What Is the Best Business Structure for Doctors to Save on Taxes?
Physicians are often advised to incorporate as a limited liability company (LLC) to reduce their tax liability, but did you know that this can end up increasing taxes? Or, it can result in such minor savings that the benefit is outweighed by the costs and effort of running a corporation.
The tax effects of incorporation can be complex and will differ depending on the taxpayer’s situation. Taking time to consider the implications in your particular case is well worth the effort.
What is a limited liability company (LLC)?
An LLC is a separate legal entity from its owners. It protects the owners' assets from the business' debts and liabilities and vice versa (except for malpractice). The IRS, however, doesn't have an LLC classification. It taxes LLCs either as sole proprietorships or partnerships (for LLCs with multiple owners), while owners are taxed in their personal capacity for the business' profits, which is known as pass-through taxation.
Note that in some states, doctors can't form LLCs. Professionals such as doctors, lawyers, and engineers may have to form a professional limited liability corporation (PLLC). A PLLC is similar to an LLC, but it requires that all the owners of a PLLC hold professional licenses.
What is an S corporation (S Corp)?
There isn’t a separate entity called an S corporation (S Corp), but LLCs choose to become an S Corp for tax purposes. By doing so, a business gets taxed separately from its owners.
LLCs and S Corps are both able to deduct reasonable business expenses for tax purposes. However, with an LLC, owners must pay income and self-employment taxes on the business' profits. With an S Corp, the corporation employs the owners, and self-employment taxes are only paid on their salaries.
As S Corps don’t get taxed on income, the only tax on business profits occurs when dividends are paid to owners. Dividends are then subject to income tax in the hands of the recipients. This means S Corp owners can save self-employment taxes on the profits they pay out as dividends.
What you should know before proceeding with an S Corp
Before deciding on forming an S Corp, however, doctors should consider the following:
1. S Corp salaries must be reasonable
Before thinking you can reduce your salary to a minimum and take all your earnings as dividends, know that the IRS requires all S Corp salaries to be "reasonable." It often audits S Corps where shareholder-employee salaries look too low.
The process of determining whether a salary is reasonable can be subjective, but the factors the IRS considers include training and experience, duties and responsibilities, and time and effort devoted to the business.
Doctors, therefore, need to be sure there will be a big enough dividend after paying reasonable salaries to justify the effort and expense of setting up an S Corp. For 2021, the self-employment tax rate is 15.3 percent on the first $142,800, a combination of 12.4 percent for Social Security and 2.9 percent for Medicare. As many doctors will generally struggle to justify a reasonable salary of less than $142,800, this dramatically reduces the value of an S Corp.
2. S Corps can't account for salaries from other employers.
Employed physicians considering an S Corp for moonlighting work must be aware that the Social Security threshold won't be calculated jointly. Your S Corp must pay the full 15.3 percent on your moonlight salary, up to $142,800, even if you've already exceeded the threshold elsewhere. You can claim the employee half back when you file your taxes, but not the S Corp employer half.
3. Salaries reduce qualified business income (QBI) deductions.
Self-employed individuals and business owners are allowed to claim a deduction of 20 percent of their QBI. However, in an S Corp, QBI is calculated after paying salaries. This means you could be paying tax on an additional 20 percent of your salary. The QBI calculations are complex and subject to limits based on your taxable income, so each case is potentially different.
4. Retirement funding is based on salary.
Contributions to SEP-IRAs and 401(k)s are based on income in sole proprietorships and partnerships, but in an S Corp, it's your salary. Setting your salary low to maximize dividends can impact your tax-free retirement funding.
Additionally, S Corps can be expensive to set up and cumbersome to run. They must adopt specific bylaws, hold annual shareholders' meetings, and keep minutes of decisions. Therefore, it is recommended to do your due diligence and get professional advice on whether an S Corp will be of value in your situation.
