The Corporate Decision: C- or Subchapter-

Vernon A. Schotanus, CPBC Owner, The Dental Consultant

Health professionals began incorporating their in the late 1960s. Since then, it has been debated whether they should file as a C- or a Subchapter-S Corporation. It would not surprise me if you received what sounded like good advice supporting both of these cor- porate elections. If you did not receive conflicting opinions, my guess would be you merely took the advice of one trusted advisor. I say this because the controversy between C- and S- has existed even since the laws prohibitively favored the C-Corporation. In recent years, there appears to be a trend in healthcare away from the C-Corporation to the Subchapter-S Corporation. Corporate elections were designed by the IRS to slot taxpayers into the election best suited for their needs. As a result, there are numerous corporate elections to choose from. Of all the corporate elections, the only two suitable for healthcare professionals area: C- Corporation or a Subchapter-S Corporation. On the surface, these two elections seem quite similar. For the scope of this article there are two, and in some cases three major differences. The first difference is in regard to deductions. There are certain deductions allowed to C-Corporations not permitted by Subchapter- S Corporations or S-Corporation shareholders (Table 1). The second difference is probably the most difficult to explain. It deals with C-Corporations and the taxation of profits at the corporate level should they not be distributed in a timely manner to the owners at corporate year-end. In effect, a C-Corporation needs to distribute all of its prof- its at the end of its corporate year. Failure to do so will cause the undistributed earnings to be taxed at the corporation level. The bad news is that the applied to these undistributed profits is the rate prescribed by the Personal Service Corporation’s (PSC) rules. A “PSC” is simply a definition that applies largely to C-Corporations. It determines how undis- tributed profits are taxed at the corporate level. The definition is simple: If the majority of the corporation’s gross revenue is derived from the personal services of the owners, then your busi- ness is, by definition for purposes, a PSC. Hence, healthcare professionals who incorpo- rate under subchapter C will be defined as a PSC. Those C-Corporations, that fall under the PSC defini- tion pay tax at the highest corporate rate (35%) without the benefit of the lower brackets.

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A PSC creates problems in the form of potential double taxa- ship and stock ownership only. This presents a problem as most tion. The undistributed earnings, after being reduced by the 35% group practices allocate profits by some form of production-based corporate tax rate (and corporate state tax as well) will result in net- formula. Hence the integrity of such a formula is skewed and unlike retained earnings. These net-retained earnings are then trapped in the C-Corporation, there is no effective way to correct it. The only the corporation with only three viable avenues to escape. method I know of is to have look-back adjustments, which can 1. Liquidate the corporation, which of course is impractical become tedious and cumbersome, especially as the years go by. and often not feasible. Prior to the mid 1980s, deductions were this was the largest 2. Pay a dividend to the owners. This presents a couple of prob- issue of all. Table 1 illustrates the historical differences along with lems. First is the taxation (for a second time) as the dividends the corresponding current rules. As one can see, the IRS has elimi- are reported on the owner’s individual tax returns. The sec- nated four notable differences: ond problem is that dividends must be paid based on stock 1. Retirement Plans: Of the four changes, this one is by far the ownership. This may cause problems in group practices, espe- most important. Prior to the law changes, Subchapter-S cially if profits are intended to be allocated by production. Corporations were simply not allowed to have retirement 3. Over distribute profit within three years and incur a net plans that covered its owners. From a historical viewpoint, operating loss. This is easy to do and provides a double ben- the main reason to incorporate was to avail oneself of the efit. It allows the corporation to file a net operating loss ability to fund a retirement plan. carry-back and recover the previously paid (plus inter- 2. Heath Insurance Premiums: This is next most important est). Secondly, in a group practice, it allows a production- issue. Prior to the changes, which occurred during the based allocation formula to correct itself for the year profits 1990s, Subchapter-S shareholders were unable to deduct their were not paid out on time. health insurance premiums. Now they are fully deductible. Conversely, the Subchapter-S Corporation is not subject to any 3. Corporate Owned Vehicles: Similar to changes one and form of corporate taxation. Therefore, undistributed profits do not two above, such deductions were originally not allowed. have to be bonused out to the owners by December 31 of each cal- The rules are now the same and allow S-Corporations to endar year. However, the undistributed earnings do not go away, take the deduction. nor are they trapped in the corporation. They automatically are 4. Retirement Plan Loans: Retirement plans can elect a loan taxed to the shareholders by virtue of the corporation issuing form feature whereby participants (owners included) can borrow K-1. Form K-1 (should you not be familiar with it) is submitted to up to half their account balance, but not to exceed $50,000. the IRS with the corporate tax return. It informs the IRS that the I, for one, am not a fan of plan loans, but most healthcare owner or owners must report the undistributed income on their professionals prefer to have it. The bottom line is that a respective individual tax return. This is regardless of whether the quirk in the law previously prevented Subchapter-S owner receives the actual cash or not. However, the cash can be paid Corporations from allowing retirement plan loans. This out later without consequence because the shareholders have quirk in the law was eliminated in 2001. Now Subchapter- already paid taxes on them. S Corporations are allowed to have the loan provision. This is where the potential third difference can occur. It is only The remaining four differences, separately are not all that signif- an issue with group practices. In a Subchapter-S Corporation, any icant. However, when added together they likely will sway the undistributed income is required to be allocated by stock owner- informed professional towards the C-Corporation.

