Which Tax Treatment Is Best for Your Dermatology Practice?

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When it comes to the tax treatment you choose for your dermatology practice, there is no one-size-fits-all solution, and the ideal tax treatment for one practice may be suboptimal for another. The key to minimizing the tax liability for both the practice and its owners is a thorough analysis by a corporate tax specialist who can make recommendations customized for your particular practice. Here we review the 2 leading options for the tax treatment of a dermatology practice, along with the pros and cons of each.

Tax Treatment for S and C Corporations
All businesses, including medical practices, that incorporate are automatically C corporations absent an election to become an S corporation. Both S and C corporations have separate tax ID numbers and are required to file tax returns with the federal and appropriate state tax agencies. Both entities have shareholders and can be created in any state in the country.

When a C corporation earns a profit (the difference between income and expenses), it must pay tax at the corporate level. Compensation paid to medical practice owners, as long as it is reasonable, is deductible by the corporation on its tax return (and is therefore not taxable to the corporation).

The salary received by the practice owner is taxable to the owner as wages. After the C corporation pays taxes, distributions of earnings already taxed at the corporate level can be paid to the owners in the form of dividends. These would generally be taxed to the owners as qualified dividends, thus leading to the double taxation of such earnings.

An S corporation is often referred to as a pass-through entity. Rather than paying tax at the corporate level, all income and deductions pass through to the shareholders, and the shareholders must pay tax on any S corporation income at their individual rates. In an S corporation, there is never any tax on the corporation; therefore, there is no double taxation.

Tax must be paid on the owner’s share of taxable income regardless of whether that income is paid to the owner as salary or as a distribution, and the owner’s ordinary federal and/or state income tax rates will be applied.

Double Taxation Risk for C Corporations
Many practice owners and their advisers elect to form an S corporation instead of a C corporation to avoid the C corporation’s potential double taxation. For this reason, the S corporation election is often made without these 2 important considerations:

First, the double taxation problem can be avoided by reducing profits to zero, or close to zero, at the end of the year with reasonable compensation and bonuses to the owner(s). Second, some benefits are deductible by a C corporation but not by an S corporation. Determining which of these factors might be meaningful to you can help you determine which structure is right for your practice.

Additional Deductible Benefits for C Corporations

For some dermatology practices, C corporation can be the right choice because of the deductions it allows. The corporate deduction for fringe benefits paid to employees is generally limited for shareholders owning more than 2% of an S corporation. However, a C corporation enjoys a full deduction for the cost of employees’ (including owner-employees) health insurance, group term life insurance of up to $50,000 per employee, and even long-term care premiums without regard to age-based limitations. If one has a small corporation and a lot of medical expenses that aren’t covered by insurance, the corporation can establish a plan that results in all of those expenses being tax deductible. Fringe benefits such as employer-provided vehicles and public transportation passes are also deductible.

In contrast, health insurance paid by an S corporation for a shareholder with more than 2% is not deductible by the corporation. The shareholder must generally take a self-employed health insurance deduction on their personal return. Long-term care premiums paid through an S corporation are also not deductible for these shareholders.

Lower Tax Rates for C Corporations

C corporations currently are subject to a flat 21% tax rate on taxable corporate income. For dermatology practices looking to maintain capital inside the practice rather than distributing it out, this lower tax rate could be beneficial. An S corporation owner in the highest tax bracket would have that taxable business income subject to a 37% tax rate. However, many small businesses, including medical practices, want to maximize distributions to the owners rather than maintaining capital inside the practice. In this case, an owner in the top tax bracket would be subject to the corporate tax rate of 21% plus a 20% tax on the ensuing dividend distribution and likely the 3.8% net investment income tax on the dividend as well. For a practice owner in this situation, an S corporation or a C corporation that can bonus out taxable income would be preferable.

C corporations can also take advantage of the full Section 179 expense deduction in writing off furniture and equipment in the year of purchase because they are afforded their own Section 179 deduction limitation. Shareholders of an S corporation must accumulate the Section 179 deduction among each of their pass-through entities, thus they may be limited in a given year.

Note: If your medical practice is structured as an LLC, there are 2 tax treatments in addition to S corporation and C corporation available. An LLC owned by 1 owner can be taxed as a disregarded entity and one owned by multiple owners can be taxed as a partnership. Because further discussion on these tax options is beyond the scope of this article, feel free to contact the authors to learn more.

Conclusion

Understanding the varying tax aspects of S corporations and C corporations is an important first step in determining which structure will work best for your practice. Many practices can even take advantage of the benefits provided by both C corporations and S corporations by setting up 2 distinct entities to operate different aspects of their practices. Once you have selected a structure (or structures) for your practice, your tax adviser can help you take advantage of all available benefits to maximize your potential tax savings.

David Mandell, JD, MBA, is an attorney and author of more than a dozen books for doctors. He is a partner in the wealth management firm OJM Group (www.ojmgroup.com).

Carole Foos, CPA, is a partner and tax consultant. They can be reached at 877- 656-4362 or mandell@ojmgroup.com.

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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, or as a recommendation of any particular security or strategy. 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.