Common Tax Mistake Costing Physicians Thousands

Carole C. Foos

,
David B.

Too many physicians who own their own medical practice treat most or all of their income as employee compensation instead of company profits. This could cost them thousands.

Are you an owner of a medical practice taxed as a flow-through entity, such as an S corporation? Likely you are. We would estimate that 70% of medical practices operate as S corporations.

As such, you may be paid both as an employee of the practice — receiving a W-2 — and as an owner of the practice — through a K-1 distribution. The key difference between these two incomes is that you pay FICA (Medicare and Social Security) tax on the income earned as an employee but not necessarily on K-1 profit distributions.

While the large Social Security portion of FICA phases out after income of $110,100 in 2012, the 2.9% Medicare tax has no phase-out. Also, it is scheduled to increase to 3.8% in 2013 under the Patient Protection and Affordable Care Act signed into law in March 2010.

While this is only a 2.9% to 3.8% tax in 2012 and 2013, we have seen poor advice here cost physicians $10,000 or more each year, every year of their career. Over the course of an entire career this can amount to nearly half a million dollars of capital lost for no good reason!

Let’s look at two examples. Do you see yourself in any of these?

D

Situation 1: W-2

r. Smith is part of a three-doctor cardiology practice. He earns about $400,000 annually as a cardiologist. He calls the other two doctors “partners,” but technically they are co-owners of the practice, an S corporation. Each month, Smith gets paid $20,000. Then at the end of each six-month period, he gets another $80,000 based on the practice’s performance.

His accountant deems both the monthly and semi-annual payments to be salary payments. Thus, he pays Medicare tax on all $400,000 for a tax of $11,600. This, of course, is in addition to state and federal income taxes, property taxes, etc. If he works for 25 years earning the same income, he will have lost over $550,000 in Medicare taxes, assuming a 5% growth rate.

Situation 2: W-2 and K-1

Down the road, Dr. Jones is in the exact same economic situation. However, his CPA treats the monthly payments as W-2 wages and the semi-annual payments as K-1 distributions of the profit earned by the practice. Thus, he pays Medicare on $240,000 for a cost of $6,960.

If Jones works for 25 years earning the same income, he will have lost about $330,000 in FICA taxes, assuming a 5% growth rate — an improvement of over $220,000 over Smith.

Rule of thumb

Obviously, any of you reading here would not want to be Smith. Yet, we are continually astounded to see so many physicians come to us in the same position. They are having all, or most, of their income treated as W-2 when much of it is earned because of the profitability of the practice rather than the doctor’s personal services.

Wouldn’t all of us prefer to be in Jones’ situation? If we are allowed to be, yes. So, the question really is: What are the tax rules that govern this situation?

There is a simple rule of thumb to determine how much income should be treated as W-2: the amount one would need to pay an associate physician with the same training to come join your practice.

The rest of your compensation can be characterized as distributions. One CPA, practicing for over 20 years, commented “this is what I do for my clients, and when the issue has been discussed in audits over the years, the IRS finds it very difficult to argue that our client should be paid more on their W-2 than a staff member doing the same job.”

Looking again at the examples above, Smith could easily attract another cardiologist to his practice paying $250,000 salary. This would allow him to avoid Medicare tax on $150,000, which means saving over $4,000 annually. Not coincidentally, Jones is in the right situation.

As hard as physicians work, throwing away hundreds of thousands of dollars over a career — for no good reason — is a shame. Yet it happens every day.

David Mandell, JD, MBA, is an attorney, author of five books for doctors, and principal of the financial consulting firm OJM Group. Carole Foos, CPA, works at OJM Group as a tax consultant. They can be reached at mandell@ojmgroup.com or (877) 656-4362 for a free consultation to discuss 2011 taxes. You can also call for a free (plus $5 S&H) copy of

For Doctors Only: A Guide to Working Less and Building More.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.