Incorporating to Reduce Liability and Save Taxes

Incorporating to Reduce Liability and Save Taxes Does incorporating really make sense in order to decrease liability and taxes for physicians? The White Coat Investor breaks this down for us on today's classic.

Today’s Classic is republished from White Coat Investor. You can see the original here.

Enjoy!

From time to time I hear doctors talk about incorporating in order to decrease liability and taxes. Almost without fail, the doctor overestimates the decrease in liability and taxes to be paid, especially once the costs of incorporation are taken into account. We’ll try to set the record straight here.

Should You Incorporate to Reduce Liability

Incorporating your business also won’t really help with other liability concerns, such as accidents on your property, auto accidents, or issues with other businesses you may be involved with. The best way to reduce these is to carry high liability limits on your auto and property policies, and to add on an umbrella policy. Other businesses with significant liability (such as rental properties) should be placed into limited liability companies so that your maximum liability will be limited to the value of the business. Incorporating doesn’t decrease your malpractice liability one iota. The only way to do that is to practice good medicine, have good risk management techniques, and to carry adequate malpractice insurance. Obviously, this is the greatest liability issue for most doctors.

However, there can be other liability issues, such as your employees suing you for discrimination or other issues in which incorporation can help protect your personal assets. You need to balance this decreased liability with the increased complexity and cost of incorporation.

For many doctors, incorporating probably doesn’t decrease your overall liability enough to justify the trouble.

Should You Incorporate to Save on Taxes

Remember that tax avoidance is legal and good, and that tax evasion is illegal and bad. A wise physician does many things to avoid taxes, such as funding 401Ks, keeping track of write-offs throughout the year, and giving to charity. Only a fool gets involved in tax evasion schemes.

There are basically three types of corporations as far as taxes are concerned.

C Corporations

C corporations pay corporate tax rates. The C corporation tax schedule is pretty similar to the personal tax schedule, so there is really no significant benefit for a doctor to use this structure. In fact, it introduces double taxation on money.

Consider a physician that makes his business a C corporation and earns $300,000. First, he pays $100,000 in corporate tax. Then, he distributes the money to himself as a dividend which is taxed at 15%, the dividend rate, for another $30,000 in taxes. If he hadn’t been structured as a C Corp, his tax bill would have only been $85,000 in taxes (even less if he were married), instead of $130,000. This just doesn’t make sense for most doctors, who actually want to be able to have what they earn for their services.

S Corporations and Limited Liability Companies (LLCs)

As an employee, you make a salary. Your income taxes and your payroll taxes (social security and medicare) are taken out of your pay. You’ll always pay the employee portion of the payroll taxes, and either you (if you’re a sole proprietor) or your employer will pay the employer portion. So that leaves the pass-through entities such as S corporations, limited liability companies, and professional limited liability companies (if available in your state). These entities do not pay corporate tax rates, “passing through” the tax liability to their owners, who then pay the appropriate taxes at their ordinary tax rates. As far as federal and state income taxes go, there is little difference between your tax bill if you are a sole proprietor (not incorporated), an S Corp shareholder, or an LLC member.

As an S Corp shareholder, you will be paid both a salary AND dividends. On the salary, you pay income tax and both halves of the payroll taxes. However, on the dividends, you do not pay the payroll taxes. This is a significant tax, as high as 15.3%, so not having to pay it can be pretty advantageous. This makes your incentive, obviously, to pay yourself a tiny salary and a huge dividend each year.

This is a big difference between an LLC and an S Corp. With an LLC, all of your income is subject to payroll taxes. (Although technically, an LLC can choose to be treated as a corporation, and an LLC with multiple members is taxed as a partnership.)

The IRS, of course, understands the incentive to form an S Corp to save some taxes. So they have a rule that requires your salary to be “reasonable” for the services rendered:

“Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”

There are no specific guidelines as to what reasonable compensation is, but various courts have had rulings that help to define this, so you’ll need to tread carefully in this area, probably with some qualified legal advice. The IRS has suggested the following factors should be considered when determining what reasonable compensation is

Training and experience
Duties and responsibilities
Time and effort devoted to the business
Dividend history
Payments to non-shareholder employees
Timing and manner of paying bonuses to key people
What comparable businesses pay for similar services
Compensation agreements
The use of a formula to determine compensation

So how much can you reasonably save in taxes in this situation? Well, let’s use an example from my own field.

Let’s say as a partner in my emergency medicine group I generate income of about $225 an hour, and after working 1500 hours for the year, I have an annual income of $337,500. Let’s also say that in our emergency department, we pay our prn, employee, or moonlighting physicians $150 an hour. If a moonlighting physician worked 1500 hours at that rate, he would have an income of $225,000. So “reasonable compensation” could be defined as $225,000 and you could pay yourself $112,500 as a dividend.

What would the tax savings be? Well, federal and state income taxes would be equal, and with a salary of $225,000, you’ve already maxed out your social security tax for the year. So that leaves Medicare tax. Both halves of medicare are equal to 2.9%, so 2.9% times $112,500 equals $3262.50. You would then have to subtract the costs of incorporation from that.

You can quickly see that there isn’t a huge tax savings to be had here by incorporating. It might be worth it, depending on your circumstances, but you’d have to run your own numbers.

[Update 2020: As we republish this post that originally ran in 2011, one notable update is the 199A deduction included as part of the 2018 TCJA. Although it really doesn’t apply to physicians and other specified service businesses, an S Corp has wages for its owner-employees which are often necessary for there to be any significant 199A deduction. But for a physician business, there is still no real tax benefit to incorporating other than saving payroll taxes.]

Incorporation Cost

In summary, incorporation isn’t the financial boon that many uninformed doctors think it will be. The tax savings are generally pretty limited, and it won’t decrease your main liability issues a bit. You should plan on paying at least several hundred dollars to incorporate, although you may be able to find packages on the internet that will help you do it yourself for less than $200. There are also additional legal and accounting compliance costs that will vary (you have to file a corporation tax return each year). Only you can decide how much the hassle to do it yourself is worth. Otherwise, you’ll need to pay a highly trained professional such as an attorney or accountant to take care of those tasks. You’ll probably want to incorporate in Delaware or Nevada to save on incorporation fees.

Agree or disagree? Do you think it’s worth it for doctors to incorporate to lower liability and their tax bill? Comment below!