[Editor’s Note: This is a guest post from forum moderator and financial advisor Johanna Turner CPA, CFP, RLP.  She is also an advertiser on the site. It deals with an important subject that many high income professionals will deal with at some point in their career.]

When I started out as a CPA 1980, all of our doctor clients were Personal Service Corporations (PSCs). Today, I would be hard-pressed to find a PSC used by a doctor or group that has been in business for less than 20 years. So why do some doctors hang onto them? Probably because that’s what their CPA is most comfortable with – which may not be in the client’s best interests. Look around: is your CPA or attorney set up as a PSC? I doubt it – they’re mostly PLLCs or S-corporations. So what do we know today that doctors don’t know?

Johanna Fox Turner

Johanna Turner, CPA, CFP, RLP

Origin of PSCs

PSCs are a relic of the 1980s and before, when personal tax rates were higher than corporate tax rates. In order to prevent professionals from getting a tax break by incorporating, the IRS created a set of rules to define and tax PSCs. In general, your corporation is a PSC if it is owned and run by a professional(s) who must be licensed to practice that hasn’t filed an “S” election. In other words, it is a “C” corporation that pays a flat tax rate of 35% on all profits. [By the way, any corporation is, by default, a “C” corporation. It must file an election to be taxed as an “S” corporation. For the rest of this article, “corporation” will refer to a “C” corporation.]

There are a few benefits to operating as a PSC. You can choose the cash basis of accounting rather than accrual. You can deduct some benefits, such as life insurance , but amounts above $50,000 are taxable to you as an employee. You can also provide disability and dependent care fringe benefits to employees, including owners. (Note that tax-deductible disability premiums render any benefits collected as taxable.)

What are the problems of operating as a PSC? Mainly that 35% tax rate. PSC owners avoid the 35% rate by paying bonuses to shareholders at the end of each year. That’s right – all PSC owners go through the same annual ritual: prepare a draft of the tax return and then write bonus checks to lower the taxable income to as near zero as possible. Any losses must be used to offset profits of the two previous years or netted against future profits for 20 years. If you close the business or elect “S” status, however, unused losses evaporate.

What if your marginal tax rate is 39.6%? Wouldn’t it make sense to pay some tax at 35% through the corporation? Not exactly. The only way to get the remaining profit out of the PSC is to pay dividends. That means the corporation will pay 35% and the recipient will pay another 15% or 20% on the already-taxed profits, depending upon his/her tax bracket. That’s the “double taxation” problem with corporations. Since the goal is to bonus out any profits, PSCs rarely pay dividends.

Another disadvantage of corporations is that long-term capital gains do not benefit from the preferential capital gains tax rate that individuals enjoy. Any sales within a corporation that would normally generate a long-term capital gain will be taxed at 35%. In other words, you never want to use a corporation to hold appreciating property such as real estate or stocks.

If not a PSC, then what? You can choose to be self-employed or to incorporate and elect “S” status.

Self-employed

Your options are either sole proprietorship, a limited liability company (“LLC”) or another partnership structure (see below). If you choose to be an LLC, you will be a SMPLLC (Single Member Professional Limited Liability Co.) if solo or a PLLC if in a partnership.

I usually recommend self-employed for solo owners who have no employees, particularly if this is a second job. Any risk of lawsuit should already be covered by your umbrella, liability, and property and casualty insurance policies. You will not have to file a separate “business” tax return, at least for federal purposes, and you will report your profit or loss on a schedule C included with your form 1040. You can (and should) have a home office, if applicable to your needs, to deduct additional expenses. Be sure to check local zoning regulations and obtain any appropriate business licenses.

If you’re still concerned about liability, file online with your Secretary of State to become a SMPLLC. Rules and costs vary by state. The disadvantage is that you’ll likely have to file a separate state tax return and pay an annual fee, ranging from under $50 to $800 per year. The advantage, of course, is that you’ll have another layer of legal protection. If that helps you sleep better at night, it’s probably worth the cost and time. Your business will still file a schedule C attached to your 1040. (Note that PLLCs are not allowed in one state, California.)

With multiple owners, called “members”, your LLC will be required to file a partnership income tax return, Form 1065. This is required even if your spouse is your partner. Your business results will be reported on a K1 that will “flow through” to your form 1040. A partnership enjoys two special benefits that aren’t available to an S-corporation:

  • The partnership agreement governs the operations of the business, and
  • Partners are allowed to make special elections not afforded to S-corporations, in particular, the 754 election.
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The flexibility afforded by the partnership agreement allows for a partnership to allocate profit and loss disproportionately rather than under the “one class of stock” rule for S-corporations, which we’ll learn about next. The 754 election is complicated and beyond the scope of this article.

