Healthcare providers in private practice often ask whether they should form a legal entity. You need to decide if you want to “incorporate,” and to determine which business entity is best for you based on your individual needs and goals. This article will highlight why you should consider forming a legal entity, as well as review some important aspects associated with the most common legal business entities available.
Why Consider Forming a Legal Entity?
Because physicians are personally responsible for their own professional negligence or malpractice, regardless of whether they practice with or without a legal entity, what is the benefit of having one? Although a legal entity does not provide any liability protection from professional negligence or malpractice, it does shield you from liabilities that result from the actions of others.
One example may be a patient who slips and falls in your office and subsequently sues for the injuries sustained. Rather than being sued personally, the legal entity is sued, and your personal assets are not at risk. Although commercial liability insurance would likely cover such an occurrence, having a legal entity further insulates your personal assets. Other examples may include landlord and tenant disputes, disputes with vendors, and the liability associated with an employee of your practice or another physician or owner of the practice.
Choosing an Entity for Your Medical Practice
The type of business entity under which you can choose to practice normally includes partnerships, corporations, and limited liability companies (LLC). Each category has its own advantages and disadvantages in terms of personal liability protection, tax treatment, flexibility, and administration. For this reason, it is important to review all the details with your attorney and your accountant before making a final decision.
A sole proprietorship is the easiest way to structure your medical practice, because no separate legal entity is actually formed. A sole proprietor’s business is simply an extension of the sole proprietor. Sole proprietors are liable for all business debts and other obligations the business may incur. This means that your personal assets can be subject to the claims of your business’s creditors.
For federal income tax purposes, all business income, gains, deductions, or losses are reported on Schedule C of your Form 1040. Although a sole proprietorship is not subject to corporate income tax, some expenses that may be deductible by a corporation may not be deductible by a sole proprietorship.
In a partnership, 2 or more people form a business for mutual profit. Therefore, if you are going to own a medical practice with at least 1 other physician, then a partnership is a viable option to consider. However, in a general partnership, all partners have the capacity to act on behalf of one another and with full authority on behalf of the practice. This also means that each partner is personally liable for any acts of the others, and all partners are personally responsible for the debts and liabilities of the practice.
It is not necessary that each partner contributes equally to the practice or that all partners share equally in the profits, which will be reflected in the partnership agreement. In fact, in most businesses it is not uncommon for one partner to contribute a majority of the capital while another contributes the business acumen or contacts, and for the 2 partners to share the profits equally.
Although a partnership is a recognized legal business entity in the sense that the entity can obtain credit, file for bankruptcy, and transfer property, among other things, a partnership is not itself a taxpaying entity and, generally, only files an information income tax return (Form 1065). Each partner receives a Schedule K-1 from that return (the income, gains, deductions, and losses of the partnership), and then reports the information from the Schedule K-1 on Schedule E of Form 1040.
An S corporation is formed by filing Articles of Incorporation with the state. The election of S corporation status is made by filing with the Internal Revenue Service (IRS; Form 2553), making a state-level S corporation election after incorporating your business, and the decision must be unanimous among shareholders. An S corporation is a corporation that has made an election to have its income, deductions, capital gains and losses, charitable contributions, and credits passed through to its shareholders.
To a great extent, an S corporation is treated for tax purposes like a partnership. However, the S corporation retains some features of the corporation, such as limited liability of shareholders. S corporations also require some operational formalities, including regular meetings of shareholders and a board of directors, written minutes of those meetings, and corporate resolutions authorizing certain actions.
Generally, an S corporation only files an information income tax return (Form 1120S); each shareholder receives a Schedule K-1 from that return (for the income, gains, deductions, and losses of the S corporation) and reports the information from the Schedule K-1 on Schedule E of Form 1040. Without an S corporation election, the business will be taxed as a C corporation. Although the business may consist of many owners, it is considered a single entity that is separate from the owners.
An S corporation must be a domestic corporation and must not have more than 10 shareholders. Although an S corporation may have only 1 class of common stock, IRS regulations have permitted S corporations to issue voting stock and nonvoting stock. Both kinds of stock, however, must have the same rights with regard to allocation and distribution of earnings. The S corporation is also attractive because income is only taxed once, not twice, as is the case with a C corporation. The corporate alternative minimum tax and the tax on unreasonable accumulations of income also do not apply.
Generally, if you are a shareholder physician, you are paid as an employee of the practice with a W-2 form, and as an owner of the practice via a K-1 distribution. The main difference is that you pay Medicare and Social Security tax on W-2 income but not on K-1 distributions. Although the large Social Security portion of the Federal Insurance Contributions Act phases out after you reach an income of $118,500 (for 2016), the 2.9% Medicare tax has no phase-out. Wages of more than $200,000 that are earned in 2016 will face an extra 0.9% Medicare tax, which will be withheld from employees’ wages (employers are not responsible for this additional tax). In addition, qualified retirement plan contributions are limited by the W-2 income for the S corporation owner.
The consensus among experienced certified public accountants is that the W-2 “salary” must be reasonable. This is the amount that you could earn if you worked somewhere else in a similar capacity. The remaining amount would then be paid as a distribution to avoid paying Social Security and Medicare taxes on that income.
Generally, S corporations are also audited less frequently than sole proprietorships.
A C corporation is formed by filing Articles of Incorporation with the state. C corporations require a great number of operational formalities, including bylaws, regular meetings of shareholders and a board of directors, written minutes of those meetings, and corporate resolutions authorizing certain actions.