Table 1: Historical and current rules regarding the most notable differences in allowable deductions C-Corp Old S-Corp New S-Corp Current Rules Rules Rules Advantage Owner Health Insurance Premiums Deductible Not Deductible Deductible None Out of Pocket Medical Reimbursement Plan Deductible Not Deductible Not Deductible C-Corp Retirement Plan Allowable Not Allowable Allowable None Eligibility for Owners To Take Retirement Plan Loans Allowable Not Allowable Allowable None Owner Disability Insurance Premiums Deductible Not Deductible Not Deductible C-Corp Owner Participation in Cafeteria Plan Allowable Not Allowable Not Allowable C-Corp Owner Automobile Deductions Allowable Not Allowable Allowable None Group Term Life Insurance Premium for $50,000 Deductible Not Deductible Not Deductible C-Corp Life Insurance Policy

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1. Out of Pocket Medical Reimbursement Plans: Prior to Self-Employment Taxes 1984, virtually all C-Corporations maintained such a plan. Self-employment taxes represent Social Security and Medicare Prior to this time the IRS allowed such plans to legally dis- taxes. Social Security is currently set at 6.2% of one’s earned (W-2) criminate and only reimburse the medical expenses of its income up to a maximum earnings of $90,000. After this level of owners. After 1984 the rules changed whereby the highest income it ceases to apply. Then, the employer has to match the tax. benefit awarded to any given owner had to be provided to Since Healthcare professionals own their own corporations, they in each eligible employee of the corporation. effect absorb both the Social Security tax and the match. So, the This usually made such programs cost prohibitive, true cost to the dentist is 12.4% (2*6.2%) of the first $90,000 of except for those situations where the only employee of the one’s W-2 income. corporation is the owner. However, times have changed. The Medicare tax rate is 1.45% and is also matched by the Health insurance premiums have escalated at an alarming employer (owners). Hence the effective rate is 2.9% (2*1.45%). It rate. A quality family policy can cost $1,000 to $1,500 per unfortunately applies to all W-2 income. month. To counteract this issue many healthcare profession- Therefore a C-Corporation, by virtue of its need to timely dis- als have revived these plans and instead of giving eligible tribute all of its profit cannot avoid any self-employment taxes. employees an annual pay raise, they instead provide an However, the Subchapter-S Corporation provides a vehicle to increase to the non-taxable benefit level of the reimburse- potentially avoid some of these taxes. The Subchapter-S ment plan. Then, they increase the deductible for the health Corporation can elect to pay part of its income as W-2 compensa- insurance to achieve lower premiums. This can result in tion and let the rest flow out via the K-1 as non W-2 income. Hence huge savings in premiums and payroll taxes. In addition, the some self-employment taxes are avoided. owner gets to participate and receive the same annual bene- In regards to this potential savings there are two basic issues you fit, all on a pre-tax basis. need to be aware of: 2. Owner Disability Insurance Premiums: C-Corporations 1. The ability to substantially save on self-employed taxes is can deduct the owner’s disability insurance premiums, S- unfortunately relegated to those who have extremely Corporations cannot. This is regardless of whether it is profitable practices. If you earn less than $250,000 you will group disability or an individual policy. In regards to indi- likely want to take as much W-2 salary as possible. Failure vidual policies, the C-Corporation is permitted to legally to do so could dramatically reduce your ability to fund the discriminate between owners and the other employees. In retirement plan on behalf of yourself. effect the C-Corporation may simply elect to only pay the Here is why. Even if you make $500,000 the retirement premiums of the owner. It should be duly noted that if the plan can only count $200,000 for its internal calculations C-Corporation pays and deducts the premium, then the when determining the owner’s contribution. Hence, assum- benefits, if received, would be taxable to the recipient; oth- ing you make enough profit it behooves you to achieve a W- erwise the benefits would be tax-free. 2 of $200,000 and leave the remaining $40–50,000 for your plan contribution costs. Therefore the potential to save on Because of this tax issue, professionals used to be the 2.9% Medicare tax becomes a function of how much inclined to pay their premiums personally (outside of the your earnings exceed $250,000; otherwise you undermine corporation). More recently the trend is to pay and deduct your own retirement funding. them through the corporation. This is because only 2% of 2. How does the IRS feel about these non-W-2 earnings? For disability policies ever pay out benefits. Furthermore only a years they have stated that they felt self-employment taxes quarter of this 2% (or one-half percent overall) ever pay out should apply. benefits on a long-term basis. So the current prevailing the- Well here comes the bombshell! They have accom- ory is to roll the dice and take the deduction. plished it! They did so by establishing revenue ruling 74-44. 3. Cafeteria Plan: This, like the medical reimbursement plan, They have even gone so far as to issue a warning to newly has become a very popular vehicle to help defray escalating created Subchapter-S Corporations as part of their notice of healthcare costs. Once again a quirk in the law prohibits acceptance of the S election. owners of Subchapter-S Corporations from participating in I filed a Subchapter-S election for a new corporation in March such plans. 2004. Below is a direct quote from that acceptance notice: 4. Group Term Life Insurance: This is probably the least signif- We would like to take this opportunity to inform you of your tax icant of the remaining differences. A C-Corporation can obligation related to the payment of compensation to shareholder establish and deduct group term life insurance premiums employees of S-Corporations. whereby the owner receives $50,000 in coverage while the When a shareholder- employee of an S-Corporation provides service other eligible employees are awarded lower coverages. The to the S-Corporation, reasonable compensation is subject to employ- lower coverages are defined by employee class––as defined by ment taxes. the IRS. Consult with your accountant or insurance agent Tax practitioners and Subchapter-S Corporations shareholders need should you have questions about how this program works. to be aware that revenue ruling 77-44 states that the internal revenue The strongest prevailing arguments for the Subchapter-S service (IRS) will re-characterize small business corporation dividends Corporation centers on the self-employment tax, easier administra- paid to shareholders as salary when such dividends are paid to the tion and practice sale and/or liquidation issues. shareholders in lieu of reasonable compensation for services.

