Clinical Updates — Clinical Updates
Choosing a Business Entity for Your Medical Practice
Now that you have completed your training and are ready to enter private practice, you need to decide if you want to “incorporate” and determine which business entity is best for you based on your needs and goals. The following is information on why you should consider forming a legal entity and important aspects associated with the most common legal business entities available.
Why consider forming a legal entity?
Since physicians are personally responsible for their own professional negligence or malpractice—whether they practice with or without a legal entity—what is the benefit to having one? While a legal entity does not provide liability protection from professional negligence or malpractice, it does shield you from liabilities that result from the actions of others.
Example: A patient who slips and falls in your office and sues for injuries sustained. Rather than being sued personally, the legal entity is sued and your personal assets are not at risk.
While commercial liability insurance would likely cover such an occurrence, having a legal entity further insulates your personal assets. Other examples might include:
- Landlord and tenant disputes
- Disputes with vendors
- Liability associated with an employee or another physician/owner of the practice
Which types of entities are available to physicians?
The choices of business entities for a medical practice normally include:
- Limited liability companies (LLCs)
Each category has its own advantages and disadvantages in personal liability protection, tax treatment, flexibility, and administration. For this reason, it is important to review things in detail with your attorney and accountant before making your final decision.
A sole proprietorship is the easiest way to structure your medical practice, as no separate legal entity is formed. A sole proprietor's business is simply an extension of the sole proprietor.
Sole proprietors are liable for all business debts and other obligations the business might incur. This means that your personal assets can be subject to the claims of your business's creditors.
For federal income tax purposes, all business income, gains, deductions, or losses are reported on Schedule C of your Form 1040. While a sole proprietorship is not subject to corporate income tax, some expenses that might be deductible by a corporation may not be deductible by a sole proprietorship.
In a partnership, 2 or more people form a business for mutual profit. Therefore, if you are going to own a medical practice with at least one other physician, a partnership is a viable option to consider.
However, in a general partnership, all partners have the capacity to act on behalf of one another and with full authority on behalf of the practice. Unfortunately, this also means that each partner is personally liable for any acts of the others, and all partners are personally responsible for the debts and liabilities of the practice.
It is not necessary that each partner contribute equally to the practice or that all partners share equally in the profits; these terms will be reflected in the partnership agreement. In fact, it is common for one business partner to contribute a majority of the capital while another contributes the business acumen or contacts, and the 2 share the profits equally.
Partnerships are a recognized legal business entity in the sense that they can obtain credit, file for bankruptcy, and transfer property. However, a partnership is not itself a tax-paying entity, and generally files only an information income tax return (Form 1065); each partner receives a Schedule K-1 from that return (the income, gains, deductions, and losses of the partnership). Each partner then reports the information from the Schedule K-1 on Schedule E of Form 1040.
An S corporation is formed by filing articles of incorporation with the state. The election of S status is made by filing Form 2553 with the IRS, making a state-level S corporation election after incorporating your business; this decision must be unanimous among shareholders. An S corporation elects to have its income, deductions, capital gains and losses, charitable contributions, and credits passed through to its shareholders.
To a great extent, an S corporation is treated for tax purposes like a partnership. However, the S corporation retains some features of the corporation, such as limited liability of shareholders. S corporations also require some operational formalities, including regular meetings of shareholders and board of directors, written minutes of those meetings, and corporate resolutions authorizing certain actions.
Generally, an S corporation files only an information income tax return (Form 1120S). Each shareholder receives a Schedule K-1 from that return (for the income, gains, deductions, and losses of the S corporation) and reports the information from the Schedule K-1 on Schedule E of Form 1040.
The business will be taxed as a C corporation unless it makes an S corporation election. Though the business may consist of many owners, it is considered a single entity, separate from the owners.
An S corporation must be a domestic corporation and have no more than 10 shareholders. While an S corporation may have only one class of common stock, IRS regulations have permitted S corporations to issue both voting and nonvoting stock. Both kinds of stock, however, must have the same rights with regard to allocation and distribution of earnings.
The S corporation is also attractive because income is taxed only once—not twice, as is the case with a C corporation. The corporate alternative minimum tax (AMT) and the tax on unreasonable accumulations of income also do not apply.
Generally, if you are a shareholder physician, you are paid both as an employee of the practice with a W-2 and as an owner of the practice via a K-1 distribution. The main 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 $118,500 (for 2016), the 2.9% Medicare tax has no phase-out. Wages over $200,000 earned in 2016 will face an extra 0.9% Medicare tax, which will be withheld from employees’ wages. (Employers are not responsible for this additional tax.) In addition, qualified retirement plan contributions are limited by the W-2 income for the S corporation owner.
The consensus among certified public accountants (CPAs) is that the W-2 “salary” must be reasonable; this is the amount you could earn if you worked somewhere else in a similar capacity. The remaining amount would then be paid as a distribution to avoid paying Social Security and Medicare taxes on that income.
Generally S corporations are also audited less frequently than sole proprietorships.
A C corporation is formed by filing articles of incorporation with the state. Corporations require a great number of operational formalities including bylaws, regular meetings of shareholders and board of directors, written minutes of those meetings, and corporate resolutions authorizing certain actions.
