The way you categorize your payments may make a difference of $10,000 or more each year, every year of your career. Find out how.
Are you an owner of a dermatology practice taxed as a flow-through entity, such as an S corporation? In working with over 1,000 doctors of all specialties, we estimate that 70% of medical practices operate as S corporations. As such, you may be paid both as an employee of the practice - receiving a W-2 - and as an owner of the practice - through a K-1 distribution.
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The key difference between income earned as employee compensation (W-2) and that earned as a K-1 profit distribution is that you pay FICA (Medicare and Social Security) tax on the income earned as an employee but not necessarily on K-1 profit distributions. While the large Social Security portion of FICA phases out after income of $118,500 in 2015 the Medicare tax has no phase-out. Also, the Medicare tax increased a few years ago to 3.8% for higher income taxpayers, under the Affordable Care Act.
While this is only a 3.8% tax, we have seen poor advice here cost surgeons $10,000 or more each year, every year of their career. Over one’s career, this can amount to nearly half a million dollars of lost capital, and for no good reason.
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The above cases are hypotheticals, and any change or deviation from the circumstances discussed above could affect the outcome. However, obviously, you would not want to be Dr. Smith. Yet, we are continually astounded when we see so many physicians come to us in the same position - having all, or most, of their income treated as W-2 compensation when in fact much of it is earned because of the profitability of the practice rather than the doctor’s personal services. 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: What are the tax rules that govern this situation?
NEXT: CPAs simple rule
In discussions with tens of CPAs of our clients throughout the country, the consensus is that one should follow a simple rule: One can reasonably be paid as a W-2 salary what one would need to pay an associate physician with the same training to come join your practice. The rest of your compensation can be characterized as distributions.
One CPA, practicing for over 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 their W-2 than a staff member doing the same job.”
Looking again at the examples above, Dr. Smith could attract another dermatologist to her practice paying $250,000 salary. This would allow her to avoid Medicare tax on $150,000, saving over $5,500 annually. Not coincidentally, Dr. Jones is in the right situation.
As hard as physicians work, throwing away hundreds of thousands of dollars over a career - for no good reason - is a shame. Yet it happens every day.
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.