The formation of pass-through entities, such as partnerships, limited liability companies (LLCs), S corporations and sole proprietorships, have long been extremely popular with chiropractors and their practices.
In fact, one form of pass-through entity, the S corporation, is currently the most-used business entity. Limited liability companies (LLCs), however, are coming on strong and are the pass-through most frequently chosen today.
Under last December’s Tax Cuts and Jobs Act (TCJA), individual tax rates—including the income of pass-through practices—have been lowered in seven tax brackets, with a top tax rate of 37 percent. In contrast, an incorporated practice will be taxed at a flat 21 percent tax rate.
To balance things out, lawmakers created a deduction of up to 20 percent for the “qualified business income” (QBI) of pass-through entities. QBI is defined as net income from a practice without counting compensation and excluding investment income.
Although the deduction from pass-through income may be good news for some chiropractic professionals who will see the top effective federal tax rate on their practice income drop, it will not help all chiropractors or practices.
Passing through practice profits
Profits are taxed only once, when applied to personal tax returns, so many chiropractors choose to operate as pass-through entities because of the protection from personal liability. By electing to operate as a pass-through entity, a chiropractor can benefit from the legal advantages available to practices with a corporate structure as well as enjoying the tax advantages available to a sole practitioner.
The main attraction of being a pass-through entity is the tax savings for both the practice and its principals. But having a pass-through designation also allows a practice to have an independent life, separate from its principals.
If a principal leaves the practice, or sells his or her shares, the pass-through entity can continue doing business relatively undisturbed. Maintaining the practice as a distinct, separate entity also creates a clear line between the principals and the practice, greatly improving the principals’ liability protection.
TCJA pass-through practices and businesses
Those chiropractic professionals operating as pass-through entities are effectively taxed on earnings at their individual tax rates, much in the manner corporate owners are taxed on wages. Now, thanks to the TCJA, pass-through income can benefit from a unique 20 percent deduction.
The TCJA’s 20 percent deduction applies to the first $315,000 of income (half that for single taxpayers) earned by practices operating as pass-through entities. For pass-through income amounts above the threshold, the new law also provides a deduction of up to 20 percent—but only for “business profits.”
Because the TCJA places limits on who can qualify, that 20 percent deduction from pass-through income applies only to business profits, generally income that has been reduced by the amount of “reasonable compensation” paid to the practice’s principal. Reasonable compensation (wage income) clearly does not qualify as pass-through income for the purposes of the 20-percent deduction. Unfortunately, there are still more, equally strong safeguards to ensure that the pass-through income deduction is not abused.
Despite being good news for many professionals, this benefit will not help certain service providers because of restrictions placed on “specified service trades and businesses.” Under the TCJA, “service businesses” are not eligible for the 20 percent deduction. These businesses include those in the fields of health care as well as “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”
For pass-through entities whose owner’s taxable income exceeds the thresholds above, an exclusion of qualified business income and wages is phased in beginning at the threshold limits, and completely phased in when taxable income reaches $207,500 for individuals and $415,000 for joint filers.
With the 20 percent deduction phased out by “reasonable” compensation paid to the practices’ principals, restrictions for practices labeled as “service businesses,” and with some chiropractic professionals facing potential tax rates as high as 29.6 percent on pass-through income, many are considering switching to the basic C corporation structure for their practices.
Lost with pass-through
Chiropractors practicing as pass-through entities lose fringe benefits while facing personal tax rates that haven’t been substantially reduced (39.6 percent is the new top personal tax rate), must also deal with the elimination of a number of itemized, personal deductions.
The vast majority of chiropractors receiving pass-through income are no longer able to deduct state and local income taxes and can write off only $10,000 of their property taxes.
As a general rule, losses from a pass-through entity cannot be claimed by S corporation shareholders, LLC members or partners in excess of the amount they have invested, i.e., their “basis” in the practice entity. Not too surprisingly, there are several other tax issues pass-through practices and businesses must consider.
Partners, for example, are considered to be self-employed—not employees—and required to file a Schedule SE with their Form 1040 and pay self-employment taxes. Because of this self-employed status, each partner is also responsible for paying his or her share of Social Security taxes and Medicare.
Partners are responsible for paying double what an employee would pay (because employers match employees’ contributions). Of course, the partners’ tax burden is reduced by an allowance for one-half of the self-employment tax that can be deducted from taxable income.
While pass-through entities are generally not subject to federal income tax, they may be liable for and required to make estimated tax payments based on the entity-level tax bill for previously unrecognized profits, known as the built-in gain (BIG) tax that results from an entity change. Other entity-level taxes include a tax on passive income, voluntary and involuntary terminations, as well as a tax on profits accumulated rather than paid out.
Switching corporate form
In the eyes of many experts, there is no longer a reason to operate any practice as an S corporation or other pass-through entity. However, converting from a pass-through entity to a regular C corporation can be a complicated process requiring quite a few adjustments.
To determine the best corporate structure for tax purposes, you need to take certain factors into account. A sale of assets by an S corporation that was formerly a C corporation during a “recognition period” is, for example, subject to the aforementioned BIG tax.
The BIG tax is imposed on an incorporated chiropractic practice at the highest corporate tax rate—21 percent—based on the appreciation in asset value from the date the incorporated practice switched to an S corporation. Shareholders may, of course, be subject to a second tax when sale proceeds are distributed.
This double tax created by imposing the BIG rules can be eliminated if the corporation holds assets and sells them only after the five-year recognition period has expired. Naturally, the longer the recognition period, the more difficult it is to avoid paying the double tax.
Entities with more than one shareholder, partner or member can elect corporate status right on the tax returns. Thus, a partnership under state laws may elect to file federal taxes as a C corporation or an S corporation by using Form 8832 (Entity Classification Election). Unfortunately, under those “check-the-box” regulations, entities formed under a state’s corporate laws are automatically classified as corporations and may not elect to be treated as any other type of entity.
Changing business entities
Changing circumstances, revised tax laws and even the success of the practice might prompt a reassessment of the entity type. Although many of the tax law’s provisions apply to all business entities, you want to have clarity regarding which type of corporate structure to file as.
Because some areas of the law specifically target each type of entity, choosing among the various options can result in significant differences in federal income tax treatment. Unquestionably, there is more to consider when choosing a structure for your practice than taxes.
Not only will a decision to change your practice entity type have an impact on your taxes but it will also affect the amount of paperwork required, the personal liability faced by the principals and, especially important in today’s economy, the practice’s ability to raise money.
To switch or not to switch?
Knowing how much income will qualify for the pass-through deduction is critical when evaluating the advantages of a pass-through practice. If earlier tax law changes are any indication, the IRS can be expected to issue guidelines to help practices switch entities without incurring penalties. In the meantime, ensuring your practice qualifies for any or all of the new provisions should be a priority. To help in this decision-making process, professional advice is strongly recommended.
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. Consult your professional adviser about issues related to your practice.