To achieve maximum success, structure your practice correctly.
For tax purposes, the predominant types of enterprise structures are the regular C corporation, its pass-through small-business cousin, the S corporation, a partnership, limited liability company (LLC), or sole practitioner (akin to the sole proprietorship).
To choose among those entities is to choose among significant differences in federal income tax treatment. But there is more to choosing the right structure for a practice than tax considerations. Not only will the decision have an impact on how much is paid in taxes but it also affects the amount of paperwork required, the personal liability you will face, and your operation’s ability to raise money. State and local licensing requirements must also be taken into account.
The tax question
Of all entities, the regular C corporation is generally subject to the toughest tax bite because the earnings of an incorporated practice or business are taxed twice. First, a corporate income tax is imposed on the practice’s net earnings and then, after the earnings are distributed to the shareholder(s) as dividends, each shareholder must pay taxes separately on his or her share of the distributions.
Naturally, a corporation can reduce or even eliminate its federal income tax liability by distributing its income as salary to shareholders—employees who actually perform services for the corporation. Although this can reduce taxation at the corporate level, those who receive profits from a corporation in exchange for services must pay tax on the amount received, which is treated as salary. Fortunately, there is some relief available to individual shareholders who currently benefit from the new, lower tax rate on dividends.
This scheme of taxation differs radically from that applied to S corporations, partnerships, LLCs, and sole practitioners or proprietorships. These entities are often referred to as “pass- through” entities and do not pay an entity-level tax on their earnings. Only the principals in these practices are taxed on their share of the entity’s earnings.
Going it alone
Although the easiest structure to create is the sole practitioner involving just one individual, liability concerns frequently eliminate this entity from the starting gate. This is a shame because the tax aspects of being a sole practitioner can be especially appealing. Income and expenses from the practice are included on the sole practitioner’s personal income tax return.
What’s a friend for?
If the practice will be owned and operated by several professionals, partnerships warrant a close look. Partnerships come in two varieties: general and limited. In a general partnership, the partners manage the practice and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership does not pay tax on its income but “passes through” all profits or losses to the individual partners. Each partner is required to report profits from the partnership on his or her individual tax return. Even though the partnership pays no income tax, the partners must complete and file a partnership informational return, Form 1065.
Personal liability is obviously a concern for many chiropractors, especially those making use of a general partnership for their practice. Similar to a sole practitioner, general partners are personally liable for the partnership’s obligations and debt.
Partnerships are also more expensive to establish than sole proprietorships and often require more extensive legal and accounting services.
Incorporating and protecting
Using the corporate structure for a chiropractic practice is, as mentioned, more complex and expensive than for other types of practice entities. The resulting corporation is, however, an independent legal entity separate from its owners.
The biggest benefit from incorporating is the liability protection it provides. Although the courts are increasingly “reaching behind” the corporate structure, for the most part the debt of an incorporated practice is not considered its principal’s debt.
Corporations also continue indefinitely, even if one of the shareholders dies, sells his or her shares, or becomes disabled. Of course, on the downside, there is the double-tax paid at both federal and state levels.
Not always small: S corporations
An S corporation is merely an incorporated practice that has chosen to be treated as a partnership for tax purposes. It offers some appealing tax benefits while providing its principals with the liability protection of a corporation.
With an S corporation, income and losses are passed through to share-holders and included on their individual tax returns. As a result, there is just one level of federal income tax to pay.
On the downside, S corporations are subject to many of the same requirements corporations must follow. This results in higher legal and accounting fees. They must also file articles of incorporation, hold meetings for directors and shareholders, keep corporate minutes, and allow shareholders to vote on major corporate decisions.
Personal service corporations
Professional athletes, entertainers, chiropractors, and other professionals have long benefited from being professional corporations. It is no secret that many chiropractors incorporate because of liability concerns. As a large number of those incorporated entities involve the services of the chiropractor, they are frequently labeled as “personal service corporations” by the Internal Revenue Service—a designation that a surprising number of chiropractors have not found to be a deterrent.
Identifying certain PSCs as “qualified” and taxing them at a flat rate of 35 percent was the government’s way of reducing incentives for professionals to shelter part of their income in a corporate entity with a lower marginal tax rate. But PSCs remain popular as they afford protection against many forms of liability—and continue to provide the tax benefits of an incorporated practice.
No limits to the LLC
While S corporations remain the most popular type of entity, the limited liability company (LLC) introduced in 1997 is fast becoming the entity of choice among many professionals and businesses. An LLC is a hybrid entity, bringing together some of the best features of both partnerships and corporations.
LLCs were created to provide business owners with the liability protection that corporations enjoy without the downside of double taxation. The earnings and losses of an LLC pass through to the owners and are included on their personal income tax returns.
Although similar to an S corporation, an LLC has no limit on the number of shareholders. In fact, any “member” or shareholder of the LLC is allowed a full participatory role in a chiropractic practice’s operation.
To set up an LLC, articles of organization must be filed with the secretary of state where the practice or business will operate. Some states also require the filing of an operating agreement, which is similar to a partnership agreement.
As is the case with partnerships, LLCs do not have perpetual life. Some states stipulate that the operation must dissolve after 30 or 40 years. Technically, an LLC dissolves whenever a member quits, retires, or dies.
Despite its popularity and its many benefits, an LLC also has disadvantages. And because an LLC is a relatively new type of entity, its tax obligations vary by state.
Group practices and the PSC
Professionals in group practices are often more concerned about liability exposure for the malpractice of their co-owners than themselves. Although a PSC, LLC, or S corporation may shield a chiropractor from claims against his or her personal assets, the assets inside the practice often remain at risk. For this and other reasons, professionals often form multiple personal service corporations when engaging in group practice.
Generally, each professional forms a separate PSC in which the individual owns 100 percent of the stock in his or her corporation. The overall group practice can then be organized as a firm under one of the following methods:
- Each PSC owns a partnership interest in a firm organized as a partnership,
- Each PSC is a member of a group practice organized as an LLC, or
- Each professional owns stock in an S corporation. In turn, the S corporation contracts with the separate PSCs for professional services.
Entities with more than one member are allowed to elect their corporate status on their annual tax returns.
Thus, an entity that is a partnership under state law may elect to be taxed as a regular C corporation or even as an S corporation for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under these check-the-box regulations, entities formed as corporations may not elect to be treated as another kind of entity.
Changing circumstances, changes in tax law, and even the success of a practice can—and should—prompt a reassessment of the type of taxable entity a chiropractor and his or her practice operates as. It makes sense to ensure you are using the best entity to provide your practice and yourself with the most liability protection, benefits, and consistently lowest tax bill possible.
Mark E. Battersby is a tax and financial adviser, freelance writer, lecturer, and author located in Philadelphia. He can be reached at 610-789-2480.
Disclaimer: the author is not engaged in rendering tax, legal, or accounting advice. please consult your professional adviser about issues related to your practice.