404-662-3318
Tax Structure
How doctors should select the right legal entity for their medical practice – LLC, partnership, S corp sole proprietorship.
Basic Rules to understand as a medical practice owner
- You pay taxes on earnings, not on distributions (aka dividends).
- For taxable income, defer revenue, and accelerate expenses.
- Avoid paying taxes, but don’t evade paying taxes.
- Healthcare compliance must be considered.
The tax code is a mystery to most people even though everyone is subject to its laws. However, you don’t have to understand the tax code to understand basic tax issues. It continues to amaze me how confused most medical practice doctors/owners are when it comes to tax issues.
I’ve seenall kinds of responses to tax issues. I’ve seen the head-in-the-sand approach, in which the doctors ignore tax issues; I’ve seen the opposite, in which every step the practice makes is governed by the potential tax consequences; and I’ve seen everything in between. The most common thread I’ve noticed is this: Doctors that own medical practices don’t take the time to understand the basic concepts. The critical issue surrounding businesses and taxes comes not in the planning or execution of a tax strategy. The missing link for most is an understanding of the critical tax concepts. It’s my argument that if you understand the key tax concepts, you make smart tax-planning decisions and avoid a lot of headaches—not to mention penalties.
To start us off, let’s look for a moment at three tax truisms:
- There is no such thing as an LLC tax return.
- You can take zero distributions and still pay tax on $100,000, or you could take $100,000 in cash distributions and pay no tax.
- Your real goal is to generate as much cash as you can with as little profit as possible, with a loss being the best answer.
If that list makes complete sense to you, you know more than most doctors when it comes to your income tax issues. If you’re confused, you have lots of company. Below, I will review the three basic tax concepts embedded in that bulleted list: entity classification, book income versus tax income, and distributions versus taxable income.
If you understand these three concepts, all other tax issues will make sense to you. You will also more clearly understand what you (and most business owners) have been doing wrong for years.
Entity Classification: How and Why
The driving force behind deciding what entity you should form should not be tax. You should focus on the business model first. I break out this process into three tiers: the business model, the tax structure, and the accounting.
Tier I: The Business Model. The model defines how you go to go to market as a physical owned medical practice, what you services you provide no matter your specialty. If you are a podiatrist, chiropractor, psychiatrist, or MD, and how you will profit from it. The model should always be the determining factor in how you structure your business, what legal entity you should form, and where you are located. Tax issues are secondary. Always.
Tier II: The Tax Structure. This is where a lot of businesses get into trouble. The first person Doctors generally talk to about how to set up or expand their practice is a CPA, and CPAs think like CPAs (naturally). They worry about tax liability and how to reduce it. They do not worry so much about the practice itself and how to make a profit. They will generally ignore tier I issues or tell you that the tax issues are more important than your business model.
A basic medical practice structure (Not a super-group) is generally set up on the basis of tax liability rather than the business model. The first consideration should always be: what is the best way to conduct business in a compliant manner? where should you have the physical location? How many employees should you have, nurse practitioners, medical assistants, or Physician’s assistant? Outsource your billing? How will you handle calls? What insurance should you take? Once you have the business model figured out, then you look at the tax issue to see how you can minimize your tax liability without affecting your business model.
You must be careful to set up a practice based on the business model rather than on tax structure. I have seen medical practices that are poorly set up because the owners worried about taxes more than the actual business model. I also never recommend a tax plan or structure for practices with greater than $10 million in revenue, projecting more than three years out. Tax collectors will tell you something different, but the larger the practice, the more dynamic it is—and tax structures are definitely not dynamic. I find them very constraining. Letting the taxes plan your future might cut you off from some otherwise positive decisions. In this situation, healthcare compliance should drive your business model and your structure.
Another good example is when a medical practice incorporates two separate entities because of some perceived tax advantage. Some practices have a different corporation if they have multiple doctors office locations. This just doubles the efforts for keeping track of many back-office duties. Remember that the only time a complicated tax structure is beneficial is when you are making lots of money, not when you just think you will.
