The New Partner Committee (NPC) will be composing articles on financial information in future editions of Inside Track. The following is the first in the series:

 

To Incorporate or Not Incorporate

By Jeff Tsai, NPC Member and Gregg Miller, CEP Administrative Fellow

 

WHAT INCORPORATION IS:

A corporation is a legal entity separate from the individual where the individual is the controlling shareholder in the company.  Corporations are established to provide tax benefits or legal protections for the individual.  There are two types of corporations, a C or an S corporation that are treated differently in terms of taxes and accounting methods.  Usually an accountant and an attorney, with their concomitant fees, are involved in filing the paperwork with the state and in preparing your taxes.

 

A C corporation is essentially treated like a person. It receives an income minus its expenses (wages and “fringe benefits” paid to you, the employee).  The remainder is profit which is taxed at the corporate level.  The after-taxes income can then be used to expand the business or pay dividends to the shareholder.

 

An S corporation is a “pass-through” entity that is treated like a partnership for tax purposes.  The S corporation does not pay taxes.  Instead all income and loses flow through the company and is directly represented in the shareholder’s income taxes.  For example, if the S corporation makes $50,000, then the shareholder has to pay income taxes on the $50,000 even if the S corporation keeps all the earnings in the corporate bank account.  S corporations also offer less fringe benefits then the C corporation.

 

REASONS TO INCORPORATE:

1.  Allows limited protection of assets in the rare case of a huge lawsuit.  If there was a judgment against you greater than the limits of your malpractice insurance, the settlement could theoretically be limited to the assets in the corporation.  You are also protected from any acts of negligence committed by the other partners of your medical group.  However, professional practitioners (i.e. doctors, lawyers, accountants) typically, are still liable for their own acts of negligence and the acts of those they supervise. 

 

2.  Allows you to write off health care expenses.  The corporation can give the shareholder tax-free money to spend on health care as part of their “fringe benefits”.  However, an HSA provides similar benefits, up to $5650/yr, with substantially less hassle and costs to set up than a corporation.  If you are spending significantly more than $5650/yr on a regular basis, (for example, a child or a spouse with chronic medical condition or the need for out of network specialists) then it might be worthwhile to set up a corporation so that you can deduct their health care expenses.

 

3.  Allows important legal protection of your assets when you own multiple businesses (i.e. Smoothie Kings, real estate rental properties, etc.) or have employees.  For example, if someone is injured at your Smoothie King, they can only sue the corporation which is renting the store and has little to no assets.  They cannot sue you, the shareholder.

 

4.  Allows you some tax relief when you split you income into earned wages/salary, dividends and corporate profit.

 

a.       In a C corporation, corporate profits are taxed at lower rate (i.e. 15% for first

$50,000) as long as it remains in the corporation.  This ideally can be used to purchase items for the corporation (i.e. car).  You could also depreciate your “corporate equipment” over time and take it as a loss/deduction.

 

If however, the corporate profits are instead distributed as dividends to the shareholder, then you can be faced with double taxation -- you will have to pay income tax on top of the 15% in corporate taxes you have already paid.

 

b.  In an S corporation, only wages/salary are subject to the self-employment tax.  The

dividends portion will be exempt from the self-employment tax, providing a tax shelter.

However, the earned wages/salary portion must be reasonable for the work performed to

pass scrutiny.  For example, you cannot pay yourself a salary of $10/hr and take the rest

as a distribution to evade self-employment tax.  In our tax bracket this likely provides an

overall 2.9% relief on the distribution/dividends portion of your income.

 

REASONS NOT TO INCORPORATE:

1.  It is a hassle.  There's a lot of paperwork, a lot of new concepts, a lot of new terms to learn.  Additional hassles include keeping minutes for annual meetings, setting up a separate bank account, zeroing the balance of the corporation at the end of the year, and making sure that your wages, expenses, profits, dividends all adds up.

 

2.  It costs money.  You will have to pay annual state corporation fees.  You also will probably need a lawyer to help you set up a corporation, an accountant to help you manage the corporation and file complicated tax returns that could cost around $2000 per year.  Although there are some on-line sites that offer their services for a few hundred dollars, the time and monetary cost of setting up and maintaining a corporation could offset much of your gains in tax savings. 

 

3.  Many of the tax benefits/deductions available to a corporation are already available to the independent contractor or partner.

 

4.  401(k) and IRAs have grown over the past decades such that there is really no additional benefit to an incorporated individual versus what's available for an unincorporated individual.

 

5.  Some accountants argue that it is difficult for ED physicians to define themselves as a corporate entity when the typical ED physician has no employees and does not own an official office.  Furthermore, most of the ED physician’s income is based on a hourly compensation and comes from one source.  Filing as a corporate entity could potentially create problems during an IRS audit.

 

BOTTOM LINE:

 

Do some research yourself, talk to your accountant and fellow partners and decide what is best for you.  Some sources of information used for this article are listed below.

 

Tax Smarts for Small Business, 2E: Maximize Your Deductions Using the Latest Changes to the Tax Laws (Tax Smarts for Small Business) (Paperback)
by James O. Parker (Author)

 

Tax Savvy for Small Business: Year-round Tax Strategies to Save You Money (Paperback)
by Frederick W. Daily (Author), Diana Fitzpatrick (Editor)

 

Tax Deductions for Professionals (Paperback)
by Stephen Fishman (Author)