A corporation is owned by its shareholders, who elect a board of directors responsible for managing the business. The board thus elects officers to run the company. The shareholders are investors who contribute cash, property, or services for their stock; their liability for the corporation’s debts and obligations is limited to the amount of their investments. C corporations can also have several classes of stock, such as common and preferred stock.
Corporations pay taxes at the entity level; they file a corporate tax return (Form 1120), and then may distribute the remaining earnings as dividends to the owners.
The dividends are not deductible to the corporation and are income for the owners of the corporation. Thus, a C corporation is subject to double taxation on earnings. This double taxation of corporate earnings was reduced by the 2003 tax act, which made dividends taxable at the same rate as capital gains.
Limited liability partnership (LLP)
Most states allow professionals (such as physicians, lawyers, and accountants) to form an entity similar to the LLC. A limited liability partnership (LLP) is a general partnership managed by its partners. An LLP is taxed like a partnership, but the partners’ liability for any professional malpractice of other partners is limited to partnership assets.
The partners of an LLP have more liability protection than partners of a general partnership, but still have unlimited personal liability for obligations of the practice.
To form an LLP, the partners must file a form with the secretary of state, and then renew the registration annually to maintain the protection from liability. The name of the business entity must include a designation that it is a limited liability company. (“LLP” or “LP” must appear in the name.)
Limited liability company (LLC)
An LLC is formed by filing articles of organization with the state, and all members must sign an operating agreement. Members contribute cash, property, or services, and income is apportioned according to the members’ contributions. The name of the business entity must include a designation that it is a limited liability company. (“LLC” or “LC” must appear in the name.) As a default, the LLC is taxed as a partnership or sole proprietor.
The LLC must elect to be treated as a corporation. Unlike an S corporation, an LLC permits unequal allocation of profit and loss, while affording the same limited liability that the equity owners receive when organized as a corporation.
Unlike partners in a limited partnership, all LLC members can take an active role in the operation of the business without exposing themselves to personal liability. In California, professionals are not allowed to form an LLC or professional limited liability company (PLLC) and instead must form either a professional corporation (PC) or a registered limited liability partnership (RLLP).
Professional corporation (PC)
PCs, or qualified personal service corporations, as they are sometimes known, are a special type of corporation composed of professionals who require a license to practice. The tax code defines a qualified personal service corporation as one formed under state law in which substantially all activities involve services in health, law, engineering, accounting, actuarial science, performing arts, or consulting.
To form a professional corporation, you must file articles of incorporation with the secretary of state and pay a filing fee. In contrast to an ordinary corporation, which may be formed for any lawful purpose, a professional corporation’s articles must limit its corporate purpose to practicing the profession its shareholders are licensed to perform.
Unlike ordinary corporations, professional corporations must also usually obtain approval from the state’s applicable professional licensing board. The state licensing board will ensure that all shareholders are licensed professionals in good standing. Such corporations must also identify themselves as professional corporations by including "PC" or "P.C." after the firm's name.
Most states’ laws forbid professionals from forming C or S corporations as well as LLCs. However, the urge to incorporate reflects a desire to take advantage of Internal Revenue Code provisions that grant more generous deductions or other tax benefits to corporate employee benefit plans than for similar plans created by self-employed individuals. The owners of PCs are its shareholders, who perform services for the corporation as employees.
The IRS imposes 2 tests to ensure that a corporation qualifies under state law as a personal service corporation. These tests focus on what the corporation does (the "function test") and how it is owned (the "ownership test"). If a PC does not qualify as a personal service corporation, it is generally treated under the tax code as a C corporation. However, a PC can elect to be treated for tax purposes as an S corporation.
Although the tax treatment will depend largely on how much of the outstanding stock is owned by employee-shareholders, a PC generally is a separate entity from its owners, similar to a C corporation. Therefore, it must file its own corporate tax return every year, and it may offer many of the fringe benefits available to C corporations. As noted, however, a PC can elect to be treated as an S corporation.
Qualified personal service corporations must use a calendar tax year unless a business purpose for a fiscal year is established. PCs are not taxed at the same graduated rates that apply to C corporations; they are taxed at a flat 35% rate on their taxable income. PCs are subject to the passive activity loss rules and the at-risk rules. For more information regarding these rules, be sure to speak with your accountant and attorney.
There is no single best form of ownership for a medical practice. This brief overview highlights the most common legal entities available and some important aspects of each. Consult your attorney and accountant to weigh the pros and cons of each and determine which entity best meets your needs and goals. After you have chosen your entity, be prepared to reassess your situation as your practice evolves and your personal circumstances change.
This article is intended for informational purposes. The opinions and positions expressed in the article are solely those of the author and do not represent the opinions or positions of the American Society of Retina Specialists Board of Directors, members or employees.
Gary S. Sastow, Esq. is a partner in Brown, Gruttadaro, Gaujean, Prato, PLLC, a New York-based law firm providing legal services to health care professionals and other business owners. Please email comments or questions to him at email@example.com.
Lawrence B. Keller, CFP®, CLU®, ChFC®, RHU®, LUTCF is the founder of Physician Financial Services, a New York-based firm specializing in income protection and wealth accumulation strategies for physicians. Please email comments or questions to him at Lkeller@physicianfinancialservices.com.
(Published March 2016)