The business entity you choose for your medical practice can have lasting consequences, particularly in light of business tax changes included in the federal tax law enacted late last year.
Are you the sole owner of your practice, or is it a partnership? What level of liability protection do you want for the practice’s partners or shareholders? All these questions could influence the type of business structure you should use for your practice, based on the various administrative and tax implications.
C Corporation or Pass-Through Business?
The business structure that you choose for your practice generally falls into one of two buckets: C corporations or pass-through entities. The primary difference is that revenue from C corporations is taxed at the entity level and again when dividends are distributed to shareholders. Pass-through businesses only pay tax once on the income tax returns of the owners and shareholders.
Pass-Through Business Options
A physician operating a solo practice should form a sole proprietorship to properly track business income and expenses separately from their personal accounts. There are relatively few requirements for establishing a sole proprietorship beyond requesting a taxpayer identification number for the business. However, sole proprietorships could expose your personal wealth to any liability created by the medical practice.
General partnerships run the same risk. If your practice is owned by multiple practitioners, a general partnership is fairly easy to form and one of the business structures where a tax is not imposed on the entity itself, only on the income tax returns of the partners. But a general partnership exposes each partner to more risk. You and your personal wealth could be liable for the practice’s debts and obligations or the legal liability of another partner.
There are several options to choose from if you decide to incorporate:
- Limited Liability Partnership (LLP): Instead of a general partnership, many medical practices form under an LLP. Under an LLP, each partner’s liability is limited to the partnership’s assets. This makes it easier to attract investors. Plus, an LLP can have limited investors who are not required to participate in the practice’s operations. As with a partnership, LLP profits and losses are filed separately on the individual income tax return of each partner. An LLP must file certification paperwork with the state where it is located and pay filing fees.
- Limited Liability Corporation (LLC): Unlike an LLP, an LLC member’s (owner’s) liability is limited to their investment in the practice. Your personal wealth is protected. However, California precludes medical practices from registering as an LLP or LLC. Instead, medical practices can form professional corporations to operate similarly to an LLP or LLC.
- S Corporation: Forming as an S corporation allows a practice to have the same limited liability as a C corporation without being exposed to the two-layered tax structure. It’s also easier to transfer S corporation interests than with LLPs and LLCs. Also, S corporations, unlike C corporations, can use the cash method of accounting. However, S corporations and LLCs may have to pay more annual taxes and fees than partnerships and could draw more scrutiny from the IRS and have to classify salaries and wages carefully.
Entity Considerations Under The Tax Cuts and Jobs Act
New tax reform made substantial changes to the tax treatment of both C corporations and pass-through entities. The Act dramatically reduced the corporate income tax rate from 35 percent to 21 percent. However, the Act also provided tax relief to pass-through entities in the form of a temporary business income deduction, but it is important to understand the limitations for some medical practice owners.
The new Qualified Business Income (QBI) deduction, also known as the Sec. 199A deduction, is a 20% tax break for pass-through entities against their flow-through income. Specifically, for tax years beginning after Dec. 31, 2017, the new 20% deduction is allowed for taxpayers who have domestic “qualified business income” from a pass-through or sole proprietorship engaged in a “qualified trade or business.”
Eligibility for the 199A deduction depends upon the type of business operated by the owner, and there are two general categories of businesses. The first category, restricted businesses, consists of any business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, financial science or any business where the principal asset is the reputation or skill of its employees. The second category, non-restricted businesses, consists of all other businesses. Owners of the latter are entitled to claim the 199A deduction regardless of their taxable income (subject to certain limitations).
Physicians can fully benefit from the 199A deduction only if their taxable income is below $157,500 for single filers and $315,000 for joint filers. For taxable income levels between $157,500 and $207,500 for single filers, and between $315,000 and $415,000 for joint filers, the 199A Deduction is phased out. Once taxable income levels reach $207,500 for single filers and $415,000 for joint filers, the 199A deduction can no longer be applied.
Even though a C corporation pays taxes at both the entity and dividend level, the lower corporate rate might make this structure more attractive than before. On the other hand, the new 20 percent deduction of your QBI is a significant outcome of the tax reform act, as long as you understand how it can be applied.
There are several complexities surrounding the deduction, particularly if your income exceeds the threshold. Each structure comes with different administrative responsibilities and tax liabilities, so it’s important to review your options with legal and accounting professionals.If you have questions about business entity choices and tax advantages offered under the new tax reform, please contact SVA.
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