Tier III: The Accounting. No matter what structure you form for your practice, you still have to account for it. If you have two legal entities, you have two sets of books and two tax returns to file—twice the work. The general ledger (GL) is where you actually capture and record the daily activity of the business model. This is important to understand because you might come up with some kind of tax scheme that sounds great and does not really affect your business model but is very difficult to account for. I hear radio commercials for companies that will create an LLC for you. They have a person raving about how he has seven LLCs and how easy they were to create. That might be true, but who wants seven bank accounts, seven GLs, seven tax ID numbers, and, worst of all, seven tax returns that need to be filed, with six times the chance of being audited? Sounds like more work than I’d take on for no good reason. Let the business model dictate the need for more than one practice entity. Tax purposes alone are not a good reason.
Which Legal Entity is best for my medical practice?
| LEAGAL ENTITIES Important tax issues |
Partnership | Corporation | S corporation | Sole Proprientorship |
Distribution percentage
|
 |
 |
|
N/A |
Reqired to pay
|
|
|
|
|
Ownership % Profit %, and Loss %
|
|
|
|
N/A |
Subject to double
|
|
|
|
|
Please note we do not address healthcare compliance issues here. Information is for a single or multiple location medical practice and does not consider surgery centers, Pathology, pharmacy or other healthcare legal issues owned by the same group. If you wish to discuss super-group or ancillary services, please call us at 678-800-1005.
When it comes to forming an entity, you have many options: the standard corporation tax return, the S corporation return, the partnership return, or just your 1040 with an extra schedule (Schedule C) are the most popular and most used.
The entities have many differences, and there are reasons for selecting one entity over another. Following are the basic differences:
Can’t I Just Be an LLC?
There is no such thing as a limited liability company (LLC) tax return. An LLC is a legal entity invented by the state, not the federal government. The protections afforded by the LLC are generally the same as those for a corporation but without all the requirements. If you have a corporation, S corp or not, there are certain duties you must perform every year to keep liability protection in place. Most business owners, large and small, do not perform these duties.
The main reason you incorporate your medical practice is to create a separate entity that will shield the Doctors/owners from liability. However, if these corporate duties are not performed, the entities afford their owners and shareholders no protection. This means the shareholders are liable for the actions and debts of the corporation. In legal jargon, it is called “piercing the veil” or “disregarding the corporate entity.” Generally, in a court of law, anyone suing the corporation for such things as breach of contract, failure to pay a debt, or some kind of medical malpractice lawsuit could try to prove that the doctor/owner or shareholders did not operate the medical practice as a corporation and could sue the shareholders as well. It is fairly easy to prove that the shareholders did not treat the business like a corporation. Many medical practices that are incorporated operate with a false sense of protection from liability.
What are these duties or actions that pierce the veil? The following are a few:
- There is no such thing as an LLC tax return.
- You can take zero distributions and still pay tax on $100,000, or you could take $100,000 in cash distributions and pay no tax.
- Your real goal is to generate as much cash as you can with as little profit as possible, with a loss being the best answer.
Any of these issues could be enough for a court to disregard the protection of the corporation. Why not? If you did not treat the business like a corporation, why should the court? The LLC does not have as many restrictions, and it is much harder to pierce the veil. It was created in the late 1970s in Wyoming. We have the oil companies to thank for its creation.
LLCs didn’t really catch on with other states until the IRS issued a ruling stating that you could have an LLC and still avoid double taxation.
Book Income versus Tax Income
Every medical practice has a profit or a loss, and every practice has a taxable income or a tax loss. The two numbers can be similar or very different. It is possible and desirable to have income on the income statement generated from your accountant (called “book income”) and a loss on the income statement generated from your tax accountant (called “tax loss”). The rules are different. There is no mystery. The rules for accounting are different from the rules for taxes. By their very nature they have to be. Accounting rules are created by business-minded people, while tax rules are created by politicians and self-interested lobbyists. If you are confused about how you can have a book profit and a tax loss, think about who is making up the rules.