A C corporation is owned by its shareholders, who elect a board of directors, which is responsible for managing the business. The board, thus, elects officers to run the company. The shareholders are investors who contribute cash, property, or services for their stock, and their liability for the corporation’s debts and obligations is limited to the amount of their investments. C corporations can also have several classes of stock (common stock and preferred stock are good examples).
C corporations pay taxes at the entity level. They file a corporate tax return (Form 1120) and pay taxes at the corporate level, and then may distribute the remaining earnings as dividends to the owners. The dividends are not deductible to the corporation, and are income for the owners of the corporation. Therefore, a C corporation is subject to double taxation on earnings. The double taxation of corporate earnings was reduced by the Jobs and Growth Tax Relief Reconciliation Act of 2003, which made dividends taxable at the same rate as capital gains.
Limited Liability Partnership
Most states allow professionals, such as physicians, lawyers, and accountants, to form an entity similar to the LLC. A limited liability partnership (LLP) is a general partnership that is managed by its partners and is taxed like a partnership, but the partners’ liability for any professional malpractice of other partners is limited to partnership assets.
The partners of an LLP have more liability protection than partners of a general partnership, but they still have unlimited personal liability for obligations of the practice.
To form an LLP, the partners must file a form with the secretary of state, and annual renewal of registration is required to maintain the protection from liability. The name of the business entity must include a designation that it is an LLP (ie, LLP or LP must appear in the name).
Limited Liability Company
An LLC is formed by filing Articles of Organization with the state, and all members must sign an operating agreement. The members contribute cash, property, or services, and income is apportioned according to the contributions of the members. The name of the business entity must include a designation that it is an LLC (ie, LLC or LC must appear in the name). As a default, the LLC is taxed as a partnership or sole proprietor.
The LLC must elect to be treated as a corporation. Unlike an S corporation, an LLC permits unequal allocation of profit and loss, while affording the same limited liability that the equity owners receive when organized as a corporation. Unlike partners in a limited partnership, all LLC members can take an active role in the operation of the business without exposing themselves to personal liability. In California, professionals are not allowed to form an LLC or a professional LLC, and instead must form a professional corporation or a registered LLP.
A professional corporation, sometimes known as a qualified personal service corporation, is a special type of corporation composed of professionals who require a license to practice. Under the tax code, a qualified personal service corporation is defined as a corporation formed under state law in which substantially all of the activities involve services in the fields of health, law, engineering, accounting, actuarial science, performing arts, or consulting.
To form a professional corporation, you must file Articles of Incorporation with the secretary of state and pay a filing fee. Compared with an ordinary corporation, which may be formed for any lawful purpose, a professional corporation’s articles must limit its corporate purpose to the practice of the profession that its shareholders are licensed to perform.
Unlike ordinary corporations, professional corporations must usually also obtain approval from the state professional licensing board that regulates the profession. The state licensing board will ensure that all shareholders are licensed professionals in good standing. Such corporations must also identify themselves as professional corporations (by including PC or P.C. after the firm’s name).
Although most state laws forbid professionals from forming regular corporations, the urge to incorporate reflects a desire to take advantage of Internal Revenue Code provisions that grant more generous deductions or other tax benefits to corporate employee benefit plans than to similar plans created by self-employed individuals. The owners of a professional corporation are its shareholders, who perform services for the corporation as employees.
The IRS imposes 2 tests to ensure that a corporation under state law qualifies as a personal service corporation. These tests focus on what the corporation does (the “function test”) and how it is owned (the “ownership test”). If a professional corporation does not qualify as a personal service corporation, then it is generally treated under the tax code as a C corporation. Keep in mind, however, that a professional corporation can elect to be treated for tax purposes as an S corporation.
The tax treatment will largely depend on how much of the outstanding stock is owned by employee shareholders. In general, however, a professional corporation is a separate entity from its owners, similar to a C corporation. Therefore, it must file its own corporate tax return annually, and it may offer many of the fringe benefits available to C corporations. As noted, however, a professional corporation can elect to be treated as an S corporation.
Qualified personal service corporations must use a calendar tax year, unless a business purpose for a fiscal year is established and they are not taxed at the same graduated rates that apply to C corporations. Rather, professional corporations are taxed at a flat 35% rate on their taxable incomes. Professional corporations are subject to the passive activity loss rules and the at-risk rules. For more information regarding these rules, be sure to speak with your accountant and attorney, because it is beyond the scope of this article.
There is no single best form of ownership for a business. This article provides a brief overview of the most common legal entities available and highlights some important aspects associated with each. You should consult with your attorney and accountant to weigh the pros and cons of each type of legal business to determine which best meets your individual needs and goals. After you have chosen your entity, be prepared to reassess your situation as your practice evolves and your personal circumstances change.
Gary S. Sastow, Esq, is a partner in Brown, Gruttadaro, Gaujean & Prato, PLLC, a New York–based law firm providing legal services to healthcare professionals and other business owners. He can be reached at 914-949-5300 or by e-mail at firstname.lastname@example.org with comments or questions.
Lawrence B. Keller, CFP, CLU, ChFC, RHU, LUTCF, is the founder of Physician Financial Services, a New York–based firm specializing in income protection and wealth accumulation strategies for physicians. He can be reached at 516-677-6211 or by e-mail at Lkeller@physicianfinancialservices.com with comments or questions.