Are you an employee of your practice?
By Mark E. Battersby

Are you an employee of your chiropractic practice? More importantly, at least to lawmakers and the Internal Revenue Service (IRS), does your practice compensate you, the principal/employee, for services you provide to the practice?

A number of factors contribute to the confusion this question often triggers. With a sole practitioner, all of the practice's income goes into the chiropractor's pockets, with the chiropractor paying expenses and labeling anything left as profits and taxes paid.

Although a sole practitioner is often legitimately called an "employee" of the practice, in reality the chiropractor is the practice.

When a second practice entity enters the picture, things get confused for tax purposes and the IRS often injects its opinion.

Generally, every principal/employee of a profitable chiropractic practice should receive amounts labeled as both wages and dividends. The practice can reward principals/employees with bonuses and fringe benefits, but favoring the principal/employee at the expense of others within the practice is not something the IRS allows.

Depending on the type of entity the practice is operating under, principals/employees can be sole practitioners, partners, or shareholders.

Principals/employees must, of course, include some — but not all — amounts received from their practice in their taxable income, although the tax rate usually varies depending on the payment type.

The chiropractic practice can generally claim a tax deduction for some — but not all — amounts distributed and/or paid to principals/employees as wages or salaries.

Dividends paid by the practice to shareholders are not tax deductible by the practice.

Confused? It is not surprising, given the complexity of our federal tax laws; the tax breaks, limits, and penalties which are an integral part of those laws; and the many different types of entities under which a chiropractic practice or business can operate.

The type of entity under which the practice operates (sole practitioner, partnership, corporation, S-corporation, limited liability corporation [LLC], limited liability partnership [LLP], or personal services corporation [PSC]) contributes significantly to the confusion in this area.

Also contributing to the confusion are questions concerning profits and amount of compensation paid to the shareholder/employee.

SOLE PROPRIETORS

Even the most basic of business entities, the sole practitioner, poses potential pitfalls for the unwary principal/employee. The difference between sole practitioners and their practices is often difficult to establish since the practice and chiropractor are one and the same, reporting the operation's profits on a Schedule C of their Form 1040 individual income tax returns.

Under our tax rules, the term "employee," unless otherwise indicated, specifically includes principals/employees who participate in an unincorporated enterprise as either a partner or sole practitioner. When reference is made to the "employer," a sole practitioner is his or her own employer, while a partnership is the employer of each partner.

Largely due to liability considerations, the sole practitioner (as defined by law) is becoming increasingly rare. New small, professional practices and businesses most often select limited liability (LLC and LLP) entities. The S-corporation, however, remains the single most popular entity, affording flexibility and some protection from liability.

S-CORPORATIONS

An S-corporation is simply an incorporated chiropractic practice that chooses S-corporation status. In general, an S-corporation does not pay income tax. Instead, the corporation's income and deductions pass through to shareholders much like a partnership. The shareholders report the income and deductions on their own income tax returns.

The tax treatment of fringe benefits paid to S-corporation employees is different from principals/employees who are not shareholders, or who own 2 percent or less of the outstanding S-corporation stock. The fringe benefits paid to nonshareholder employees are tax-free and the employee can exclude them from taxable wages. Those nonshareholder fringe benefits are deductible by the corporation.

Employees/principals who own more than 2 percent of the S-corporation stock, on the other hand, are not considered employees for fringe-benefit purposes, and their fringe benefits may not be tax-free. More-than-2-percent owners are treated in the same manner as partners in a partnership.

Payments to a partner for services are considered guaranteed payments to the extent the payments are made without regard to the partnership's income. Guaranteed payments are treated as made to a person who is not a member of the partnership, but only for certain purposes. This generally means the payment is included in the income of the partner.

DIVIDENDS OR COMPENSATION?

You can distribute profits from your closely-held chiropractic practice as wages or dividends. The Jobs and Growth Tax Relief Reconciliation Act of 2003 contained a provision that reduced individual income tax rates on dividends to 15 percent (5 percent for those in the 10 percent or 15 percent tax bracket).

Double taxation — taxing money once at the corporate level and once at the shareholder level — is a problem for many principals/employees. Typically, a closely-held incorporated chiropractic practice avoids double taxation by paying most of its profits in the form of a bonus or by leaving profits in the practice as accumulated earnings.

REASONABLE COMPENSATION

The IRS and the courts frequently scrutinize year-end bonuses to principals/employees because of the possibility of a disguised dividend. With tax rate reductions on dividends, the focus is now on closely-held, incorporated chiropractic practices that traditionally paid a large bonus and no dividend, but switch to a large dividend payment and no bonus since the dividend rates were reduced.

Each year, the IRS reminds S-corporations they must pay reasonable compensation (subject to employment taxes) to shareholder-employees in return for the provided services to the incorporated chiropractic practice before a nonwage distribution may be made to that shareholder-employee.

Failure to heed this warning allows the IRS to step in.

Provided an S-corporation shareholder is an employee who receives an actual distribution, the only remaining question concerns the definition of "reasonable" for a principal/shareholder/employee. Whether the amount paid for the services provided constitutes "reasonable compensation" is based upon all the relevant facts and circumstances, according to the IRS.

SELF-EMPLOYMENT TAX

Although shareholders of a so-called S-corporation are treated much the same as partners, they are not subject to the self-employment tax on their share of the S-corporation's ordinary income attributable to the business' operation. After all, a corporation is a separate entity for tax purposes.

The question of qualifying for Social Security benefits at some future date is merely one of the long-range factors couples and families operating chiropractic practices should consider. Today, married couples in business are a reality, even though many chiropractors are not aware that their own practice may be operating as a partnership.

QUESTiONS AND MORE QUESTIONS

Are you an employee of your chiropractic practice? What might have, at first, seemed to be a basic question is actually extremely complex to answer. It is also a question without a definitive answer.

Best advice: Seek professional guidance to plan your practice and your status in order to get tax breaks due to you, the principal/employee of your chiropractic practice. Professional assistance can also ensure that you do not run afoul of the tax laws in this area.

Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.

DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional advisor about issues related to your practice.