Don’t overpay your taxes! How to avoid a costly salary issue
By David B. Mandell, JD, MBA and Sandy Stokes, MBA, CPA

Are you an owner of a chiropractic practice taxed as a flow-through entity, such as an S-corporation? Most chiropractors who are in practice with “partners” are in this situation.

As such, they are paid both as a W-2 employee of the practice and as an owner of the practice — as an S-corporation owner through a K-1 distribution.

If you are in this situation, you should be aware that the key difference between income earned as a W-2 employee and that earned through a K-1 distribution is that you pay FICA (Medicare and Social Security) tax on the income earned as a W-2, but not on K-1 distributions. While the large Social Security portion of FICA phases out after income of $90,000, the 2.9 percent Medicare tax has no phase-out.

While this is only a 2.9 percent tax, it can cost you $10,000 or more each year, every year of your career. Over your career, this can amount to nearly $500,000 of lost capital — for no good reason!

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

ARE YOU DR. SMITH?

Dr. Smith is part of a three-doctor chiropractic practice. He earns about $400,000 annually as a chiropractor. He calls the other two chiropractors 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, he gets another $80,000 or so, based on the practice’s performance.

His accountant deems both the monthly and semi-annual payments to be salary payments. Consequently, he pays Medicare tax on all $400,000, for a tax of $11,600. This, of course, is in addition to state and federal income taxes, property taxes, etc.

If Dr. Smith works for 25 years, earning the same income, he will have lost more than $550,000 in Medicare taxes, assuming a 5 percent growth rate.

OR DR. JONES?

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.

Consequently, 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 percent growth rate — an improvement of more than $220,000 over Dr. Smith.

Obviously, no one wants to be Dr. Smith. Yet, many physicians are in this position — having all, or most, of their income treated as W-2.

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 this: What are the tax rules that govern this situation?

The consensus of a number of CPAs is that you should follow a simple rule of thumb. That rule basically says that you can reasonably be paid as a W-2 salary what you would need to pay a young associate chiropractor with the same training to come join your practice. The rest of your compensation can be characterized as distributions.

One CPA, in practice for more than 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 the W-2 than a staff member doing the same job.”

Looking again at the examples above, Dr. Smith could easily attract an experienced chiropractor to his practice paying $250,000 salary. This would allow him to avoid Medicare tax on $150,000 — saving more than $4,000 annually. Not coincidentally, Dr. Jones is in the right situation.

Perhaps you do not (yet) earn $400,000 in salary like the doctors in this example. But, the moral of the article remains: As hard as you work, throwing away hundreds of thousands of dollars over a career is a shame. Yet it happens every day.

David B. Mandell, JD, MBA, is an attorney, lecturer, and author of the book Wealth Protection, M.D. He is also a co-founder of the Wealth Protection Alliance – a nationwide network of independent firms whose goal is to help clients build and preserve their wealth.

Sandy Stokes, MBA, CPA, is a member of the Alliance and has been a practicing CPA for more than 20 years. To reach either of them, call 800-554-7233.