Whether to incorporate is a pressing question for many physicians working as independent contractors. Incorporation establishes a medical practice as a separate business entity; as a result physicians are shielded from certain types of liability and may be able to reduce taxes on business profits.
At first glance, some physicians greatly overestimate the benefits of incorporation without considering the cost and effort associated with the process. There are numerous legal, financial, and practical considerations that a doctor should weigh before taking on the additional cost and complexity of incorporating. To help you decide which business entity is most appropriate for your practice, we’ll explore the two biggest potential advantages of incorporation: reduced liability and tax advantages.
Reduced liability is one of the major reasons that physicians choose to incorporate. By shifting from a partnership or sole proprietorship to a corporation, doctors can help shield their personal assets from liability in a professional lawsuit and vice versa. However, incorporation only decreases certain types of liability, and it is important to understand the limits of its protection.
LLCs and other corporate structures (e.g., Professional Corporations, Professional Limited Liability Companies) can act as a barrier between a physician’s personal and professional assets in the event of a lawsuit or outstanding debt. If an LLC owes money to a vendor, an LLC member’s personal assets cannot be claimed by creditors. Conversely, if a corporation member or shareholder is sued because she accidentally struck and injured a pedestrian, the plaintiff would not be able to go after the medical practice’s assets for damages.
By contrast, a doctor who is a sole proprietor or partner in a medical partnership is personally liable for the debts and liabilities of an unincorporated practice. This arrangement can leave physicians exposed to extreme professional and personal liability. In the case of a general medical partnership, partners can be personally liable for the medical malpractice of a partner. Incorporation shelters physicians not only from the liability of the business entity, but also from liabilities emanating from actions of other physicians in the practice. For this reason, incorporating is highly advisable for practices with multiple physicians.
While incorporating can provide valuable protection from certain types of lawsuits, incorporation offers no protection for a physician from malpractice liability. Malpractice insurance is the only protection from lawsuits resulting from professional negligence.
In addition, professional corporations can always be exposed to liability in the event of accidents or injuries that occur on company property or in company vehicles. But, in such cases, it’s only the assets of the corporate entity that are exposed, not the personal assets of members or shareholders. Only high liability limits on business, auto and property insurance can protect your business financially in the event of such accidents, injuries or other types of claims. You can also place rental properties and other assets (e.g., equipment) with substantial liability exposure into separate LLCs – separating them from the operating side of your business/practice – which can further shield the operating entity. However, there will be additional complexity and expense as a result of incorporating these assets.
The bottom line: Incorporation does decrease physicians’ liability to a certain extent. It cannot replace other forms of insurance such as malpractice, business liability, property and auto insurance. If you are considering incorporation, you have to weigh the time, cost, and effort of incorporation against the value of reduced liability.
Preferential tax treatment is another potential benefit of incorporating a medical practice. Depending on the specific type of corporation you select, as well as your financial goals for the practice, incorporation can offer substantial tax savings. However, the precise tax benefits of incorporation vary significantly between different entities.
A simple LLC allows physicians to establish a separate business entity that passes company profits (and losses through operational expenses, equipment and real estate depreciation, etc.) through the business and directly to the LLC members. The entity itself does not have tax liability (although it will have to file an informational tax return.) Therefore your federal and state tax burden as an LLC member will not differ significantly from your tax burden as sole proprietor.
In order to benefit from the tax benefits of being compensated as a shareholder rather than merely an LLC member, you must designate your LLC as an S-Corporation. Note: some States do not permit physicians to organize themselves as an LLC and they must be organized as professional corporations.
If you have an LLC, you can choose to be taxed an S-Corp. While still a pass-through entity, S-Corps have the option to pass through income in the form of dividends to company shareholders. As a result, physicians can split their income between salary and dividend distribution. Company profit distributed as dividends are taxed at lower, favorable rates and are not subject to payroll taxes such as FICA, self-employment, or Social Security and Medicare taxes, leading to a nearly 15% reduction in taxation.
Considering the significant tax benefits of dividends, you may be wondering: Could I just pay myself a miniscule salary, and then divert the rest of the profits to be paid in lower-taxed dividends? The IRS is well aware of the temptation to use this strategy, and as a result, S-Corps regularly attract extra tax scrutiny. Tax law stipulates that payments to a corporate officer from an S-Corp must reflect “reasonable compensation” for services rendered. If auditors suspect your salaried compensation is unreasonably low, you can lose all incorporation tax benefits and find yourself embroiled in an unpleasant dispute with the IRS.
Thus, while a S-Corp designation will technically allow you to split your income between salary and dividends, you may only be able to reduce a small portion of your income. Otherwise, an unreasonably low salary will be an obvious red flag for the IRS. In addition, S-corps have stricter management and operation requirements than a simple LLC, including corporate bylaws, shareholder meetings, and stock distribution regulations. Physicians should carefully consider the cost and complexity of managing an S-corp against the tax benefits of dividend income.
If you’re considering incorporation, you may have also heard about the option of forming a C-corporation. Unlike LLCs and S-Corps, C-Corporations are not pass-through entities, and their profits are subject to corporate tax rates.
For the most part, a C-corporation tax structure will only benefit physicians if their practice maintains a substantial amount of the profit within the business. If you plan to keep a large portion of the profits in the practice in order to save up for future costs or expansion, you can reduce your taxes significantly on earnings kept within the practice. However, if you plan on distributing most of the practice earnings to shareholding physicians in the form of dividends, you will end up being taxed twice on earnings.
You might also be interested in our Disability Insurance Guide for Physicians.
It is important to note that incorporating is not a simple shortcut to automatic tax windfalls and immunity from liability. Forming an LLC does provide increased protection from operational liability and the malpractice of your fellow members, and certain LLC structures can offer valuable tax benefits. Understanding the extent of these advantages can help you determine if and when to incorporate.
Physicians should also consider the cost of establishing and maintaining a corporation. The exact legal and accounting costs will vary depending on which type of corporate entity you establish. It can range from a few hundred dollars to several thousand each year.
Once you evaluate the benefits, cost, and workload of incorporating your medical practice, only you can decide if the advantages outweigh the disadvantages. Depending on the scope of your profits or business goals, you may decide that the simplicity of operating as a sole proprietor is well worth the slightly higher liability. As the number of partners in your practice increases and your business expands, you may consider consulting an attorney and/or accountant to determine which type of corporation offers the most legal and financial protection.
Wondering if incorporation could benefit your medical practice? Talk with a Physicians Thrive advisor today.