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The IRS may also re-characterize distributions other than dividend timely corrections. Lastly, my clients preferred to know the year-end distributions as salary. This position has been supported in several results now versus waiting until February, March or later. recent court decisions. I have found that attorneys and accountants who specialize in healthcare corporations almost always recommend the C- Easier Administration Corporation. Attorneys and accountants who only service some or When it comes to administration, the only true difference is in few healthcare providers usually favor S-Corporations. It is my regards to the timing of when the corporate closing functions are belief that these advisors either do not grasp all the issues or they performed by the accountant. The C-Corporation requires this just don’t want to deal with the crunch of performing all these cor- attention precisely at year-end. So, in effect the corporation account- porate closings over the holidays. Furthermore, it is my opinion that ant needs to complete this work sometime between late December it is the responsibility of the advisor to provide the client with the th and January 15 (depending on when the corporation is required to best product available. The dentist should not suffer because the deposit payroll taxes). The accountant for a Subchapter-S accountant desires to spread out their closings to March 15th. Corporation has from late December until March 15 (or September 15 if an extension is filed) to take care of the year-end work. So the Conclusion issue is not the amount of work, (which is the same either way), but To me it is quite obvious that the C-Corporation still consis- purely the timing of when it needs to be completed. tently outperforms the S-Corporation, even given the changes in My personal bias is to get the closing work done sooner rather the law. Hopefully, the information contained in this article than later versus letting it linger into the heart of tax season. will help you realize that (at least for healthcare providers) the Furthermore, by virtue of doing the work right at year-end, the S-Corporation still takes second place to the traditional accountant has the opportunity to catch overlooked items and make C-Corporation.

Vernon A. Schotanus owns The Dental Consultant. He’s been a Certified Professional Business Consultant (CPBC) since 1985, and his exclusive focus is in the area of providing support and advice in the area of dental management. Schotanus has been a mem- ber of the Society of Medical and Dental Management Consultants (SMD) since 1982, and served as its Midwest Regional Director from 1985 to 1990. Author of a number of articles for dental management publications, Schotanus is a graduate of the University of Wisconsin with a BBA in accounting, and is also a member of the National Collegiate Honor Society (Phi Eta Sigma). Available for onsite practice evaluations, Schotanus can be reached at (262) 818-1220 or through e-mail at [email protected].

Tsunami Relief Fund Ultradent Matching Dentist Donations to $1 Million

Ultradent Products Inc. has offered to cause, and by working together we can match charitable contributions from any make a difference! dentist made toward the Tsunami Relief Any contributions/questions should Effort up to $1 million. Since January be directed toward Ms. Robyn Drown 2005, due to the kindness of many, at 800-552-5512 ext. 4137 or Ultradent is off to a good start. Working [email protected]. directly with people in the devastated areas whom Ultradent has built rela- tionships with over the years, the effort is avoiding administrative costs and 100% of the funds raised go directly to those effected. The three projects involved are an orphanage in Please send charitable Thailand, a 10-unit housing com- contributions to: plex in Indonesia and the building of Smiles for Diversity 20 homes in Sri Lanka. Attn: Robyn Drown There is a great need in each of 505 West 10200 South these countries, as families of humble South Jordan, Utah 84095 means try to gather together and rebuild their lives. Ultradent sincere- ly appreciates any contribution as it believes this to be an important

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