One of the first decisions made in forming a medical practice is determining the type of legal and tax entity to be established. Both tax and non-tax considerations must be studied to make the best decision for your particular practice. Tax considerations have changed over the years — while there was a substantial tax incentive in the past to incorporate and practice under the C Corporation rules, almost all of those advantages have been eliminated or substantially reduced. So too are gone the days where physicians practicing by themselves would operate as a sole proprietorship or those operating in a group practice would do so as a general partnership. Today, while the C Corporation, the sole proprietorship and the general partnership are still available for anyone who desires them, most new medical practices find that the S Corporation and the limited liability company provide better tax and non-tax advantages under which to operate.
The advantages of incorporating and electing S Corporation status for the practice of medicine are well developed. The shareholders of a corporation generally are not liable for any corporate debt which is not personally guaranteed. While there is no way to shield against your personal professional liability concerns, the corporate form of business limits the liability of the other shareholders to their share of the corporation’s assets.
A corporation has continuity of life which means it can operate indefinitely — even after a shareholder dies. Corporation shareholders have the opportunity to transfer their ownership interests to others, usually following the terms of a separate agreement between the shareholders called a stock transfer or buy-sell agreement. This agreement generally sets the price of the stock and limits those who can hold the stock, making the transfer more controlled for all parties.
Under current tax rules there are Medicare tax savings for retirement plan contributions and corporate distributions that are not available to unincorporated practices. Shareholders of incorporated practices are considered employees and are paid wages subject to withholding taxes. These entities incorporate under state law, and require legal documentation, such as articles of incorporation, by-laws, minutes of meetings held by shareholders and the board of directors.
Additional reporting and taxes may be due if you operate as a corporation.
The limited liability company can be established under state law. States establish their own Act to govern the establishment and operation of LLCs. Alabama has such an act which allows for single or multiple members. The formation of an LLC occurs with the filing of Articles of Organization. The members (owners) of the LLC will adopt an Operating Agreement to define do’s and don’ts of operating the practice. Limited liability companies, by law, can have such legal characteristics as limited liability, centralized management, continuity of life and transferability of interests.
As the S Corporation and the LLC become what are to many the preferred choices of medical practice operation, let’s look at some considerations of choosing one over the other.
First, let’s consider some advantages of the LLC over the S Corporation. LLCs:
- Do not require any special tax election to pass income through to its owners
- Generally have no restrictions on the type of entities who can own LLC interests (S Corporations limit who can own stock)
- Have no restrictions on the number of its owners
- Can have different classes of owners
- Have much more ability to allocate income, gains and losses
- Have the opportunity for stepped up basis rules under Section 754
- Have more liberal contribution and distribution rules
- Can include debt for which they are liable to their basis for deduction purposes
There are still some areas of uncertainty for LLCs, including rules relating to allocating to liabilities, passive activity rules, allocation rules in certain circumstances, and self-employment tax rules. Particular circumstances must be studied to be sure you don’t run afoul of these areas.
Remember to review the state law in your particular state to verify that state law rules apply to you.
Now, let’s consider some advantages of the S Corporation over the LLC. S Corporations:
- Do not have to allocate pre-contribution gains under IRC Section 704(c)
- Calculate discharge of business indebtedness income at the corporation level
- State law is more developed
- Shareholders are employees for tax purposes, receiving a W-2 form for salary paid, reducing the necessity of quarterly estimated tax payments
- Retirement plan calculations are more easily calculated than LLC members
Choosing the right entity will depend on your practice’s facts and circumstances. Before making a decision, discuss the implications with your legal and tax counsel. Making the best decision is crucial to your operations.
December 2007