By RALPH LEVY, JR.
In prior articles in this publication, this author addressed a federal tax issue faced by practice entities- the possible attack by the Internal Revenue Service (IRS) on a common practice of incorporated medical and other types of practice groups. By use of the “zero out” technique to pay compensation to the practice group’s owners as salaries during the year and year-end bonuses, practice groups organized as ‘C’ corporations (set up as a professional corporation or professional association under local law) will pay little or no federal income taxes. The potential tax risk to this compensation method is that depending on the facts and circumstances of each situation, the IRS could disallow the compensation deduction for the “salary” and bonuses paid and treat these payments as non-deductible dividends made by the practice entity to its shareholders. In such case, the practice entity would be liable for federal income taxes on the disallowed compensation deductions.
However, the care and feeding of practice groups to avoid adverse federal income tax issues involves more than maintaining the recommended compensation practices as outlined in more detail in these prior articles. This article will discuss two other areas that could result in federal tax indigestion for practice entities.
Area #1 Avoid use of the practice group as an “incorporated pocketbook”
Owners of medical and other types of practice groups are often tempted to use the practice entity to purchase items (such as art, collectibles and food or drink) that do not relate to the specific practice for which the entity is organized. The risk in doing so is that if the IRS audits the practice entity and identifies those items as being personal in nature and not related to its business, it could deny the deductibility of the personal items and treat them as distributed as an in kind dividend to the practice’s owners. For practice entities organized as ‘C’ corporations, a disallowed deduction for items expensed by the practice entity will result in the practice entity being responsible for federal income taxes at a 21% tax rate and taxation to its owner(s) on the value of the items deemed distributed by the practice entity as a dividend (15% tax rate plus 3.8% NIIT tax). So, as a practical matter, the use of the practice entity as an incorporated pocketbook could cost the owner of the entity total taxes of 39.8% of the value of the item(s) improperly purchased or paid for by the practice entity- exclusive of any penalties, interest and fees of accountants or attorneys to defend the tax audit. This combined tax rate is higher than the highest individual income tax rate (37% for joint married taxpayers as to taxable income in excess of $693,751 for 2023). The combined cost for taxes and other items should give practice owners more than a little indigestion.
Area #2: Understand how self-employment taxes work for the practice entity
The professionals who own a practice entity should make sure that the practice entity properly pays employment taxes and that the professionals who provide services for the entity are aware of their responsibility for employment taxes whether they are practice owners or employed physicians. In addition, if the practice works with part-time providers, care should be taken to make certain that these providers are in fact independent contractors if the practice entity does not treat them as employees. Failure to comply with these rules could result in an additional area of tax indigestion for the practice entity, its owners and its part-time providers.
If the practice entity is organized as a professional corporation or a professional association (i.e., a corporation for federal tax purposes), regardless of whether or not the practice entity is taxed as an S corporation or as a regular C corporation, it should withhold and remit employment taxes from any salaries or bonuses paid to its employees (whether practice owners or not). If the practice entity is organized as a professional limited liability company (PLLC) or a similar entity under local state law, the entity must withhold and remit employment taxes on wages and bonuses paid by the PLLC to its employees who are not owners. The professionals who are owners of the PLLC must report all payments received from the PLLC as self-employment income as should all part-time providers of services to the PLLC that are not employees of the PLLC but independent contractors.