S corp or C corp?: Maximize tax deductions by using both structures for your medical practice

January 1, 2009

Choosing the form and structure of one's medical practice is an important decision. Most advisers to medical practices believe that the avoidance of potential double taxation makes the S corporation the logical choice. This "conventional wisdom" overlooks the potential benefits a C corporation can offer.

Keypoints:

Choosing the form and structure of one's medical practice is an important decision. Most advisers to medical practices believe that the avoidance of potential double taxation makes the S corporation the logical choice. This "conventional wisdom" overlooks the potential benefits C corporation can offer.

Basics of corporations

First, let's assume that your practice is either an S or C corporation. There is no reason to practice as a sole proprietorship or general partnership. This results in unnecessary lawsuit risk, in addition to the inability to take advantage of many valuable tax-deductible business expenses mentioned in this article.

Both S and C corporations have separate tax identification numbers and are required to file tax returns with the federal and appropriate state tax agencies. Both entities have shareholders. Both entities can be created in any state in the country.

When a C corporation earns profit, it must pay tax at the corporate level. Profit is the difference between income and expenses. Compensation paid to physicians, as long as it is reasonable, is deductible by the corporation on its tax return (and is, therefore, not taxable to the corporation). The salary received by the owner is taxable to the owner as wages.

After the C corporation pays taxes, distributions of earnings already taxed at the corporate level can be paid to the physician-owners in the form of dividends. These would generally be taxed to the physician-owners as qualified dividends, thus leading to the "double taxation" of such earnings. As you will see below, this drawback is often overrated.

An S corporation is also a separate entity that must file its own tax return. However, the S corporation is often referred to as a "pass-through" entity. Rather than paying tax at the corporate level, all income and deductions pass through to the shareholders and the shareholders must pay tax on any S corporation income at their individual rates.

Whether the income to an S corporation is paid to the physician owners as salary or as a distribution will not impact the federal or state income tax rates that will be applied to that income for the physician. There is never any tax to the corporation; therefore, there is no "double taxation" in an S corporation.

Double taxation

Mistakenly, most physicians think of S and C corporations as having exactly the same benefits. Since the C corporation has a potential double taxation, most doctors and their advisers elect to make an S election to avoid one more potential problem.

First, the double taxation problem can be easily avoided by reducing practice profits to zero, or close to zero, at the end of the year.

Secondly, after you review the next section, you will see the increased benefits the C corporation offers medical practices; you will see that the cost (in time, not money) of zeroing out a C corporation is far outweighed by the benefits.

Additional deductible benefits

Contrary to much "conventional wisdom," a C corporation can be the right choice for many small entities because of the deductions it allows. The corporate deduction for fringe benefits paid to employees is generally limited for shareholders owning more than 2 percent of an S corporation.

However, a C corporation enjoys a full deduction for the cost of employees' (including owner employees') health insurance, group term life insurance of up to $50,000 per employee, and even long-term care premiums without regard to age-based limitations.

The C corporation can also deduct the costs of a medical reimbursement plan. If one has a small corporation and a lot of medical expenses that aren't covered by insurance, the corporation can establish a plan that results in all of those expenses being tax deductible. Fringe benefits, such as employer-provided vehicles, and public transportation passes, are also deductible.

In contrast, health insurance paid by an S corporation for a more than 2 percent shareholder is not deductible by the corporation. The shareholder must generally take a self-employed health insurance deduction on his personal return.