There are two more kinds of partnerships, but they are rarely used, as follows:

  • General Partnership (“GP”): each partner is fully responsible for the debts and obligations of all other partners. A GP is never used for professional practices.
  • Limited Liability Partnership (“LLP”): Occasionally used in large multi-member practices. An LLP must have one managing partner, who typically has a significant ownership stake in the practice and assumes full responsibility for the actions of all partners. The limited partners can have no say in the management of the business but have no liability exposure, either. Management activities carried on by the limited partners could cause the protective liability veil to be pierced.

The downside to being self-employed for most doctors is the Medicare tax of 2.9% you’ll owe on taxable income.

S Corporation

To be taxed as an S-corporation, a corporation files IRS Form 2553 by the 15th day of the 3rd month of the year in which you want to be taxed as an S-corporation. The IRS is extremely forgiving if you forget to file on time. We’ve successfully gone back as far as three years to elect S status, but it’s not something I would routinely recommend.

The biggest benefit of being an S-corporation is that you will not have to pay Medicare taxes on distributions (the S-corporation’s term for “dividends”). I believe this benefit is hyper-inflated for professional practices, particularly for doctors. It is important to understand that distributions are paid from retained earnings and profits that remain in the business after paying market wages to the owners.

The general “red flag” rule of thumb for S-corporation owners is to pay distributions of no more than the salary of the owner(s), or a 50:50 split. With a medical practice, however, it can be difficult to justify excess profits generated beyond the efforts of the owner(s). Non-owner employees who contribute to the profitability of the practice and produce profits beyond their compensation (i.e. – generate income when you are not working), makes excess profits possible. Otherwise, if it’s just you, the RN, and the office manager and you don’t sell anything but care, I don’t see a lot of margin for distributions.

The disadvantages to operating as an S-corporation are:

  • You are required to file annual federal and possibly state and local corporate tax returns. You will definitely need to pay a professional to prepare these forms.
  • You’ll pay unemployment and be subject to payroll compliance and reporting. Even if you’re the only employee of your moonlighting job, the business will cut paychecks to you and you must receive a W2 at the end of the year and file all necessary tax returns during the year.
  • You will need to set up an “Accountable Plan” to reimburse yourself if you have a home office. Not a deal breaker, but can be a bit of a headache to manage.
  • Because of the “one class of stock” rule, you must pay “proportionate” distributions to every owner. In other words, if you have four equal shareholders, you must distribute the same amount to each, no matter their seniority, value to the business, etc.
  • You will have to pay tax on any appreciated property removed from the business, even though you haven’t sold it. (Note that if the business sells the property, the resulting gain or loss will retain its character as capital or ordinary when passed through to you via your K1.)
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A few final points:

  • If you are a shareholder in a multi-owner S-corporation, you should be aware of an important election under IRS section 1377 for mid-year ownership changes. Shareholders have two choices for reporting the year’s results when an owner leaves or comes on board. The default is to allocate results for the whole year proportionately on each K1. Otherwise, they can choose to file under section 1377 electing to treat the year as two parts of a whole and file two part-year income tax returns. In a high-profit practice, this can be significant. Let’s say, for example, that you leave a practice mid-year and profits double after you leave the practice. You will be taxed on a proportionate amount of those profits unless all shareholders agree to file a 1377 election. In all fairness, you should pay taxes only on the profits generated while you were a shareholder. Consider including a section 1377 requirement in your shareholder agreement.
  • I have never been able to find reasonable justification for forming an LLC and then filing an S-election rather than just forming an S corporation to begin with. You will have no more liability protection and it’s just an extra step.
  • File paperwork to incorporate or form an LLC before you start your business. Otherwise, you will not have liability protection for any transactions before your entity’s official start date and you will have to file a split-year tax return. It is always complicated when you file payroll tax returns with separate EINs (Employer Identification Numbers) for the same tax year.

Can you change from one entity to another? Absolutely. Review the steps with your CPA or financial planner in order to plan ahead for any tax or liability pitfalls.

I believe a PSC is rarely – if ever – appropriate for today’s professional practice. If you’re operating as a PSC “just because”, it might be time to get a second opinion on your options.