Whether you are buying into a practice, forming your own, or working locum tenens, chances are that at some point you are going to be an owner of a business. As the owner of an active business, as opposed to something passive like real estate, you may have the opportunity to engage in tax planning by allocating your income between salary and dividend. This can potentially save thousands of dollars a year in taxes. However, it is important that you are aware of the reasonable compensation rules, as not following them can result in a significant tax liability far greater than the potential tax savings.

With c-corporations, the reasonable compensation rules make sure that a company reports a profit rather than pay out all of its would-be-profits as salary. This is because the profits of a c-corporation are taxable to the corporation, and then, when those profits are distributed as dividends, they are taxable again to the shareholder (hence the term “double taxation”). Medical practices try to get around this by bonusing all would-be-profits at the end of the year so that the practice has no profit or very little profit. The IRS, however, wants double taxation, and so they occasionally challenge the compensation structure of these types of businesses. How courts evaluate reasonable compensation varies by circuit, but some of the factors include the nature of the employee’s work, the size and complexity of the business, how the compensation compares to similar companies and how the compensation compares within the company (other employees and past compensation). If a medical practice pays its physicians a flat salary plus bonus tied to work performance, and then at the end of the year the practice pays another “bonus” that is not tied to work performance and is not according to a written policy, but rather according to ownership of the company, then there is some risk with that arrangement. A written, consistently implemented compensation policy is key, as is actually paying a dividend when warranted. In any event, there is little reason to be a c-corporation now because of double taxation, the risk of being subject to reasonable compensation rules, and the accumulated earnings tax on c-corporations that do not distribute their profits.

With s-corporations, the IRS is concerned with the compensation being too low, instead of it being too high with a c-corporation. This is because s-corporations are not taxed on their profits, but rather the shareholders report all of the company’s income either as wages or as dividends. The wages are subject to employment taxes, whereas the dividends are not, which is a significant tax savings. Depending on what is considered reasonable compensation, the tax savings can be as high as 12.4% on Social Security taxes for wages under $118,500 and 3.8% on Medicare taxes, which have no income limit (I’m listing the employer and employee portion, although the employer portion is tax deductible and that lowers the effective rate).

Most of us have heard the phrase, “pigs get fat, while hogs get slaughtered”, and it applies to s-corporations frequently. There are cases in which an attorney or physician attempted to take something like a $50,000 salary and a $200,000 bonus, and the IRS has a fair amount of success against such extreme situations. Although the law varies by district, some of the factors in determining reasonable compensation are the nature of the job, the education and experience of the employee, the compensation history of the company, the compensation of similar employees and the company’s written compensation arrangements. So a cardiologist making $300,000 a year in an area of the country in which cardiologists make about $300,000 a year is going to have a hard time surviving an audit if she instead takes a $100,000 salary and a $200,000 dividend. The best way to protect yourself in addition to a written compensation plan is to get a CPA to provide a reasonable compensation determination, and then use that amount as your salary with anything else a dividend.

Limited liability companies taxed as partnerships are the easiest, as the owner-employees are taxed on all profits of the company as self-employment income, so there is no reasonable compensation problem. On the other hand, there is no tax saving mechanism. In some states, though, LLCs taxed as partnerships are the preferred structure because state income taxes on corporation profits are higher than the FUTA that can be saved by moving some salary to dividend. Tennessee is a prime example of this because its excess tax on s-corporation profits (i.e. dividends) of 6.5%, plus its Hall income tax of 5% on dividends received (although it is being phased out) is currently greater than the amount of Social Security and Medicare taxes that can reasonably be saved. The take away is that the choice of entity between LLC’s and s-corporations must be determined on a state-by-state basis.

One additional consideration for LLCs is what is called a “charging order”.  A charging order basically limits the creditors of a member of a LLC to receiving the distributed profits of the debtor-member as opposed to receiving the actual membership interests, including voting rights. This gives the members of the LLC, especially the members not subject to the debt, significant leeway to limit the impact of the creditor’s collection efforts.  Not every state specifically gives the protection of charging orders, and in many states there is little or no case law involving them.  Also, there is an argument that single member LLCs do not receive the benefit of a charging order, meaning that a creditor can be assigned the membership interests. Finally, as with piercing the veil of a corporation to collect the corporation’s debts against its officers, directors and/or shareholders, there are arguments that charging orders can be pierced as well, for the same reasons as a corporate veil can be pierced.

If you are a part owner of your practice, and you are not sure whether your practice’s structure is best, ask your CPA to explain it to you, make sure you have a written compensation plan in place for any c-corporation or s-corporation and that you have some support for your position of what is reasonable compensation.