,000 annually. As a sole proprietor, we would observe this income that the practice “paid” them by observing Line 31 on the Schedule C.

Assuming this practice owner is married and files their tax return as MFJ (Married Filing Jointly), here’s how their taxes would be broken down:

Federal:$64,152

FICA (Social Security & Medicare): $30,138

Total: $94,290 or 26.94% total effective tax rate

Now, let’s assume this practice owner is (a) in a state that recognizes an S-corp and (b) is reading this early enough in the year that they’re able to change their tax election status for the ensuing year.

Here’s how the tax break-down shakes out with an LLC electing S-corp tax status in which our OD pays themselves a reasonable wage of $130,000 for the work they do in the practice as a clinical OD and takes the difference as a distribution of profits from the practice:

Federal: unchanged

FICA: $18,368.42

Total: $82,520 or 23.58%

Total tax savings: $11,770

You’ll note that the tax savings are in FICA taxes. This is because profit distributions from an S-corporation are not subjected to FICA taxes.

Conclusion: Your Business Entity Noticeably Impacts Your Net Income

As we can see, the tax form you choose to report your business income can have a noticeable difference on our net income. Does it mean you’ll likely have a higher tax prep bill because of having to file an S-corp tax return? Yes, it does. But this is one of many areas where we’ve seen ODs be myopic when it comes to running their business: they focus on the short-term costs rather than the long-term benefit.

It’s important to know all the options that exist and make an educated and informed decision to help you keep as much of the income your practice generates as possible.

Adam Cmejla, a certified financial plannerAdam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM and Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For many free resources, visit the Learning Center at https://integratedpwm.com/ and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.

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