Imagine paying less to the IRS and loving every minute

Are you an owner of a dermatology practice taxed as a flow-through entity, such as an S corporation? In working with over 1,000 doctors of all specialties, we estimate that 70% of medical practices operate as S corporations. As such, you may be paid both as an employee of the practice - receiving a W-2 - and as an owner of the practice - through a K-1 distribution.

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The key difference between income earned as employee compensation (W-2) and that earned as a K-1 profit distribution is that you pay FICA (Medicare and Social Security) tax on the income earned as an employee but not necessarily on K-1 profit distributions. While the large Social Security portion of FICA phases out after income of $118,500 in 2015 the Medicare tax has no phase-out. Also, the Medicare tax increased a few years ago to 3.8% for higher income taxpayers, under the Affordable Care Act.

While this is only a 3.8% tax, we have seen poor advice here cost surgeons $10,000 or more each year, every year of their career. Over one’s career, this can amount to nearly half a million dollars of lost capital, and for no good reason.

Let’s look at two examples. Do you see yourself in either of these?

• Dr. Smith is part of a three-doctor dermatology practice. She earns about $400,000 annually. She calls the two other doctors “partners” but technically they are co-owners of the practice, an S corporation.  Each month, Dr. Smith gets paid $20,000. Then at the end of each six month period, she gets another $80,000 based on the practice’s performance. Her accountant deems both the monthly and semi-annual payments to be salary payments. Thus, she pays Medicare tax on all $400,000 for a tax of $12,950 at the 3.8% rate on wages exceeding $250,000 and at 2.9% on the first $250,000 of wages. This, of course, is in addition to state and federal income taxes, property taxes, etc. If she works for 25 years earning the same income, she will have lost over $615,000 in Medicare taxes, assuming a 5% growth rate.
• Down the road, Dr. Jones is in the exact same economic situation. However, his CPA treats the monthly payments as W-2 wages and the semi-annual payments as K-1 distributions of the profit earned by the practice. Thus, he pays Medicare on $240,000 for a cost of $6,960. If Dr. Jones works for 25 years earning the same income, he will have lost about $330,000 in FICA taxes, assuming a 5% growth rate - an improvement of $285,000 over Dr. Smith.

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The above cases are hypotheticals, and any change or deviation from the circumstances discussed above could affect the outcome. However, obviously, you would not want to be Dr. Smith. Yet, we are continually astounded when we see so many physicians come to us in the same position - having all, or most, of their income treated as W-2 compensation when in fact much of it is earned because of the profitability of the practice rather than the doctor’s personal services. Wouldn’t all of us prefer to be in Dr. Jones’ situation? If we are allowed to be - yes. So, the question really comes down to: What are the tax rules that govern this situation?

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In discussions with tens of CPAs of our clients throughout the country, the consensus is that one should follow a simple rule: One can reasonably be paid as a W-2 salary what one would need to pay an associate physician with the same training to come join your practice. The rest of your compensation can be characterized as distributions. 

One CPA, practicing for over 20 years, commented “This is what I do for my clients, and when the issue has been discussed in audits over the years, the IRS finds it very difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job.”

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Looking again at the examples above, Dr. Smith could attract another dermatologist to her practice paying $250,000 salary. This would allow her to avoid Medicare tax on $150,000, saving over $5,500 annually. Not coincidentally, Dr. Jones is in the right situation.

As hard as physicians work, throwing away hundreds of thousands of dollars over a career - for no good reason - is a shame. Yet it happens every day.

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This article contains general information that is not suitable for everyone.  The information contained herein should not be construed as personalized legal or tax advice.   There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances.  Tax law changes frequently, accordingly information presented herein is subject to change without notice.  You should seek professional tax and legal advice before implementing any strategy discussed herein.