To understand it, consider this example of the many differences that exist between book income and tax income. The government will allow you to deduct only up to half of what your doctor’s practice spends on meals and entertainment. When you look at the example below, notice that the CFO will have a book income of $100; he or she does not care about tax rules. The money was spent, it was an expense, and it should be reflected in the income statement. Your tax accountant has a different set of rules. Even though the money was spent, he or she will come up with a taxable income of $125.
| BOOK INCOME VERSUS TAX INCOME | Book | Tax |
Net Income before meals and entertainment |
&150 | &150 |
Meals and entertainment |
(150) | (25) |
Book income |
&100 | &125 |
The most common differences in book income and tax income are seen when considering issues of depreciation, meals and entertainment, deferred revenue, bad debt expense, and balance sheet reserves. There are fewer differences if you pay taxes on a cash basis rather than an accrual basis, but there are still some. Tax accountants call these differences M-1s. They get the name because that is the line number on the tax return where they go: line M-1. You can now see where your goal as a medical practice business owner is to have book income as high as possible and tax income as low as possible. This is where a good tax accountant can be very valuable: not when it comes time to prepare your return but before. The person who just bangs out your tax return is providing a commodity service, telling the score after the game is over. A good tax planner is like a coach. You want his or her help before and during the game. It is too late after the end of the year to do tax planning.
Distributions (aka Dividends) versus Taxable Income
Many doctors owners or shareholders don’t know what they actually pay tax on. S corporations, partnerships, and sole proprietorships don’t pay tax at the entity level. What about the LLC? There is no such thing as an LLC tax return. If this is confusing, reread the first part on this page.statement generated from your tax accountant (called “tax loss”). The rules are different. There is no mystery. The rules for accounting are different from the rules for taxes. By their very nature they have to be. Accounting rules are created by business-minded people, while tax rules are created by politicians and self-interested lobbyists. If you are confused about how you can have a book profit and a tax loss, think about who is making up the rules.
If the medical practice has a taxable income, each doctor pays tax on the percentage of that income equal to his or her ownership or equal to the percentage stated in the partnership agreement. Shareholders do not pay tax on cash distributed to them. The actual cash distributed is not relevant to the tax you pay unless you are just stripping the medical practice of all cash and taking cash way in excess of earnings—then other rules apply. But for now, let’s hope you are not doing that.
Here is the example I use. If your doctor owned practice has taxable income of $100K and you are the only shareholder, the practice issues you a K-1. (A K-1 is just the name of the form the company provides you with that states your share of taxable income or loss.) On that K-1 it states that your personal share of the taxable income is $100K. So you show the $100K as business income on your 1040. Think of the K-1 as another kind of W-2.
You think to yourself, “Hey, I did not take any cash distributions from the practice. There is only $20K in the bank, and my book income is only $50K. I should not pay tax on $100K.” However, that is the way it works: you pay tax on the taxable earnings of the company. It can work the other way as well. Let’s say you still have taxable earnings of $100K, but you have book income of $300K, and you have $500K in the bank. You think to yourself, “Hey, my book income is $300K. I think I’m going to take a distribution of $200K.” You pay tax only on the $100K of taxable earnings stated on your K-1. You get to take $200K out of the company and pay tax only on the $100K. So you get $200K in cash but pay tax only on what your K-1 states.
See the chart below for a better understanding of distributions versus taxable income in a medical practice.
| Distributions Versus Tax Income | Example 1 | Example 2 |
Book Income |
&50,000 | &300,00 |
K-1 FOR 100% SHAREHOLDER |
&100,000 | &100,000 |
Distributions to shareholder |
&None | &200,000 |
Shareholder pays tax on |
&100,000 | &100,000 |
Cash that you take out of the company is not what determines your taxable income for the year. There are many more rules that go along with this—basis, earnings stripping, and loans—but the concept is the most important thing to understand. You pay tax on the K-1 and not the cash distributions or the cash in the bank.
Parting Thoughts
You must understand that tax is a cost of running your own medical practice. It is a cost with no benefit to the practice, but if you are generating profits, it is there, and you must pay it. Some people think raising kids is the largest expense for their family. Some think it is the mortgage. It is neither. It is the taxes they pay. Most medical practices file partnership, S corporation, and sole proprietorship tax returns. The doctor/owners of these are taxed at the individual level. However, the tax planning and tax issues generally originate at the practice level, where they should. If they are not addressed or too much worry goes into them, either the individual doctor/owner or the business will suffer—or both.
